Life Insurance for Financial Protection
September 25, 2018 | Updated October 25, 2018
How much Life Insurance do I need?
If you’ve decided that you need life insurance, how do you know how much is enough to protect your family financially in the case of premature death? The amount of life insurance you need can be a difficult question to answer, but this article will help you understand what to expect before speaking with your insurance advisor. The appropriate amount of coverage varies for each circumstance, and the various rules of thumb, such as multiplying your income by 10, are not an effective way of determining how much you really need.
It is crucial to have the correct amount of coverage, as the money your beneficiaries receive from your death benefit will help them pay any tax liabilities and other expenses that may arise upon your death as well as help them sustain their lifestyle after you have passed away. We will walk you through a “needs-based assessment”, which will ultimately help you gain a better understanding of how to protect your family with life insurance.
A needs-based assessment considers cash and income needs that your beneficiary or beneficiaries will need to sustain their current lifestyle. Cash needs include funeral fees (last expenses), probate fees, tax liabilities, legal fees, outstanding loans, a mortgage redemption, an emergency fund and an education fund for any minor children. Income needs take into account the family’s current annual income and the percentage of this income that your family will need to maintain their current lifestyle. For example, you can decide that upon your death, with the cash needs met, your spouse will need 50% of your income while any children remain dependent, and 30% thereafter.
Within the above-mentioned cash needs, some may be categorized as permanent or temporary. Temporary cash needs are the costs that most people pay out during a set period such as a mortgage and their children’s education. On the other hand, permanent cash needs are costs including last expenses, probate fees, tax liabilities, legal fees, and an emergency fund that are required at any stage of life. It is worth considering purchasing some amount of permanent insurance that will last your whole life to cover these permanent needs.
Application of the Needs-Based Assessment
Now, there are various things to take into account when you’re determining the amount of insurance you may need to cover your family’s immediate and ongoing needs upon your death. In addition to determining these needs, it’s important to consider things such as:
How much savings do you have put away?
What insurance do you already have personally?
Do you have insurance through a work plan?
What benefits are available from the government?
For instance, Josh and Rachel have two young children. Josh is a stay at home dad and Rachel is a teacher with an income of $75,000 (nearly $60,000 after-tax). They have $50,000 of permanent cash needs including last expenses, outstanding loans, legal fees, and an emergency fund. Josh and Rachel have estimated that the cost of their children’s education will amount to $80,000. Additionally, they have a $500,000 mortgage and they are aiming to pay it over the next twenty years. These necessary costs amount to $630,000. These represent cash needs.
Now, Rachel has decided that she would like to support Josh and their children financially for as long as their children are dependent. She needs to cover 50% of her income to do this. Since the insurance death benefit is not taxed, and because she plans to insure the cash needs, she does not need to replace 100% of her income. Using the needs-based assessment approach, a professional insurance advisor will take into account a surviving spouse’s income needs and the sources discussed above. This will help determine how much insurance would be required to cover any shortfall in the event of the applicant’s death, which in Josh’s case would be $25,000/year. Moreover, taking into account inflation and a reasonable rate of return on the insurance proceeds, the advisor would determine that Rachel requires an additional $500,000 of coverage. With the help of a needs-based assessment and considering which life insurance and assets they already have, we have determined that Rachel will need a policy of approximately $1.13 million. It is important to note that if we had used the well-known rule of thumb of multiplying your income by 10 to determine your coverage, there would be a dramatic shortfall. In turn, in the event of Rachel’s premature death, their needs would not be met and Rachel’s family would struggle to be financially stable.
Now that you understand the basics of needs-based assessments, you know that having the right amount of coverage is key in protecting your family financially. Without the right coverage, your family could have trouble paying for necessary costs such as legal fees and last expenses.