This blog post originally appeared on our previous blog site, financialclarityblog.com on June 13, 2017 and has since been revised and updated.
In the last couple of weeks, I cannot count how many times a client has reached out to me asking about their life insurance. I get questions clarifying whether or not life insurance will pay if they die from COVID-19 (it will). I also have people asking me to help them get more life insurance in a hurry. If you are a doctor fighting on the front lines against a potentially fatal infectious disease and the possibility of death is staring you in the face, you start thinking more about things like life insurance. I thought it would be a good idea to bring back this post from a few years ago to help people understand how much life insurance they might need.
An important part of financial planning, especially if you have a family or people who depend on you financially, is life insurance. But how much life insurance is necessary? This post will explore that question.
As you are probably aware, the amount of coverage one person needs could be drastically different from the needs of another person. If you have five children, a stay-at-home spouse, two mortgages, and also help support your parents, you probably need significantly more coverage than someone who has a working spouse and no children or dependents. Let’s take a look at several hypothetical individuals to determine how much coverage they need.
Person #1 – John
John is married. His spouse is 33 years old and stays at home to care for the children. They have two kids, ages three and five and would like to pay for them to go to college at an in-state public school. They have $250,000 remaining on the mortgage, plus another $30,000 between a car loan and a line of credit. There is approximately $300,000 saved in retirement accounts and $100,000 in other investments. They need about $5,000 per month to cover living expenses, in addition to the debt payments.
Person #2 – Stephanie
Stephanie is married and she and her husband both work full-time, making $75,000 per year. Both are 35 years old. If she passes away, her husband plans to continue to work full-time. They have three children, ages two, four, and seven. She and her husband don’t believe in paying for their children’s college, since they both had to take out student loans and pay their own way through college. They rent their home currently, but would like to buy a house one day. No debts other than student loans. Both Stephanie and her husband have about $50,000 remaining in federal student loans. They don’t have much at all saved for retirement, as they are working to try to save up for a home down payment. Monthly expenses, including rent and childcare, total $8,000/month.
Person #3 – Charles
Charles is divorced and has two children in high school that he is financially responsible for. If he passes away, he would like to be able to provide for his kids (ages 15 and 17) to go to college anywhere they get accepted and also have enough money remaining to support them in the first few years post-college, until they get their careers underway. He has a mortgage with $150,000 remaining. House is worth about $400,000. He also has $200,000 in retirement accounts.
Life Insurance Needs Analysis
There are many free online life insurance needs calculators. I personally like one available on www.LifeHappens.org. It’s a non-profit company with a mission on educating people on the importance of life and disability insurance. They aren’t affiliated with any insurance companies, so they aren’t trying to sell anything.
How Much Life Insurance Does John Need?
The first step in the life insurance needs calculator is to estimate the fixed costs upon death. Their default for final expenses (funeral, burial, reception, etc.) is $15,000, so I usually go with that. Then we enter the mortgage balance ($250k) and balance of remaining debts ($30k). See Below.
Next, we estimate the amount of income, before taxes the family would need each year if John passes away. If their monthly expenses are $5,000 after taxes, they would need about $100,000 before taxes to sustain that lifestyle. Remember, the mortgage and other debts will be paid off, but we have living expenses, property taxes, etc. We’re assuming John doesn’t want his family to have to move or adjust their lifestyle. Also, we’ll assume John doesn’t want his wife to be forced to go back to work or remarry, if she doesn’t want to. Therefore, we will plan on the income need lasting into her 90’s. This is also where we enter the amount John currently has invested and any life insurance he currently has (we’ll assume zero). See below.
Next, we factor in income should the spouse continue to work. In John’s case, we aren’t planning on his wife finding employment, so we will leave this as zero. See below.
Lastly, they have us enter estimates for inflation and an assumed after-tax investment return. This is important, because we will assume that the proceeds from the life insurance will be invested so they can grow over time and provide a future income stream. We also have to factor inflation into the equation, since cost of living will go up over time. Historically, inflation has average 3% per year, so I usually enter that for inflation. Depending on how pessimistic or optimistic you are about domestic or global investments, you can enter whatever after-tax investment rate you feel comfortable assuming. For this example, I’ll assume a 5% investment return. See below.
After that, you can click the “Analysis” button (step 5) to see how much life insurance is needed. See below. If you click the button and nothing happens, you probably missed an input. Go back to previous sections to see if there is anything missing. Usually it will be highlighted in red.
Holy cow! John needs $3.8 million of life insurance to provide for his family, put his kids through college, and ensure money is available for his widow to live off of for the rest of her life. Seems a little high, doesn’t it? Rather than simply believing the mythical beings behind this website, they actually give you the math behind the analysis. If you click the “Calculations” button below the analysis, it will break it down for you. See below.
