How Much Life Insurance Do You Need?

by Marc Smith

Life insurance is a critical aspect of any sound financial plan. Yesterday we discussed how Term Life Insurance is the most appropriate and cost effective option for 99% of the people out there. Today, we are going to address the next key questions. How much life insurance do you need and how much does your spouse need?

I like to think about insurance as a way to pay for necessary, large expenses in the unlikely event that you or your spouse dies. This could include paying off a mortgage, funding a child’s college costs and covering the costs of raising a child with only one parent.

If you have two working spouses, making about the same amount annually, your life insurance needs will be very different from a household with only one working spouse and different still from a single parent household.  So, it’s important to think through your specific situation and then apply the following principles.

Mortgage – Leaving a spouse and kids with a large mortgage they can’t afford is a tragic situation. Your life insurance should allow for the remaining family to stay in the same house for at least several years before a more long-term solution can be found. When thinking about how much coverage you need for this expense, you need to know what your current mortgage balance is and how many years are remaining before you pay it off. I recommend getting enough insurance to completely pay off the mortgage that lasts for at least the remaining term of the mortgage.

Family Living Expenses – You need to determine how much money it costs to support your current lifestyle on an annual basis. It’s important to remember that if you insuring the full value of your mortgage, you shouldn’t factor in your mortgage payment to your calculation, since that expense will be paid off. Then determine how long you want to fund that lifestyle. Remember that kids will leave the house at some point and costs will decrease.

I think covering expenses for at least 5 years or potentially more if you have young children is sufficient time to allow the remaining spouse to sell the house, adjust their lifestyle and get back into the workforce. Of course, if you want to provide a lifetime of benefits, you can insure up to 20-25 years of expenses. Remember that life insurance benefits are typically not taxed, so you will get the full amount of the policy and it’s a good rule of thumb that you can safely withdraw 3-5% of the principal every year without losing principal over time, assuming your adequately invested.

College Costs – To me, this is the least important of the three main drivers of life insurance needs. Kids have a variety of ways to finance college – going to a less expensive state university, starting out at community college, working through college or even borrowing, although I don’t recommend taking on much, if any, student debt. However, if you want to leave each child some funds to help pay for college, I think somewhere around $50-100k per child is sufficient. That would cover a 4-year state university in many places. This is an issue that you need to decide how much you want to pay and how much you want your children to finance their own college.

As an example, let’s say you work and your spouse stays home with the kids. You have a $150k mortgage with 20 years remaining, your annual expenses excluding the mortgage payment are $40k and you have two kids under 10 years old. In this scenario, you might want to consider getting a 20-year term life insurance policy for between $500k and $700k. That would be $150k for the mortgage, $300-400k for family living expenses and $100-200k for college costs.

Life insurance is a critical part of any sound financial plan and hopefully this article helps you think through your life insurance needs.