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How Much Life Insurance Do You Need?

In my experience working with clients, I often find that most families do not have a plan for their life insurance needs. Because they are not sure how much insurance they need, each time they meet with a broker or agent, they buy an additional policy without a clear big picture of how much they are spending on life insurance or if their dependents have adequate protection.

When I meet with clients to go over their life insurance coverage, I first try to determine if they have a need for life insurance. Ask yourself, is there someone who is dependent on my income, such as a spouse, children, elderly parents? If the answer is no, then you don't need life insurance (there may be a few exceptions such as estate planning strategies for those with sizeable estates).

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Once you've decided that you need life insurance, you have to figure out how much to buy, which is not always an easy task. Basically, what you're trying to determine is how much your dependents need to maintain their current lifestyle if something unexpected should happen to you. The simplest way to estimate the amount of life insurance coverage is to take your annual income net of taxes and multiply it by the number of years you expect to work before retiring. For example, if your after-tax annual income is $50,000 and you plan to work another 20 years, then a $1 million policy should be sufficient to "replace" the income you would have earned to support them.

It’s important to also consider life insurance for the spouse who has little to no earned income but stay at home to take care of the children. If something unexpected happens to him or her, the working spouse will have to hire a nanny or pay for daycare in order to continue working. The amount of coverage will depend on how many years you will need a nanny or daycare and what the cost is in your area.

Another way to estimate the amount life insurance you need is to compare your surviving spouse’s “needs” (liabilities and expenses) with his or her “resources” (assets and income). Whereas the simpler calculation described above attempts to replace your income, this calculation determines what your spouse and dependents will need to cover their expenses during their lifetime. This is a bit more complicated as you have to make several assumptions about your spouse’s future income and expenses. The “needs” side of the equation is, if something happened to you, what debts would your spouse have to pay off and what are his or her future expenses, including items such as college expenses and costs during retirement. The “resources” side of the equation will be the total amount of your spouse’s future income plus current assets that are available. The difference is the total shortfall which needs to be covered by the life insurance payout. Of course this is simplifying the calculation by not taking into account inflation or investment returns. For a useful calculator that can help you estimate your life insurance needs, here is a good resource.

Your life insurance needs can change over time as you go through different stages in life. Knowing how much insurance you need can potentially save you a lot of money on premiums. Unfortunately, I've seen many situations where brokers and agents offer life insurance to clients who have no dependents or who are retired and would have to pay extremely high premiums for coverage. Integrating life insurance into your overall financial plan can help ensure that your spouse and dependents will be taken care of when they need the insurance. But at the same time, you won’t be overpaying for something you don’t need and can use the money saved from premiums during your own lifetime or eventually pass it down to your heirs.