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No one wants to think about death — but ignoring the possibility doesn’t change the fact that you still need to prepare for the worst. A big part of this planning process is buying a life insurance policy.
In writing about how to save money on life insurance, I mentioned that you shouldn’t buy too much coverage. After all, if you buy more insurance than you need, you’re just throwing money away. But that begs the question…
How much life insurance do you need?
Unfortunately, there are no easy answers. In fact, my wife and I have bought and re-bought new life insurance policies several times in the past 5-10 years as we tried to get it right. The real challenge for us has been that the “right” answer has been a bit of a moving target. As our income has increased and our responsibilities have grown, we’ve outgrown our coverage.
Given our past experiences, I thought I take some time to share what we’ve learned. Note that I’m talking specifically about term life insurance policies here. I’m a big proponent of the view that you should keep your insurance and investment needs separate — in other words, buy term and invest the difference!
Do you even need life insurance?
Depending on where you’re at in life, it’s possible that you don’t need life insurance at all. For example, if you’re single and have no dependents, you might be able to get away without buying a policy (though it might be a good idea to have enough to cover your funeral expenses). But if others depend on you for your income, then you’ll likely want at least enough coverage to replace your earning potential, at least temporarily.
Life insurance rules of thumb
If you poke around online, you’ll find a number of websites that claim that the ‘best’ approach to determining your life insurance needs is to simply buy a policy that corresponds to a certain multiple of your annual salary. The problem here is determining the correct multiple.
Should you buy a policy for 8x your annual salary? 10x? Why not 12-15x? In the end, this really boils down to what you want your life insurance to do. If you’d want your life insurance policy to provide support for your family for an extended period, you’ll obviously need more. If you’re comfortable with your insurance policy being a short-term stopgap, you can get away with less.
An alternative approach to buying an arbitrary multiple of your salary would be to use an online life insurance calculator. In this case, you enter data on anticipated one-time expenses, ongoing living expenses, timeframe, and so on. Then, the calculator will spit out an answer.
Don’t forget employer-provided coverage
Another factor to consider when determining how much life insurance to buy is whether or not you have coverage from work (and how much). In many cases, as valuable as this sort of coverage can be, it’s important to not become too dependent on it. After all, if you lose your job, you’ll also lose your life insurance coverage.
What about a non-working spouse?
Another important thing to consider is whether or not you have a non-working spouse. On the one hand, you’ll have to decide whether or not to purchase coverage for them (we did, more below). On the other hand, you also have to worry about your spouse incurring expenses that aren’t directly reflected in your salary.
Perhaps the most troublesome point in this context is health insurance. In our case, we have great health insurance coverage. Unfortunately, it’s tied to my job. Since my wife stays home with the kids, and since we’d want her to continue doing so at least for awhile, we need to plan for private health insurance.
Other factors to consider
Are you relatively early along in your career path? Do you plan on expanding your family? Do you anticipate any other major changes in the future? If so, then it’s likely that your life insurance needs will change (perhaps dramatically) in the years ahead.
There are two main ways for dealing with these sorts of things. One is to try and project your needs and size your life insurance policy accordingly. The other is to buy the right policy for today, and then simply replace it at some point in the future.
Both of these approaches have their downsides. Overbuying now means that you’ll spend more than necessary in the short term. However, if you wait to buy more coverage, you run the risk that you’ll fall ill in the interim, and your rates will increase dramatically.
How we approached it
In the end, determining your life insurance needs is a very personal matter, and broad rules of thumb are unlikely to provide you with the right answer. This last time around, my wife and I sat down and outlined exactly what it is that we want from our life insurance policies if something happened to one of us.
In short, we’d both want for our family’s lifestyle to change as little as possible. We have four young kids, and my wife stays home with them during the day. If she were to pass away, we’d need to replace her efforts at home with someone to watch the kids while I’m at work, help around the house, etc. Thus, even though she doesn’t generate any outside income, she provides significant value to the family and we need for her to be insured.
Likewise, if I were to die, we wouldn’t want for her to suddenly have to go back to work. Therefore, we’d need to completely replace my income for the foreseeable future. We’d also need for the payout to be large enough to cover new expenses like private health insurance since our health insurance is currently tied to my job.
How much life insurance do we have?
In the end, we bought a pair of twenty year term life insurance policies to cover us. We selected twenty years because that roughly corresponds to the time at which our kids will be out of the house and completely on their own. At that point, our day-to-day responsibilities, as well as our need for life insurance coverage, will drop off dramatically.
In terms of amounts, my policy is worth roughly 20x the income from my day job. That might sound like a lot, but I also make a decent amount of self-employment income, so it’s a much smaller multiple of my total annual income. On top of this, I also have a limited amount of coverage — 3x my annual salary — through my day job. The nice thing about the employer coverage is that it rises with my salary, such that our total coverage will grow slightly over time.
In my wife’s case, we bought a smaller policy, corresponding to roughly one-third of my coverage. As noted above, it’s important for us to have coverage for her, as we’d want to maintain a very similar way of life for our family even if one of us were out of the picture. We’d need to hire someone to help with the kids, help keep the house in order, etc. However, since my wife doesn’t currently generate any outside income, we can get away with less coverage for her.
Deciding how much life insurance you (or your spouse) need is a very individual process. But thinking about what you want your insurance policy to be able to provide, and the expenses you’d need to be able to cover, is a great starting point.
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