How Much Life Insurance Do You Need?

Why bother owning insurance in the first place? As we grow up the risks we face change. One way to mitigate some of those risks is through the use of insurance, which serves to transfer risk from an individual to a group. Some types of insurance protect us against obvious risks such as the risk of a car wreck or the cost of healthcare. Other types of insurance can protect us from the risk of disability, the cost of long-term care, or death. Life insurance serves to protect your loved ones from financial problems stemming from your untimely death. No one wants to consider their mortality, myself included. The hard reality is that we are all going to die one day though. With some forethought and planning we have the ability to make that circumstance a bit easier for our loved ones by taking away the added stress of dealing with financial issues during the immediate aftermath. Today I’ll explain some of the different types of life insurance and some basic ways of calculating the amount of coverage you need in order to protect your family from loss.

There are many options when it comes to life insurance and each type has its pros and cons. At its simplest, life insurance can be broken down into two different types: term and permanent. Term life, as its name implies, covers a person for a set period of time, usually from 10 to 30 years and pays a specified death benefit if the person dies during that period. One of the biggest benefits to term life is that it’s relatively cheap. Coverage is fairly easy to obtain and several hundred thousand dollars’ worth of coverage can be obtained for around the price of a monthly gym membership. One downside to term life is that it doesn’t build up a cash value, so when the term expires that’s it.

Permanent life insurance is different than term in that when you pay premiums they build up a cash value which you’re able to withdraw if you so choose. The most well-known type of permanent insurance is whole life; I’ll focus on WL for the rest of this piece. While there are plenty of other types of permanent life and some of them have great features, they’re generally not super useful for younger people with the exception of some specific situations. Whole life is similar to term life in that it pays a stated face value throughout the life of the policy. The premiums on whole life stay the same throughout the entire policy as well, which is nice. Finally, like I mentioned earlier, whole life builds a cash value on which interest is paid by the company. This is generally a fairly low level of interest but it is higher than the interest paid on savings accounts or CD’s in our current low interest rate environment.

Personally, I recommend that most young adults buy term life (I talk about this in my Financial Commandments for Young Professionals). Most people lack the coverage they need; the affordability of term life allows a client to purchase a greater death benefit for the same amount of premium when compared to whole life. Term life is generally purchased for periods that range between ten and thirty years in five year increments The best option is to purchase coverage that will last at least until you reach retirement or when your mortgage will be paid off, whichever is later. I say this because insurance, particularly term life, is generally used as an income replacement. It allows your loved ones to focus on what’s important to them, not how they’re going to pay the mortgage or for a child’s tuition without your income. As you near retirement your assets generally rise while your obligations get smaller. Most people have already paid for their houses and kids’ tuition prior to retiring, so the amount of insurance coverage can be less or even none, depending on the situation.

This brings me to my next question: how much coverage is enough? It’s a simple question yet it can be tough to answer. I prefer to address the issue by using a needs based approach which takes into account current and future salary along with any known future obligations. Starting out with the salary portion; many planners recommend 3-5 times current salary as sufficient for income replacement. I prefer to be on the higher side of that because most young adults can expect to get fairly frequent raises at the beginning of their career. If you were to go with the low end of that income multiple, it could leave your family with only a year or two of income replacement instead than the 3-5 years for which you had planned, due to the effects of raises and inflation. The other side of the equation is planning for large expected expenses. Some expenses which fall into this category include mortgages and college tuition for children. By including these into the planning process, it is possible to protect your loved ones from ill financial effects from your passing and that’s what it’s about; protecting the ones you love.

In the end there are no hard and fast rules to coverage amounts or types of insurance to choose. It comes down to one’s specific situation more than anything. A newly married couple who are early in their careers and have young children are going to have much different insurance needs than a couple who is only a few years from retirement. The same can be said for which type of insurance to purchase. For some people term makes sense while others prefer the assurance that is provided by the cash value of whole life. In the end, finding the right fit when it comes to life insurance is as much an art as it is a science, which makes having a trusted advisor incredibly important. If you want to hear more, check out episode 2 of the Plentiful Wealth Podcast.