The Right Amount Of Life Insurance
If you haven’t done so already, calculate your net worth to assess how you did this past year. Hopefully, you’ve grown your net worth, despite the stagnant stock markets through aggressive savings, retirement company matches, a diversified investment portfolio, rental property cash-flow, and an increase in your start-up’s value.
Wait, all you have is your savings? Then you better start diversifying your income stream so you’re always moving forward, no matter how rough the economy. Once you’ve calculated your net worth, make sure your life insurance levels equals this amount, especially if you have dependents, or a spouse who makes much less than you. If you die, and want your loved ones to maintain a similar standard of living, consider matching your life insurance amount with your family’s net worth amount.
Some might not agree with this life insurance guideline and wonder whether it would be better to have insurance that equals a family’s debt level only. Having enough life insurance to pay off all of your family’s debt is better than no life insurance at all.
If you’re single and have no dependents, do you really need life insurance? Probably not. If you die with a million bucks in debt, you’re living large!
Consider the Robinson family in San Francisco with two children ages 8 & 7:
* Wife (35) Income: $200,000
* Husband (34) Income: $60,000
* Savings Rate After Tax: 30%
* House Value: $900,000
* 401K/IRA: $500,000
* Cash: $100,000
* Personal Stock Portfolio: $100,000
Total Assets: $1,600,000 + $45,000 a year in savings each year they work.
* Recurring Private Education Cost: $25,000
* Mortgage: $500,000
* Consumer Debt: $20,000.
Total Liabilities: $420,000
Net Worth: $1,090,000 – $30,000 a year for the next 15 years as their two kids finish high school and go to college.
Take a moment to consider the Robinson’s family situation. How much life insurance should Mr. Robinson take out, and how much should Mrs. Robinson take out?
Mrs. Robinson’s Situation
Mrs. Robinson is clearly the breadwinner of the family. If her income disappears, it’s up to Mr. Robinson to take on the $420,000 debt level, which is 7X his annual income. Furthermore, after taxes, Mr. Robinson will only have about $42,000 left over, barely enough to cover the $30,000 a year in tuition! In this scenario, is a $420,000 life insurance policy enough? Probably not, since even after all debt is paid, Mr. Robinson would have to spend the majority of his salary on his kids tuition, buffered by the $100,000 in cash savings he can use penalty free.
With a $1,100,000 life insurance policy, Mr. Robinson can breathe much easier as he can use $420,000 to pay off all debt and have $670,000 left to pay for his kids education for 20 years and maintain his living situation without further disrupting his family.
$1.1 million happens to be 18X Mr. Robinson’s income as he is living larger than his income could allow on his own.
Mr. Robinson’s Situation
If Mr. Robinson dies, the financial hit is not as great given his $60,000 gross income. Mrs. Robinson’s $200,000 gross income can pay the $30,000 a year in tuition, an estimated $30,000 a year in mortgage costs at a 4% interest rate level, $10,000 a year in property tax, and $30,000 a year in food, clothing, and travel with $20,000 left over.
$20,000 left over for savings is still good, but will there really be $20,000 left over if Mr. Robinson is no longer around? Unlikely, given Mr. Robinson had very flexible hours and was able to care for the kids while she worked late and sometimes on the weekends. Mrs. Robinson needs help as a single mother, and the $20,000 goes towards paying for help.
Given Mrs. Robinson makes $200,000, she should have no problem paying the extra $50-$100/month for a $1.1 million life insurance policy vs. a $420,000 life insurance policy. $1.1 million equals 5.5X Mrs. Robinson’s income.
CONCLUSION
When you lose a spouse, the last thing you want to do is have more disruption due to your finances. Are you really going to pull your kids out of school and away from their friends after their mother or father just died? No. The surviving spouse will be in mourning, and needs that life insurance policy as insurance that he or she can have as much time possible to figure things out.