Let’s walk through this. John needs $595,404 in a lump sum. That will cover funeral costs, pay off the debts, and set money aside for future college for the children. College is expensive and only getting more expensive as time goes on. Paying for children to go to school 15+ years from now is going to cost an arm and a leg.
Next is the income need. $100,000 per year, adjusted for inflation, until John’s wife passes away in her early 90’s. The present value of that future income stream (if you received all of those future years of income in one lump sum today) is $3,594,097. Add that to the lump sum needs of $595k, and we are over a $4 million total need. But, don’t forget to subtract out existing investments ($400,000 in John’s case). That leaves us with the $3,789,501 life insurance need.
Presumably, as time goes on, the need will decrease, as existing assets grow and the number of years to provide for the family decreases. But, John is getting life insurance in case he gets hit by a bus tomorrow, so we need to plan for that.
Now let’s look at the other two individuals.
How Much Life Insurances Does Stephanie Need?
In this one, we will enter $15,000 for final expenses and $50,000 for outstanding debts. Stephanie’s federal student loans will be forgiven upon death, but her husbands will remain. Since they don’t want to pay for their children’s college costs, we don’t need to plan for that need. See below.
Next, we calculate the income need. Right now, they rely on their full combined incomes of $150,000 per year. With three kids, that need isn’t likely to disappear in a single parent household. We will plan on that need continuing until Stephanie’s husband passes away around age 90. Like John, she doesn’t want him to be force to remarry, or cut back on activities for the kids. See below.
Now, some of you are probably thinking, do we really need to provide that income for the rest of her husband’s life? Probably not, but you never know. There isn’t an option to change the income level at different stages of life. It would probably be safe to assume that the income need decreases once the kids are out of the house and maybe decreases even further in old age (provided medical expenses aren’t exorbitant). You can play around with different income figures if you wish, or the duration for the income to last. If you want to assume your spouse will adjust lifestyle and expenses once the kids move out, or remarry a new income earning spouse, then that is fine. I would rather plan on the worst, so our survivors aren’t forced to make a tough decision for financial reasons that could have otherwise been prevented with adequate life insurance.
Now, since Stephanie’s husband plans to continue working another 30 years until normal retirement age (mid 60’s), we need to factor in his income earning potential to offset the total income need. See below.
We’ll assume the same 3% inflation and 5% after-tax investment return in this scenario. When we jump to the analysis, it tells us we need $3.9 million of coverage on Stephanie. See the calculations below.
Even though Stephanie’s husband earns a good income, the income need in their situation is greater, and they don’t have any investments to reduce the total need. The present value of her husband’s future income for the next 30 years is $1.3 million. But if he needs double what he earns to support the family and gets accustomed to that lifestyle, both of them would need a good amount of life insurance.
If we only want to plan on providing her widower husband income until the youngest child is 25 years old, we could enter 23 years for the income need. Once the kids are no longer dependent on the bank of mom and dad, Stephanie’s husband can take care of himself. If we do that, Stephanie still would need $1.8 million of coverage.
How Much Life Insurance Does Charles Need?
Lastly, we have Charles. The Chuckster. He has a little different situation than the previous two. His only concern is providing for his children until they get through college and get established in their careers. So really, we only need to provide a moderate income for a decade. However, he wants to pay for college in full, regardless of the cost, so his children aren’t limited in their education choices. See below for the Final Expenses screenshot.
If Charles wants to provide partial support for the kids to cover some housing and food costs, let’s assume he needs $50,000/year ($25,000/year each) before taxes for the two of them to survive. We’ll plan on having this last for a decade, until the youngest is 25. By that point, they (hopefully) will be done with school and have jobs and can support themselves. In this section, we’ll also include the value of the house of $400,000, assuming his kids will sell it after Charles death. See below.
There is no spouse, so we can leave the spouse’s income section at zero. For the inflation, we will stay at 3%. For the after-tax investment return, since the time horizon is so short (less than ten years) we will want to keep those funds liquid and not take much risk in an investment account. We’ll plan on having the money in a high interest savings account , which currently yields about 1% interest, to help support the children through college. See below.
After all of the variables are entered, we get a life insurance need of just under $500,000. We’ll take a look at the calculation below.
To send two kids to a private or out-of-state university, it will cost about $375,000 today. The income need for the next decade, adjusted for inflation is about $550,000. Subtract out the current assets and investments of $600,000 and we get the life insurance need of $486,572.
Most people underestimate the amount of life insurance they need. It’s important to review the need periodically to make sure your protection is adequate. Connect with your financial advisor and he or she can help you with your insurance planning needs and determine an appropriate amount of coverage if you are unsure of what to do.