The reason that people buy life insurance is simply to provide for their dependents when they are no longer around to do so. However, as life, and death, is highly unpredictable and certainly none of us come with a predetermined ‘expiration date’ it can be rather hard to accurately predict just how much life insurance you should buy to meet how much you really need.
Like any other financial decision there is no one easy ‘one size fits all’ answer to the question ‘how much life insurance do I need?’.
The answer to the question for you personally will depend upon several factors, including:
- Your age.
The ages of your spouse and children.
Your mortgage and other debts.
College expenses for your children and/or spouse.
The desired size of the last bill you’ll ever incur: your funeral expenses.
But even these basics will change over time. In many cases before the need to tap your life insurance policy occurs your kids will long be out of college and working and at least building families of their own, essentially taking them out of the equation.
But what, not to be too morbid, if the very worst happens and you are no longer around to support your family a year from now? If you had not figured in things like college expenses your children – and your spouse – may be in a sticky financial spot you didn’t mean to put them in.
To help people more effectively address this guessing game, and the question how much life insurance do you really need, insurance companies and expert financial planners have devised models to help them better ‘zero in’ on what is essentially a perpetually moving target. These three approaches are most commonly used:
The Shortfall Calculation
The method basically works backward from the ideal annual income you would want to leave your dependents for X number of years after you die, whenever that happens to be. Once you decide upon on this target figure, you then subtract all other sources of annual income that will be available to them, such as your savings, your spouse’s salary and any other benefits your family may become entitled to. The resulting number is the shortfall you’ll want to replace with life insurance coverage.
Multiples of Income Calculation
This method works along the premise of the classic insurance industry standard that recommends that the death benefit, or payout amount, of your life insurance policy should be seven to 10 times your annual income.
This is a rather simplistic method and not always one that a younger person should follow as it is unlikely they have reached their maximum earning potential yet. However, for an older, more established individual it may work out well.
The Income Generator
There are some people who prefer to set their sights upon building a larger life insurance investment that would generate earnings to provide a beneficiary with annual income.
The problem with this method, potentially, is just who do you plan on providing an annual income for. Just your spouse? But what about your kids? If, gosh forbid, you were to die tomorrow your 12 and 13 year old children would have a difficult time getting jobs to support themselves. So again, this method is perhaps better suited to an older, more established person.
Finally there is no shame in asking a professional for help. An independent insurance broker or financial advisor is rarely vested in selling you a particular policy so they can provide the objective guidance and advice you need.