How Much Life Insurance Do I Need?
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While we are sure there are many ways to answer this question, here are three strategies we find useful in determining how much term life insurance to buy. Generally speaking, the first strategy, Paying Off Debt and Other Bills, is the least expensive, because you are buying the least amount of life insurance. While the third strategy, Permanent Income Replacement, is the most expensive – because you are buying the most insurance for a longer period of time.
Of course, you can combine strategies. For example, buy enough life insurance to pay off some debts while at the same time, provide Transitional Income Replacement.
Pay Off Debt and Other Bills
- 25% 25%
This is a pretty simple and straightforward approach. Just add up all the debts and bills you would want paid off in the event of your death. Some things to consider would be:
- Credit Cards
- Auto loans
- Student loans
- A lump sum amount to be set aside for future college expenses
- Funeral expenses
Transitional Income Replacement
(Income for a limited period of time)
- 55% 55%
In this case, you are replacing some of the household income for only a few years – a transition period. You’re not so much worried about paying off individual bills and debts as simply maintaining the household income. The idea being you want to provide the same level of the household income for a transition period to give the surviving spouse time to go back to school or transition to a different standard of living. The transition period can be any number of years. Or maybe, its until children reach a particular age, maybe 18. Let’s say you want to replace your income of $40,000 per year for five years. Then $200,000 would provide the same level of income to your spouse for five years.
Permanent Income Replacement
(Income for an indefinite period of time)
- 85% 85%
In this case, you are replacing household income on a permanent basis. Let’s say you want to make sure your spouse continues to receive $40,000 of income for an indefinite period of years. The hardest part of this strategy is figuring out how much cash flow the life insurance proceeds can generate.
Let’s assume for the sake of example, that you can generate 5% cash flow from the life insurance proceeds. Therefore, for every $100,000 of life insurance, it would generate $5,000 per year of income. If you want to replace $40,000 of income on a permanent basis, you would need to buy $800,000 of term life insurance (5% of $800,000 is equal to $40,000). As long as the investments used for the life insurance proceeds continue to generate the 5% cash flow, the income would continue indefinitely.
Life Insurance Worksheet
This worksheet can help you get a general idea of how much life insurance you need to protect your loved ones.