Most people don’t need life insurance if they don’t have any dependents and have enough money to cover their final needs.
If you wish to leave an inheritance or make a charity contribution, make sure you have enough life insurance.
If you have dependents, get enough life insurance to replace the income you currently provide for them, plus enough to cover any additional expenses they will spend to replace services you provide, when paired with other sources of income (for a simple example, if you do your own taxes, the survivors might have to hire a professional tax preparer). In addition, your family may want additional funds after you pass away to make necessary improvements. They may, for example, wish to relocate, or your spouse may need to return to school in order to better support the family.
You should also make arrangements to replenish any “hidden income” that would be lost if you died. Hidden income is money that you get from your job but that isn’t included in your gross pay. It includes items like your employer’s health insurance premium subsidies, matching contributions to your 401(k) plan, and a slew of other “perks,” both big and tiny. This is an often-overlooked insurance requirement: replacing only your health insurance and retirement payments might cost $2,000 or more per month.
Of course, you should budget for any expenses that may emerge after your death. Funeral costs, taxes, and administrative expenditures connected with “winding up” an estate and transferring property to heirs are among them. Plan for a minimum of $15,000 in your budget.
Additional sources of income
Aside from life insurance, most families have certain sources of post-death income. Social Security survivors’ payouts are the most common source.
Survivors’ payouts from Social Security can be large. For a 35-year-old who was earning $36,000 per month at the time of death, maximum Social Security survivors’ monthly income benefits for a spouse and two children under the age of 18 may be around $2,400 per month, with the amount increasing each year to keep pace with inflation. (It decreases slightly when there is a spouse and one child under the age of 18, and it completely disappears when there are no children under the age of 18.) In addition, if the surviving spouse earns more than a particular amount of money, his or her benefit will be lowered.)
Many people get life insurance through their employment, while some have it through another affiliation, such as a membership group or a credit card. A death component may be included in a vested pension payout. These kinds of income may give a lot of money, but they rarely supply enough. Also, it’s generally not a good idea to rely on job-related death benefits because you could die after moving jobs or while unemployed.
A multiple of salary?
Many experts advise purchasing life insurance that is a multiple of your annual wage. One financial advice columnist, for example, suggests purchasing insurance equal to 20 times your annual pay before taxes. She picked 20 because investing the benefit in bonds paying 5% interest would yield an amount equivalent to your income at death, allowing your survivors to live off the interest rather than having to “invade” the principal.
However, this simple method implicitly assumes no inflation and that one could put together a bond portfolio that would generate a 5% annual income stream after expenses. However, assuming a 3% annual inflation rate, the purchasing power of $50,000 in the tenth year would be around $38,300. The survivors would have to “invade” the principle each year to avoid the income drop-off. They’d run out of money in the 16th year if they did. Other sources of income, such as those described above, are likewise ignored under the “multiple of pay” approach.
A simple example
Assume a surviving spouse did not work and was responsible for two children, ages four and one. Assume her deceased spouse earned $36,000 at the time of his death and was covered by Social Security, but had no other life insurance or death benefits. Assume that the surviving spouse is 36 years old.
Assume the deceased spent $6,000 of his earnings on his own living expenses and job costs. Assume that the dead provided services to the family (such as property upkeep, income tax and other financial management, and occasional child care) for which the surviving will be responsible for paying $6,000 each year. Assume that the survivors will have to pay $12,000 per year for health insurance to replace the coverage the deceased had at work.
Taking everything into account, the survivors will need to replace the equivalent of $48,000 in income each year, adjusted for an expected 4% inflation rate. The survivors will need to replace the equivalent of $48,000 in income per year, adjusted for an expected 4% inflation rate. Because of Social Security, the survivors would only need life insurance to replace around $1,700 per month of lost wage income (adjusted for inflation) for the next 14 years, until the older child turns 18; the rest would be covered by Social Security. When the non-working surviving spouse has only one child under the age of 18, the survivors would require life insurance to replace around $2,100 per month (adjusted for inflation) for three more years.
To give the $1,700 and $2,100 monthly sums, approximately $360,000 in life insurance is required today. The minimum life insurance required for the example is $375,000, plus $15,000 for funeral and other last expenses.
What’s left out?
some potentially major unmet financial needs are left out of the scenario, such as
- Unless the deceased purchased supplementary life insurance to cover this period, the surviving spouse will receive no Social Security income from age 53 to 60. The surviving spouse may be expected to find employment at or before this time, but she may become disabled or otherwise unable to work. The additional amount of insurance required if life insurance was purchased for this period would be around $335,000.
- Some people like to prepare ahead to pay off the home mortgage with life insurance if the primary income earner dies, so that the survivors are less likely to lose their home. If life insurance is purchased for this purpose, the additional amount of insurance required is equal to the outstanding mortgage balance.
- Some people want to use their life insurance to pay for their children’s college education. We can estimate that each child will attend a public university for four years and will require $15,000 each year in tuition. College costs, on the other hand, have been rising faster than inflation for decades, and this trend is unlikely to change. The additional amount of insurance required for this goal if life insurance was purchased would be around $200,000.
- Except for what the surviving spouse would be eligible to receive from Social Security (about $1,200 per month) in the example, no money is set aside for the surviving spouse’s retirement. It’s reasonable to presume that the surviving spouse will find work and contribute to an employer’s retirement plan or an individual retirement account (IRA), but she could potentially become disabled or otherwise unable to work. If life insurance were purchased to provide the equivalent of $4000 per month from age 60 to 65, and $3,000 per month from 65 onwards (since Medicare will eliminate the requirement for private health insurance at 65), the additional amount of insurance required would be around $465,000.