One of the most commonly asked questions when considering the purchase of life insurance is “How much life insurance do I need? The truth is that there is not a cut and dry answer. While many financial advisors incorrectly advise buying ten times your income, the real answer is that the amount of insurance you need is totally subjective. In other words, it’s based on your specific situation and your objectives.
How much Life Insurance Do I Need?
The first thing you should do when determining the amount of life insurance you should buy is to ask yourself the question, “What is the real purpose for the insurance?” or “Why am I buying life insurance in the first place?” This is the best starting point and your answer could be based on a combination of any number of factors including your current income and debt, your retirement accumulation and savings, your current mortgage balance, college needs and potential inheritances among other things. So therefore, there is not a “black and white” solution.
No one situation is exactly the same, so there is no set defined principal for determining how much life insurance you need. You hear financial advisors and other people on TV talking about 10 times your current income, but for some this may result in being considerably over insured or for others even worse, underinsured. Since everyone’s financial circumstance and goals are different, you basically have to look at your own situation and actually assess how much life insurance will keep your family on the same standard of living whether you life or die. The formula for working through this calculation is called the needs based approach and is very effective for coming up with the correct amount of life insurance given your specific needs. You can also plug in your information into our life insurance needs calculator right on this website to get an idea of how much life insurance you should buy.
Needs Based Approach or Needs Analysis
The best way to determine your life insurance need is to do a “needs analysis”. This process assures that you take each of the most important variables into account and thereby assures that you have just the right amount of protection. The needs analysis is designed to cover two important aspects: Immediate or cash needs and income replacement.
You’ll start by gathering all of your financial information, establishing what your family members will need after you are gone to maintain your current standard of living. For immediate needs or cash needs, these may include funeral costs, medical expenses, mortgage and other debt, credit cards, taxes, estate costs, college planning etc.
Next, you need add up all the resources that your surviving family members could draw from to support themselves financially. In other words, cash on hand, existing life insurance, real estate income, 401(k)’s, IRA’s and any other saving and investments. Additionally, you need to factor in the effects of inflation and assumptions about how much your investments will earn over the long-term. The difference between your immediate cash needs and your savings, investments and other income sources is your need for additional life insurance.
Now that you have your cash needs determined, you can look at the other side of the equation which is income needs. The need for ongoing income to maintain your family’s same standard of living is crucial. Probably your most valuable asset is your ability to earn an income and you will certainly want to protect your human life value. To determine your income needs, you need to subtract your spouse’s income and any social security that you may receive (optional) from the amount of insurance calculated from the cash needs analysis. For a more detailed explanation and worksheet see the printable “Needs Analysis” brochure. You can then determine the amount of ongoing income that will be needed for your family. Usually, this is 60-70% of your current total income.
Then you can determine what you’re comfort level is regarding enough income to sustain your family’s lifestyle and divide that number by 3%, 4%, 5% depending on how conservative you are. For example, if your annual income need is 50,000, you can divide that by 5% which equals a life insurance need of $1,000,000. In these economic times, a 5% (after tax) rate of return is hard to find, so obviously the lower the interest rate you use, the higher the amount of need you will be looking at.
How much insurance should I buy?
As you can see, it’s really up to you as to the amount of life insurance you feel like you need and should buy. The main thing is to make sure that you purchase an adequate amount of life insurance so that your family’s basic needs are met and where they can continue to live at a similar standard of living. At MEG, we believe that with careful thought and attention to detail, you can determine the appropriate amount of life insurance that meets your needs without running the risk of being over insured. We are available toll free at (877) 583-3955 to take as much time as needed answering your questions and helping make sure that you consider all of the variables and buy the right amount of life insurance to protect your family.