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How Much Life Insurance Do I Need?

No one likes to think about their own death, but one aspect you should consider is what will happen to your family when you die. If you don't have life insurance, they could face some tough financial choices, like whether to sell the family home or pull the kids out of college. How much coverage should you buy to ensure their financial security? The amount of life insurance you need depends on your finances, family circumstances and stage in life. Here's how to figure it out.

How Does Life Insurance Work?

Life insurance works similarly to auto or homeowners insurance: You pay the insurance company a premium in return for a certain amount of coverage on your life. When you die, the insurance company pays a lump sum (called a death benefit) to the people you've named as your beneficiaries.

If your family relies on your income, life insurance helps ensure their financial security after you're gone. It can help pay funeral costs and other expenses your family will face when you die, such as paying outstanding debts that you cosigned with a spouse. It can also provide for future needs, such as financing your children's college education or paying off your mortgage.

Families with young children aren't the only ones who need life insurance. Empty-nesters or couples without children often purchase life insurance to provide for the surviving spouse. If you care for aging parents, life insurance can help finance their care if they live longer than you do.

Not everyone needs life insurance, though. If you are single, have no dependents and have enough money to cover any debts you may leave behind you when you die, life insurance isn't really necessary. On the other hand, you might want to leave money to a favorite charity, your alma mater or a beloved niece or nephew. It's really up to you.

How to Calculate How Much Life Insurance You Need

How much life insurance do you need? Conventional wisdom often recommends buying life insurance worth a multiple of your annual salary. For instance, if you earn $75,000 a year and are buying a 20-year policy, you might buy 20 times your salary, or $1.5 million worth of insurance. However, this method can fall short of your survivors' actual needs because it fails to consider any financial benefits or unpaid services you provide that your family will lose if you die.

To get a more accurate estimate of your life insurance needs, follow these steps:

  • Tally up the liquid after-tax assets your family will have access to after you die. The term "liquid" is key; your family home is an asset, but your spouse probably won't want to sell it to survive. Assets could include savings accounts, retirement accounts, pensions, estimated Social Security benefits and any other life insurance policies you have, such as insurance provided by your employer.
  • Add up your expenses and debts to determine the financial obligations your family will face without you. Estimate monthly expenses; total up debts such as your mortgage, student loan payments, credit card debt and personal loans. Also consider planned future expenses, such as tuition for children's college expenses.
    Don't forget about new expenses your family may face after you die. For instance, if your employer provides health insurance and employer matching to your 401(k), both will end when you die. Your family will have to buy individual health insurance if your spouse doesn't have a full-time job with health benefits (at an average cost of over $20,000 annually for a family) and increase contributions to retirement plans. If a stay-at-home spouse dies, the surviving spouse will need to pay for child care.
  • Subtracting your liquid assets from your financial obligations determines your coverage gap, which gives you an estimate of how much life insurance you need.

Suppose you are 30 years old with two children and want to provide for your spouse for 20 years. You currently owe $300,000 on your mortgage and $10,000 on a car, and you want to provide $100,000 in college funds for each child. Based on current expenses as well as new expenses that will occur after you die, your spouse needs $100,000 annually to maintain your family's lifestyle.

In the asset column, you have $50,000 in a retirement account, $10,000 in savings and $20,000 in life insurance from your employer.

How does it all add up? Your expenses are $2.41 million (20 times $100,000 for 20 years of living expense, plus $410,000 for your debt and college funds). Your assets are $80,000. The difference between the two—$2.33 million—is how much life insurance you should get.

Types of Life Insurance Policies

Once you have an idea of how much life insurance you need, the next step is choosing the type of policy. There are two basic types of life insurance: term life and permanent life.

Term Life Insurance

A term life insurance policy remains in force for a specific time period (term) and pays out only if you die during that period. For example, young parents might choose 20-year term life insurance policies to give their family security while the children are still young. Homeowners might select a policy term matching their mortgage to ensure their survivors can pay off the house.

At the end of the term, you have the option to renew the policy or buy a new policy. To do either, you'll generally need to go through a medical exam. In addition, premiums will typically be higher because you are older.

Term life insurance is more affordable than permanent insurance, making it a good choice for young families starting out. There are also convertible term policies that give you the option to convert to permanent life insurance without having to prove your insurability all over again.

Permanent Life Insurance

Permanent life insurance remains in force as long as you live. Unlike term life insurance, it builds equity over time in the form of cash value, in addition to its face value (the amount it will pay out when you die). You may be able to borrow against the cash value of a permanent life insurance policy or use it to pay the premiums if you can no longer afford them. These benefits mean permanent life insurance usually costs more than term life insurance. There are several varieties of permanent life insurance.

  • Whole life insurance is the most common type of permanent life insurance. Whole life insurance premiums stay the same as you age. The death benefit is guaranteed, as is the cash value.
  • Universal life insurance provides a cash value guarantee, like whole life does, but gives you the option to change your coverage and in some cases even your premiums.
  • Variable life insurance is riskier. You can choose where to invest your cash value, which can help you earn bigger returns. However, the cash value of a variable life insurance policy isn't guaranteed.
  • Variable universal life insurance has features of both universal and variable life insurance. You can choose your investments, change coverage and modify premiums. But there's no guarantee your cash value will increase.

One option most people don't know about is joint life insurance. Joint life, which comes in both term and permanent forms, is one policy that covers both spouses. Depending on the policy, it may pay a death benefit when the first spouse dies or after both are dead.

What Influences the Cost of Your Life Insurance Policy?

Other than the amount of coverage you're seeking, the biggest factor in the cost of your life insurance policy is you. A young, healthy person is statistically less likely to die than an older person with chronic health conditions, such as diabetes. To assess how risky you are to insure, insurance companies will ask lots of questions about your age, gender, general health, occupation, lifestyle, habits such as smoking or drinking, and family health history. In most cases, you'll also undergo a medical exam.

Other factors insurance companies may consider when setting your premium rates include:

  • Credit-based insurance score: Insurers generally don't check your credit score when you apply for life insurance, but they may check your credit-based insurance score. This is a special type of insurance score that can predict how risky you are to insure. LexisNexis® Risk Solutions is one provider of credit-based insurance scores; FICO® also creates credit-based insurance scores.
    Credit-based insurance scores aren't the same as your regular credit score, but they are based on some of the same information. For example, making payments on time, having low balances on your credit cards and having a good credit history will help your credit-based insurance score. Missing payments, having accounts in collection or having a bankruptcy on your credit report will hurt it.
  • Medical Information Bureau (MIB) Report: MIB is a specialized credit reporting agency that works to prevent insurance fraud. When you apply to an insurance provider that's an MIB member, MIB will review data from previous insurance applications you submitted to see if there are any discrepancies. If so, it will alert the insurance company, which will seek more information from you to clarify the issue.
  • Criminal record: Insurance companies check public records, including criminal records. A history of criminal activity, particularly felonies, may make it harder to get life insurance, because crime is inherently dangerous.
  • Driving record: Life insurance companies may also check your motor vehicle report. If you've had a lot of speeding tickets, been in multiple accidents or been convicted of driving under the influence, they'll view you as a higher risk than if your record is clean.
  • Medical records: In addition to conducting a medical exam, most life insurance companies review your medical records and check prescription drug databases to confirm the prescription medications you use.

Making the Right Life Insurance Choices

If loved ones depend on you for financial support, you need life insurance to help protect them. How much life insurance to buy depends on your life stage, your financial goals and your budget.

An insurance professional can help choose the right amount and type of life insurance to protect your family. Be sure to review your life insurance coverage annually, as well as whenever you have a major life change, to make sure it's still appropriate for your needs.