How much life insurance do you need? Well that depends on your situation. The rule of thumb is 10 times your income, but I hate rules of thumb because they are a one size fits all solution. And one size fits all is more accurately “one size fits none”. Sure I’d rather have you buy 10 times your income of protection than none at all, but is that really the best solution?
I’m going to do some calculations for a fake family. Our fake family has a husband and wife and two kids, ages 5 and 8, a mortgage of $150,000, and consumer debt of $30,000. How much life insurance do they need?
Here’s how to calculate how much life insurance you need:
Total debt + funeral costs + income replacement + college funds = Protection needs
Deciding on income needs:
Figure out your monthly budget as of right now. Subtract all debt payments since those will be paid off with life insurance proceeds. If the surviving spouse will continue to work then subtract their projected income from the monthly budget as well. What is left over is the income needs per month for the surviving spouse. You will want to do this for each spouse. What will the wife need per month if the husband dies? What will the husband need per month if the wife dies?
If the deceased spouse doesn’t work consider any additional hired help the surviving spouse may need. Will the surviving spouse need to hire daycare or housekeeping services? Add those into the monthly budget needs.
Ok, once you know how much each surviving spouse needs per month you will need to decide how long you want to provide the extra income? Do you want to provide it for life or just til the youngest child is out of the house? Or maybe even just until the youngest is in school full time?
Now it’s time to use an online calculator to help you determine the lump sum needed to provide the income for the stated amount of time. To adjust for inflation you can reduce the assumed interest rate. For example, let’s say you assume you will get 6% growth but will experience a 3% inflation rate. You would subtract inflation from growth (growth-inflation) and enter an assumed growth of 3%. Then play with the numbers until your results are what you are looking for.
For our fake family, we have decided that the wife will need $2,000 per month until the youngest child, age 5, reaches 18. So she will need income for 13 years. If we assume a 6% growth with 3% inflation (3% net growth) the husband will need to carry $260,000 worth of income protection on his own life.
We have also decided that if the wife were to die the husband would need $1,500 per month for the same time period. So the wife will need to carry $195,000 of income protection on her life.
Does that make sense?
Figuring out College Funding Needs
Do you want to provide college funds for your kids if you die prematurely? Or a better question is will you provide college funds if you don’t die prematurely? If so, the first thing you will want to know how much college costs. There are plenty of calculators that will help determine that.
Our fake family wants to send their kids to the state college down the street. They expect to spend about $17,000 per year, per kid, in today’s dollars. Of course there will be big time inflation in cost between now and when the kids enter college, which is why it’s important use the above calculator. It will help determine what the costs will be when the time comes.
Once you know what your final costs figure out what your “starting amount” is. This is the lump sum needed to invest right now to provide for college. When deciding on your interest rate remember that inflation has already been accounted for, so enter what you think you will actually get.
Using the calculators we figure out that they need to invest basically $73,000 per kid right now for that to grow at 6% and pay for 100% of college costs. So that’s a total of $146,000 in income protection needs.
Why so much? College costs are rising so fast. You almost can’t grow your money faster than they raise tuition. Paying for it monthly over time is easier than to pay for it with a lump sum. At least you can stretch out the costs over 18 years instead of 4.
Now of course you don’t HAVE to provide for 100% of your child’s college education. That’s a whole other story.
Ok, so where does that leave us?
Let’s go back to our life insurance equation. Total debt + funeral costs + income replacement + college funds = Protection needs
Total debt = $180,000
Funeral Costs = $10,000
Income replacement = Wife; 195,000 Husband; 260,000
Education = 146,000
For a grand total of 531,000 on the wife and 596,000 on the husband.
If you are having trouble calculating your insurance needs feel free to shoot me an email and I’d be happy to help.