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How Much Life Insurance Do You Really Need?
2/2/2012 12:00:00 AM
You
may have heard of a simple rule of thumb for calculating how much life
insurance you need. Just multiply your annual salary by the number of
years you would like to provide income to your family and the result
will tell you how much of a death benefit you should have. That could be
anywhere from 5 to 20 times your annual salary depending on your age.
The
problem with this calculation is that it doesn't take into account your
specific financial needs and obligations. To figure out how much life
insurance you really need, do a needs analysis now. It's a matter of
adding up the expenses your loved ones might incur in the weeks and
months right after your death and the expenses your loved ones might
incur in the years following your death. Then subtract what
assets/resources you have right now. The amount left over will give you a
general idea of how much of a death benefit you need.
What Short-Term Expenses Will Your Loved Ones Have?
Do
the best you can to estimate this amount. Some of the more common
expenses that your loved ones will have to pay for in the event of your
death include:
- Funeral costs - These typically run between $8,000 - $15,000.
- Outstanding debts - Add up your credit card balances, auto loans, college loans, etc.
- Emergency
fund - Financial planners recommend that you have 3 - 6 months expenses
in an emergency fund. So you may want to factor in what your
beneficiary might need.
- Medical/hospital expenses - These may or may not apply but you may want to add on $2,000 - $10,000 in this category.
- Attorney/probate
fees to settle your estate - This depends on the size of your estate.
Typically, overall fees will range from 2% to 6% of your total estate.
Add in Long-Term Expenses.
These are the long-term items that your lost income won't be able to cover as a result of your death. They include
- Your
outstanding mortgage - You can add up the total amount of monthly
payments left on your mortgage or just include the balance of your
mortgage if you want the mortgage to be paid off when you die.
- College
education fund for dependents - You have to calculate this using the
current cost of college education, the tuition inflation rate, and the
number of years until your child(ren) will enroll in college. Websites
like Savingforcollege.com and Finaid.org can be helpful here.
- Ongoing
monthly expenses for your family including food, clothing, utilities,
home maintenance, child care, entertainment, travel, etc. - Multiply
these monthly "budget" items by twelve and then by the number of years
you'd like these to be provided for by the proceeds of your death
benefit.
Add Up Your Assets
How
much cash do you have right now (in the form of savings accounts,
mutual funds, stocks, etc.) that would go towards paying the above
expenses? Then take a look at how much life insurance coverage you have
right now. Many people already have some form of life insurance without
realizing it.
- Social Security Survivor Benefits
- Make sure you read your Social Security statement each year. Not only
does it tell you what you might expect to get in retirement, it also
tells you how much your spouse and/or surviving dependents may receive
each month if you pass away. More information can be found on the Social Security website.
- Group Life Insurance with your employer
- Remember when you first got hired and you had to fill out a stack of
paperwork? One of those forms may have been to pick the beneficiary(ies)
for your group life insurance plan. Employers often cover their
employees up to a certain multiple of their annual salary. (A typical
plan might state that if you die, your beneficiary will receive 2 X your
annual salary.)
Your Death Benefit
The
difference between your short/long term after-death expenses and your
liquid assets/life insurance coverage represents how much of a death
benefit you should have.
An Ongoing Process
Many life events can change your life insurance needs. These include:
- Divorce
- Marriage
- Birth of children
- Death of loved one
So
calculate your needs analysis every time something significant happens
or every few years. There's no way to pinpoint exactly how much life
insurance one person should have. But do the best you can. The result
will give you peace of mind that your loved ones will be well taken care
of if the worst happens.
Royal
Neighbors Foundation has partnered with Financial Finesse, the leading
provider of unbiased financial education, to bring members financial
information that is free from any conflict of interest or sales pitch
that is exclusively developed by Certified Financial Planners whose only
responsibility is to help you resolve your financial problems and
achieve your financial goals.
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