If necessary absolutely necessary, the surviving Robinson parent can sell all assets to cover all liabilities and net roughly $1 million in cash after fees. However, the family still needs a place to stay and go to school.
It’s foolish to be underinsured to save a nominal amount of money every month. $420,000 worth of cheap life insurance is better than zero in the Robinson’s case. However, it’s best to simply match the life insurance amount for each spouse to the estimated net worth of the entire family.
To Review:
* At a minimum, take out enough life insurance to cover all liabilities.
* Consider taking out enough life insurance to match your family’s estimated net worth.
* If you’re estimated net worth is small, consider the cost of getting life insurance equal to 5X-10X the highest income earner.
* Check your company policy. Many employers will offer anywhere from a 1-5X base salary life insurance multiple. If you want more, you just have to elect and pay.
* Protect your assets by taking out an umbrella policy, which covers liability beyond your car and house insurance policies.
Readers, how do you calculate how much life insurance to take? Do you have life insurance? If not, why? How much life insurance do you have?
Regards,
Sam
Photo: Empty inner-tube, Kahala. SD.
Good read Sam. Typically, reading about life insurance is a bore, but the income and expense example really livened it up. Thanks.
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For most people, just having life insurance equal to their net worth would be far too low. But they probably don’t have a lifetime financial plan mapped out in excel so they can calculate exactly how much they need to replace their income and unpaid work at any given time. For others it might be far too high if their net worth is in investments that make income unnecessary.
It seems like the 10x income + debt approach is more common which is what I started with. I’m going in to make some minor adjustments today but I’ll be looking at an increase too since my income has gone up and become more essential. I also want to make an investment plan to leave behind that makes it really simple to manage the amount left after paying off debts.
Incidentally the current insurance amount minus current debts is just enough to invest to cover our expenses today :)
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Financial Samurai Reply:
January 18th, 2012 at 7:02 am
Good point mate. In many examples, people’s net worths are quite light, so what’s the point. The example in this article is for more of an established family with a good amount of assets and liabilities.
If for some reason, there is a family with a low net worth, 10X income + debt sounds like a good idea. It depends on costs and what the family feels comfortable spending.
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If you are in the process of getting out of debt, you should have enough to cover your liabilities. I bumped up my life insurance to that point last year and I feel great about it. I even have a little buffer that would probably feed my family for a year.
Once you eliminate consumer debt and start growing your net worth, that would be a good time to look into increasing your coverage.
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TekGems Reply:
January 18th, 2012 at 9:00 am
My confusion with life insurance is:
1) If you have liabilities, do you not expect to pay this off after a number of years? After your debts are paid off, you would be overinsured?
2) Don’t you need ongoing cash for your family? Is 10x your income really going to cover? Aren’t we assuming we will get 10% from the market? That seems a bit out of reach… Dividend stocks are not paying that much. So, wouldn’t 20x be more appropriate so that a 5% return (more realistic) is required vs 10%?
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John | Married (with Debt) Reply:
January 18th, 2012 at 9:38 am
1) I do expect to pay them off, but a house can take a number of years to pay off and I could die in that time frame. Overinsured? Maybe at the end of the repayment, but $20/month to buy $100k in coverage is a pretty good deal and probably worth keeping.
2) Depends on your family. Is your spouse disabled? If so, you may need more coverage. As long as you are managing lifestyle creep and saving, you’d probably be ok. For us, life insurance isn’t THE plan for if I die, but part of it.
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I used a needs basis to calculate life insurance and buffer in opportunity cost for loss of income. My spouse and I have similar incomes so this makes my equation a bit easier. We both have 1 million dollars of life insurance coverage. This allows us to pay off all debt and still have 600k left over. with no debt, 600k and a high income job. If one of us drops dead the other would be set for life financially even if the 600k is invested in a low risk investment paying 3% a year.
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Financial Samurai Reply:
January 18th, 2012 at 2:47 pm
The key as you say is No Debt. NO debt and no dependents makes living life easy.
