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How Much Life Insurance Should You Have?

Posted August 3rd, 2012 in Insurance by Jeremy Waller

What would happen to your family’s finances if your died today? Would they be able to pay the bills without your income? If you have someone who is depending in your income to eat, then you need life insurance.

Life insurance is designed to protect your family in the event of an early death. We’re all going to die; the question is when.

Since the purpose of life insurance is to provide for your family after you are gone, you need enough insurance to replace your lost income.

Let me also mention this, there are many different types of life insurance out there. The purpose of life insurance is to pool the risk of an early death. It shouldn’t be used as an investment vehicle (*cough* whole life insurance *cough*). To prove for your family after your death, all you need is a term policy.

The general rule of thumb is to have 10 times your annual income. Many people know this rule and many people use it as a guideline, but most don’t really think about why.

The why is very important. If you don’t understand why, then you can’t make an informed decision. Based on your situation, is 10 times your income enough? It is too much?

The amount of insurance you need depends on the number of years that your income is needed after you are gone.

Let’s Run the Math

If you were to die during the term of your policy, the death benefit would be paid in a lump sum. Now your beneficiaries could just put that money in a bank account, pay their expenses as they normally would out of that account and in approximately 10 years the money would be gone. It could be done that way, but it’s a terrible plan.

Anytime you receive a large lump sum of money and don’t have an immediate need for it, it should be invested. Ideally, an investment ladder would be set up where the funds needed in the next few months would be held in an easily accessible account (likely with a lower rate of return) and funds needed years down the road would be put in a long term investment vehicle (with a higher rate of return).

With a 4% rate of return, the proceeds would last 12.8 years.

With a 6% rate of return, the proceeds would last 15.3 years.

With a 8% rate of return, the proceeds would last 20.3 years.

Now these are conservative estimates. I’ve based this on monthly withdraws equaling your pre-tax income. In reality, your beneficiaries should only need to withdraw your post-tax income – what your take-home pay is.

However, I’ve also excluded inflation to simplify the calculation. In the end, these two factors may cancel out. These numbers are meant to be more of a general guideline.

How Much Life Insurance Should You Have?

Is 10 times your annual income enough? At a minimum, your beneficiaries should be able to achieve a 4% rate of return on the proceeds. Will your children still be at home after 13 years? After they are able to support themselves, can your spouse support their self? If you are a stay-at-home parent, can your spouse afford child-care and other help as needed?

If you are unsure, I would always be on the safe side. Term life insurance is cheap.

Regardless, if you don’t have life insurance now and you have people depending in your income to survive, you need life insurance. Don’t waste time because you’re indecisive. You can always make changes to your policies later.

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