How Much Life Insurance Do I Need?

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Guest post by Drake Richey
Drake is an advisor at Bush & Company, a boutique financial advisory firm.

Life Insurance is insurance that pays out a sum of money either on the death of the insured person or after a set period of time. It is an important part of our financial picture when we get married, have kids, or when we retire. It is a cost-effective way of protecting our income during our working years and can be pivoted to be used in other ways too.

How Much Life Insurance Is Right for Me?

Every situation is different, and there is no one size fits all piece of financial advice that we can lay out for you. That being said, there are some generally accepted guidelines and rules of thumb.

Start with your replacement value: How much money would it take to replace your income for the rest of your working life?

If you are younger (under 40 years old): You want a sum of insurance that is a greater multiple of income (20-30x) because you are protecting against more years of lost income.

Older (greater than 50 years old): You want a sum of insurance that is a lesser multiple (10-20x), because you have less working years ahead of you.

Takeaway: The amount of insurance you want depends on your personal situations, but most people start the calculation thinking about replacing their income, from today through retirement age.

Making Adjustments for Life Insurance Coverage Amounts

Adjustments are other financial factors in your life you consider when choosing the right amount of coverage for your policy. The most common adjustment people make is based on their net worth and employer paid (or group) life insurance. The more net worth or group life insurance through work you have, the less term insurance you might want.

Net Worth Life Insurance Adjustments

Stress test your net worth: Bear in mind the uncertainty of your personal situation as well as the global economic situation. Will your net worth be the same when you die as it is today?

What will the world be like when you die: What will inflation be like when you die prematurely, what will your family’s lifestyle expenses be, what will the financial markets be like (up or down?), what will be the rate of return you can expect on money at a conservative risk level? Too heavy?

Make adjustments, but don’t let your assumptions be too rosy.

Takeaway: People often reduce the amount of life insurance they buy by a portion of their net worth. If your net worth is so big that no one depends on your income, then you likely don’t want term insurance, if you have zero or negative net worth you probably do. Everyone else falls somewhere in-between.

Group Life Insurance Adjustments

Lack of control: Group insurance is a great benefit and can often be in excess of $1 million; however you are not the owner of the group policy and therefore have a limited amount of control over it. The employer can take it away or reduce it at any time.

Jobs Change: Besides the risk that your employer takes away the group life insurance policy, it is possible that you will change jobs and go to a job that doesn’t have a group life insurance policy. You can always apply for additional coverage at that time, but you risk the premiums on the policy being expensive because of your health or age.

Conclusion: Life insurance provided by your company is a real benefit but be slow to reduce your personally owned coverage because of the uncertainty around the benefit and the coverage.

Be Wary of Making The "Mom & Dad Will Cover Me" Adjustment

A never-discussed support agreement with your parents: Parents may be open to paying for vacation, providing some babysitting services or helping out with buying a house, but funding all of the expense of the next generation because a son or son-in-law (or daughter or daughter-in-law) failed to adequately plan for this emergency is generally not regarded as a solid fallback plan. If you disagree, call your parents or in-laws and ask them to put something in writing.

Life Insurance for Non-income Earners

Should non-income earners like a stay-at-home spouse be insured? The simple answer: It depends on your situation.

Term insurance is often considered for the non-income earner in order to provide the primary income earner flexibility to take adequate time out of work and find their footing if their (non-income earning) spouse dies unexpectedly.

Which statement below applies to you?

Yes, my kids and spouse are very dependent on me. The rule of thumb is for the non-income earning spouse to have half the level of coverage as the income earning spouse, assuming you followed the calculation above.

No, my kids and spouse are not dependent on me. You may not want term insurance.

Takeaway: Couples often size the amount of insurance they want on the lower or non-earning spouse based on the primary earner’s income. Usually, it is sized at 50% of the coverage of the primary earner’s income.

Life Insurance for Business Owners

Owning a business with a partner presents many difficult challenges, not least of which is the continued health of the owners and key people. Life insurance is used to protect against the risk of premature death of a partner or key person or to fund a buyout agreement that would be triggered by death.

To protect against the loss of a key person: Insurance companies will provide you with a maximum level of coverage equal to 5-10x the key employee's annual compensation. This will provide a sufficient amount of liquidity to handle a disruption in the business and hire a new key person.

To fund a buyout agreement: Most likely you agreed to go into business with your friend and colleague, not their mother, husband, son or daughter. You agree that upon the other’s death you will purchase the other’s stake from their heirs. Life insurance funds that promise and is sized based on the value of the partner’s share of the business (with some room for growth)

Takeaway: Business owners often buy coverage on their partners to help fund a buy-out should the partner die prematurely and because it might be very expensive to replace them. The liquidity from life insurance proceeds would help fund that expense.

Life Insurance Options Besides Term

The multiple of earnings calculation is generally applied to sizing the amount of term insurance people want. When people purchase permanent life insurance for retirement planning, education planning, estate planning, etc- they are often deciding how much to purchase based on their budget or net worth, not their income level.

People determine the amount of permanent life premiums and structure of the policy based on any number of factors, but here are a few:

  • As a percentage of annual savings — for example, annual premiums equal to 25% of annual savings

  • As a percentage of total net worth — e.g. face value equal to 50-100% of total net worth

  • Based on the amount of federal or state estate taxes they expect to owe; — e.g. 100% of expected estate tax liability

  • Based on how much they want to pass onto heirs or charities they value —  e.g. 100% of what they want to pass on, giving them the flexibility to spend the rest

Takeaway: The calculations for how much permanent insurance you want are different than term insurance and often based on a budget, i.e. premiums equal to 25% of annual savings; or other long-term goals.

Life Insurance for Wealthy Individuals

Wealthy people rarely buy term insurance, because the bulk of their wealth is not dependent on their income, but is generated by their assets; however, it is important to note that the wealthy are major buyers of life insurance, even if they don’t do it for income replacement.

Permanent Insurance (e.g. whole life, universal life) is used to replace the assets that are diminished through taxes or mismanagement of successive generation, and this is an issue no matter when they die.

Insurance as wealth transfer: Insurance is one of the most efficient means of passing wealth from one generation to the next; so often they will buy it on themselves, their spouse, their kids, and even their grandkids or great-grandkids!

Takeaway: The rich rarely buy term, but often use permanent insurance as an efficient means of passing wealth from one generation to another and size it based on those goals.

Make Sure Beneficiaries Can Access Your Policy Information

What's the worst investment? One that doesn't pay out! Make sure your beneficiaries are aware of any life insurance policies you hold so they know how to collect their benefit. One of the easiest ways to do this is to upload and store your policy information in a free Cake end-of-life plan (you're on the Cake Blog right now) that you share with your family. Life insurance is just one of many important parts of estate planning and end-of-life planning. Create your free Cake plan to share your life insurance information with family and tackle the rest of your planning!

The information provided is not written or intended as specific tax or legal advice. Our employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.


Author Bio

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Drake Richey
Drake is an advisor at Bush & Company, a boutique financial advisory firm that works with individuals and closely held businesses. Bush & Company has specialties in life and disability insurance as well as broader personal and business financial planning. Following 8 years of banking and finance in New York City and 2 years working for a non-profit called FOCUS in Hartford, CT, Drake joined Bush & Company with the hope of serving the complex needs of families and businesses with a model that does not require a minimum level of assets in order to provide service. He can be contacted at 617-526-9369, or at drichey@financialguide.com.

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