Most of the time, buying insurance is a straightforward endeavor. We know approximately how much our home or car is worth, so we purchase that amount of protection to replace them if an accident occurs. But when it comes to buying life insurance, how much are you worth? Because each person’s situation is unique, an individual’s goals and objectives are the driving force behind their insurance need. Here are three popular ways to calculate that need:
Rule-of-Thumb Approach: This method is the most basic and focuses on how much coverage a family needs to replace a breadwinner’s earnings while maintaining their standard of living. The general idea is that insuring for an amount equaling seven to ten times your annual gross salary will provide adequate protection in most situations.
While this approach can provide a basic estimate of your insurance need, it does not take into account individual circumstances, such as your age, the age of your dependents, or whether your home is a one- or two-income household. Like most financial planning rules-of-thumb, it provides a decent starting point but not an answer for everyone.
Income Replacement Approach: Also known as the Human Life Value approach, this method states that the economic value of a life is the present value of the future earnings of that person until retirement (i.e., replacing lost income). The amount is based on a number of factors including current after-tax income, income growth rates, expected investment returns on savings, and the remaining number of years you expect to work.
There are a few potential adjustments to consider in calculating an accurate insurance need:
- The current income value should be adjusted downwards as annual taxes and self-maintenance expenses are no longer included.
- The cost of insurance premiums is no longer being paid and should be excluded from the annual income amount. However, lost benefits such as health care should be added back in.
- Future income provided by social security should also be considered.
Needs Approach: The most common approach that usually involves a few more steps than the previous two. You can use the following formula or work with a professional to determine your insurance need:
- Sum all of your short-term needs, which likely fall into three categories: final expenses (funeral, attorney, probate), outstanding debts (credit card, auto loan, college loans), and emergency expenses (medical, auto/home repairs).
- Then add all your long-term debts and obligations, such as mortgage and college tuition expenses (using the future values).
- Add in continued living expenses, which include necessities such as food, clothing, utility bills, and transportation (using future values here, as well).
- Finally, subtract what resources you have to meet these needs. Resources include all available savings, stocks, bonds, mutual funds, and existing life insurance policies.
The remaining amount when resources are subtracted from needs is the amount of life insurance you should consider. Here is a simplified version of the above:
Short-term Needs + Long-term Needs + Living Expenses – Resources = Insurance Needed
The final part of the equation will depend on how the proceeds will be invested and the lifestyle goals of those inheriting the assets – should they be set for life or secure enough to get on without you? In general, this analysis should be done every few years, or when there is a major life event, like purchasing a home or a birth of a child.
It’s also important to remember that your life insurance need decreases with age and as you accumulate a larger savings base. For example, if you need $3 million worth of coverage when you are 30, you may only need $2 million when you turn 40. A common solution is to “stack” multiple policies, so your total coverage decreases after a certain amount of time and eventually zeroes out when you no longer need it (and should save you money in the process). This would be accomplished by purchasing three $1 million dollar life insurance policies, all with different terms (i.e., 30-year, 20-year and 10-year). Therefore, you have $3 million of protection the first 10 years, then $2 million the next 10 years, and $1 million of protection until you no longer need it or retire.
As investment and financial advisors, we are focused on managing risks in every part of our client’s lives. Life insurance can play an important role in the planning process when used appropriately. By accurately calculating your needs and deciding which policies best suits you, we can help make sure those needs are met.
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Please consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.