Sounds like you’ve got a good plan.
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Is there anybody that doesn’t have life insurance? I get some free through my employer but it only 1X my annual salary…
I want to live in this world being worth more alive than dead.
-Mike
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Financial Samurai Reply:
January 18th, 2012 at 2:48 pm
Sure, lots of self employed folks don’t have life insurance. We take it for granted that most of us with jobs have something.
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I don’t have life insurance simply because I’m single with no dependents. Once that changes I’m sure I’ll reconsider and look into a policy. As you say, it does seem foolish to be under-insured based on your example above. That said, I would probably be looking at around 10x my salary right now for an insured amount.
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Financial Samurai Reply:
January 18th, 2012 at 2:49 pm
Yep, if you’ve got little to no debt and no dependents, life insurance is a waste.
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Right now, I’ve just got the life insurance provided by my job, which is about 40 cents per month and worth approximately 2x my salary. Of course, this is enough for me right now, but since I’ll be going through some major changes in life soon (getting married) it wont be near enough then. Once i get married, I’ll consider my options with my spouse and make a decision.
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Financial Samurai Reply:
January 19th, 2012 at 12:56 pm
When is the big date again?
Even if you marry, you might need less life insurance if you don’t have kids giving cohabitation is cheaper than single habitation.
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Jeff @ Sustainable Life Blog Reply:
January 19th, 2012 at 1:06 pm
This july – have already been in cohabitation for a while, so that point is out. I’m sure that this will be one of the (many) things my future wife and I will have to do that I consider boring.
Including figuring out health insurance, etc.
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good article. personally, enough to cover all the liabilities and leave some to sustain the current lifestyle of those who depend on me for at least 10 years (yeah I know)…
agreed – umbrella is a must (IMO anyone with a net worth of half mil and more)
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Financial Samurai Reply:
January 18th, 2012 at 9:48 pm
Thanks. What type of insurance have you taken out and the multiple of income coverage if any?
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If you have a family, you should have at least 10x income in life insurance. I think life insurance should be enough to cover education cost so take 21 – (your kids’s age) and that’s how much you x you need. If your kid is 6, take 21-6 = 15. You need 15x your income.
Assuming your income is enough to cover living cost and you don’t have large recurring debt.
I don’t think net worth is the right number to look at for life insurance calculation. Currently I have 8x to 15x salary depending on how I go. Now that you made me thought about it, that’s not enough. I probably need 20x since the kid is not even a year old.
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Financial Samurai Reply:
January 18th, 2012 at 12:23 pm
Are you saying the net worth number is not the right amount because your net worth is too low?
What about in the Robinson family case?
Are you assuming one spouse, after their spouse’s death never returns back to work? That’s not a fair assumption is it?
Thx
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Like YFS, I like a needs-based analysis of my life insurance such as this. Wouldn’t they calculate the shortage for retirement also and present value that number to cover the amount he would have added to any retirement plans to meet the goal?
I love the example. Makes the life insurance discussion much more concrete.
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Having kids really calls for a good life insurance policy. I get pretty good coverage from my work as does my DH so we are comfortable with what we have right now. If we have kids though we’ll probably get additional coverage to rest easier and make sure they will be taken care of.
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Financial Samurai Reply:
January 18th, 2012 at 9:49 pm
I agree. Having kids changes EVERYTHING! The other thing is, if one spouse is living larger than his or her income would allow by themselves. If you guys have a positive net worth, just sell everything and downgrade your lifestyle.
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I see life insurance and other insurance (disability, long term care & liability) as part of financial planning. In some ways it is as important as medical insurance. After all, we are going to die sometime.
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Financial Samurai Reply:
January 18th, 2012 at 9:49 pm
Most definitely. I have a full article on long term care in the pipeline.
