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How much life insurance do you need?

LifeIf family members depend on your income or the work you do to keep your family and household running, you need life insurance.

Now the question is: How much?

It appears many of us aren't doing a good job of answering this question.

"Most people are woefully underinsured in this country," says David Woods, president of the Life and Health Insurance Foundation for Education in Washington, D.C. "They don't understand the risk they're subjecting their families to."

Admittedly, the idea of calculating the financial impact of the loss of a loved one appears cold and greedy. However, trying to put some numbers to the situation can help ensure that if a loved one dies, the surviving family members can focus on their loss, rather than agonizing over bills.

False assumptions
Coming up with a reasonable estimate means taking a look at how your household's expenses and income might change, if you or your spouse were to die. However, before getting out the calculator and crunching numbers, you'll want to check that you have a realistic handle on the ways in which the death of a loved one might impact your finances.

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Many people inaccurately assume, for instance, that their expenses will be halved if their spouse dies. While a few expenses, such as your food bill, might decline, most costs will stay the same or even increase.

"You still have your house and insurance on it," points out Kristina Sommerkamp, a certified financial planner with Sommerkamp Insurance and Financial Services in Boca Raton, Fla. If you have children, they'll still need food and clothes.

In addition, "Many people underestimate the emotional impact of death, and how that translates to financial loss," says Charlie Brown, vice president with Baker Welman Brown Insurance in Kennett, Mo.

For instance, a child who loses a parent may benefit from counseling. Or, a surviving spouse may need to cut his or her work hours, at least temporarily, in order to help the kids adjust to life without mom or dad.

Even couples without children probably will feel a financial jolt. For example, the surviving spouse may find that he or she needs to hire outsiders to take of the chores that the other one used to handle -- whether it's fixing a leaky faucet or keeping the refrigerator stocked.

Another assumption that's often erroneous: thinking you should purchase a policy for twice your salary level because that's the policy your employer offers. "People sometimes assume that some formula was used to determine this number," says Sommerkamp. "There is no magic formula."

Calculating ideas
A couple of factors come into play in calculating the amount of life insurance you need. You'll want to account for the income you're currently earning, and the expenses that any insurance proceeds would have to cover. You'll also want to look at other assets or income, such as Social Security payments, that would be available to help cover expenses.

Age comes into play, as well. The younger you are, and presumably the younger your children are, the more insurance you'll typically need. That's because the proceeds will have to help support your children until they're out on their own.

Robert Klein, associate professor of risk management and insurance, as well as director of the Center for Risk Management and Insurance Research at Georgia State University in Atlanta, offers one approach. He suggests first estimating the expenses that the surviving family members are likely to incur. You'll want to do this for several time periods. For instance, right after a spouse's death, you may need to cover funeral expenses and pay off any open bills.

Then, for some time period, a surviving parent may have the expense of raising the kids until they're through with school. After that, the spouse may need some income until he or she retires.

Offsetting income
Turning to the other side of the equation, you'll want to estimate any sources of income your family will have. This would include investment income, Social Security payments and any salary the surviving spouse may have.

Taxes come into play here. The proceeds of a life insurance policy typically aren't subject to taxes, so if the face value of the policy is $1 million, the beneficiaries should receive a check for $1 million.

But earnings from the invested insurance proceeds in a permanent life insurance policy typically are subject to taxes. They're taxed as investment or interest income, rather than as wages. If a million dollar policy earns 8 percent, or $80,000, some of that probably would be subject to capital gains tax, which usually is 15 percent. Currently, any dividends earned by the insurance money may or may not be subject to tax.

Next, you need to calculate the yearly expenses and the annual income. The difference between the expenses and the income is the amount that needs to be covered by insurance. For instance, if you estimate that your expenses until the kids are out of the house will total about $1 million, and the surviving spouse will have about $500,000 in income over that time period, a $500,000 life insurance policy probably is a reasonable place to start.

To keep this exercise from requiring too many calculations and assumptions, Klein recommends that you don't adjust for either inflation or for interest. "Assume that inflation and interest cancel each other out," he says.

You also can use this approach to determine how much insurance to purchase for a spouse who doesn't work at a paying job. In this case, of course, you don't need to calculate the impact of lost income. Instead, you'll want to estimate how much it would cost to hire someone to take over the tasks he or she used to handle, such as caring for the children and maintaining the house.

A range of options
Of course, any calculation is only a starting point. Rather than trying to pinpoint one number that will tell you how much life insurance to purchase, it may help to come up with a range of options, says Brown. One calculation might show the amount of insurance needed to fund a very bare bones lifestyle for the surviving spouse and kids, while another would show the amount needed to allow the surviving family members to live comfortably.

Typically, the calculations are valid whether you're purchasing either term or permanent (also known as whole or universal life) insurance. If you need $1 million to cover your expenses, that's what you need.

It's your budget that dictates whether you purchase term or permanent insurance, says Woods. Term, typically, is significantly much less expensive, because once the term is over the insurance is gone. Permanent insurance, on the other hand, may build up a cash value of its own. The right choice will depend on your family's income level and financial status.

For a jump start in determining how much life insurance you need, use our life insurance calculator.

Karen M. Kroll is a freelance writer in Florida.

-- Posted: Oct. 1, 2003

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