By Bryan Lee, CFP®, MBA
Life is full of unpredictable events. If you start thinking about everything that could go wrong, you’ll give yourself gray hairs and a hefty dose of anxiety. That’s where life insurance can help. It may not solve all your worries, but it does protect your loved ones if the worst-case scenario becomes a reality.
But knowing whether you need life insurance is only the tip of the iceberg. Life insurance can be complicated and is not a one-size-fits-all product. Everything from the type of insurance you get to the amount of coverage you receive will depend on your unique situation. Even though there’s no exact formula, here are a few questions to consider to help you evaluate your life insurance needs.
Do I Even Need It?
Not everyone needs life insurance. If you have enough money saved and invested so that your death would not create a financial hardship for your loved ones, a life insurance policy might be unnecessary. If you are a single young adult with no dependents, you may only need a small policy to cover the expenses of a funeral and burial – or more likely no coverage at all if you have at least some amount saved and invested to cover your final expenses. Take a good hard look at your financial situation and decide if life insurance is the right fit for you.
What Are My Options?
Once you have an idea of how much coverage you need (discussed below), you’ll then need to choose the kind of life insurance that is most appropriate for your situation. Here’s a breakdown of the two primary types of life insurance.
Term insurance offers coverage for a specified length of time, which can be anywhere from 5 to 40 years or longer. The downside to term insurance is that it only covers you for your specified length of time, so if you pass away after the term is over, no death benefit is paid to your beneficiaries. But depending on your situation, you may only need insurance for a certain time period—for example, until your kids are grown or you have enough money saved to avoid financial hardship. One of the major benefits of term insurance, as opposed to permanent insurance, is that it is usually the least expensive out-of-pocket option. Since life insurance in most cases is meant to replace lost income or to pay debts or final expenses (and not to serve as an investment vehicle or income source, although life insurance is sometimes marketed and sold for those purposes), term insurance makes sense for most people in most situations.
Permanent insurance is coverage that is not limited to a specific duration of time, meaning it can potentially last your entire life. There are several types of permanent insurance, including Universal Life, Indexed Universal Life, and Whole Life. The benefit of permanent insurance is that it can last longer than a term policy so that a death benefit will be paid to your beneficiary no matter when you die (assuming your policy has been funded properly). This type of insurance is typically much more expensive than term insurance, and for most people in most situations a permanent life insurance policy may not be necessary. Rather than paying additional premiums for a permanent policy, it often makes sense to just buy term and invest the difference in premiums.
What’s My Ideal Coverage Amount?
Finally, the question at the forefront of your mind. Accurately calculating your life insurance need requires the development of a financial plan that looks at your finances holistically. Without knowing where you’re going, how can you buy the right amount of life insurance to protect your loved ones in case life doesn’t go according to plan? Using a rule of thumb method to calculate your life insurance need can be a helpful first step, but because everyone’s situation is unique, a rough calculation can only provide a rough output, at best. If you wish to get an initial idea of life insurance needs, the method below can serve as a starting point.
The DIME Method
Conduct a needs analysis by separating your finances into different areas. Couples should do their calculations separately.
Debt and final expenses
Education costs for children
In addition to these areas, two of the biggest factors that affect how much insurance you need are your marital status and your financial dependents. The more people that depend on you, the more coverage you may need.
After calculating and totaling each of those dollar amounts, apply an income replacement multiplier to determine your needed coverage amount. The multiplier varies based on your age and the status of your home mortgage. For example, if you’re under 50 years old, you can likely use a multiplier of 20. Older couples may be able to use a multiplier of 10 or 15, depending on the number of years left on their mortgage.
Keep in mind that these are just guidelines designed to give you a general idea of the amount of insurance coverage you need. There may be adjustments for your particular situation and what makes the most sense for your family.
Put it All Together
You now have a sheet of paper with a lot of different numbers on it. Here’s how to put it all together.
Combine your annual income (multiplied by the multiplier), your mortgage balance, your debt load, estimated future financial needs, and death expenses.
Then subtract your liquid assets (think savings, life insurance policies you already hold, any college funds, etc.).
The number you end up with should give you a general idea of how much insurance you should buy.
Where Do I Start?
If you’re ready to take the plunge into life insurance, it can be helpful to talk to a financial planner and review your options. After helping clients decide on an appropriate amount of coverage, Strategic Financial Planning encourages clients to work with an independent insurance agent who can shop for coverage from many different carriers using informal inquiries based on your particular health situation to avoid denials and less favorable rate classes. Finding an agent who is not captive to one insurance company and who takes a consultative approach can save you many thousands of dollars over the years.
As a fee-only financial planning firm, Strategic Financial Planning does not sell insurance or collect commissions, nor do we receive referral fees or other third-party compensation from insurance agents or anyone else, but we can direct you to independent agents who can help put
life insurance in place. Our team is experienced with life insurance policies and can offer you guidance on the products available to you and how they can integrate into your overall financial plan. If you have questions about your life insurance policy or would like to schedule a review or discuss your options, call (972) 403-1234 or contact us online to set up a complimentary get-acquainted meeting so we can see if we are a good fit!