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The net worth figure that you suggest is too low for my situation, but I think that I have the right amount of insurance. How do I know? My life insurance would pay off all our debt and leave my wife with enough passive income from real estate to replace almost half my take home pay. Plus, she would have more left over in stocks also.
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Financial Samurai Reply:
January 18th, 2012 at 9:50 pm
Is it b/c your net worth is too low or too high?
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My fiancee and myself have 3 times our income. But we have no additional dependents. I just have it if anything happened to cover funeral costs, outstanding student loans, and our rental property mortgage.
When we have children I plan on upping the number to 10 times for each of us (I’ll probably round up to the nearest half million). At that point you want to make certain that if anything were to happen they would keep their current lifestyle.
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Financial Samurai Reply:
January 19th, 2012 at 12:57 pm
Sounds like a good plan to me. Have you ever inquired to ask how much more insurance costs?
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I agree with the needs based approach – take out enough to see the dependants through to the point where they can carry on without you.
That said, it costs money and taking on more than is needed is detrimental to your family’s finances.
At the other end of the spectrum from your example are people who don’t need any insurance even with dependants. Using myself as an example, I intend to take early retirement and will cancel my term life policy one year after I retire even though I have a spouse and two young children. Why? By definition if there are enough savings to support the four of us there has to be enough to support my spouse and children after I am gone.
NOTE: if Hong Kong had estate duty, I would look at the numbers again on an after tax basis.
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Financial Samurai Reply:
January 18th, 2012 at 9:46 pm
Sounds like a plan. The other thing is, if you can afford to retire, can you not afford to pay extra for life insurance?
I guess life insurance becomes an extra income boost option then.
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We don’t have kids, but I am the primary (currently sole) earner in the family, so I carry the max life insurance I get through my job. Besides the house, our only other debts are my student loans, which are non-transferable, so he doesn’t have to worry about paying them off. So, I have enough to life insurance for him to pay off the house and live for 2+ years depending on his spending. Since we now have a roommate paying rent and helping with groceries, I’m guessing he could make those 2+ years and still pay for school out of pocket, though without my income, he would qualify for grants/free student aid
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Needs-based makes much more sense for me. Kids college + income replacement + debt repayment – available assets (the latter 2 together are net worth). With small kids I think you do need to plan for college, and since I am sole income earner right now, income replacement for certain number of years is important, at least until kids are older. Doing the calculations we ended up with 10x my income.
I am actually just going through the process of adding more insurance to get it to that level. I had 5x insurance through my employer and was very surprised to find it’s quite more expensive than what is available outside, easily a $100-200 difference per year. Makes sense actually since I am in excellent health and don’t need to pay average group rates, but I never thought to look before
Also, on the over-insurance point, I’ve decided to stagger it up a bit. Take a 20 year policy for part of the amount and a 25 year for the rest. That way the coverage drops once college costs are mostly out of the way and a few years after we won’t need coverage at all (without dependents and hopefully enough retirement savings)
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Financial Samurai Reply:
January 18th, 2012 at 9:41 pm
Sounds like a good plan. A term policy that expires after the kids graduate from college is a good plan, that’s probably the cheapest all for what it is.
The question I’m beginning to wonder is whether people’s net worths are too low when they are in their 30s and 40s, hence why folks don’t agree with getting insurance as much as once’s net worth
In my example, the Robinson’s getting a $1.1 million policy is equivalent to around 5X the wife’s income.
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I got really panicked about this when we had our first child and got cover for both myself and my wife. Unfortunately the premiums can be a real killer, so you really do have to spend some time finding the best fit.
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Financial Samurai Reply:
January 19th, 2012 at 12:59 pm
How much are the premiums in Aus? I thought life insurance is really cheap there? Or am I totally confused?
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Do you recommend to increase the amount as one get closer to retirement? Would it be a good idea to try and get enough of a life insurance policy so that there could be a real windfall for the grandkids?
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Financial Samurai Reply:
January 19th, 2012 at 10:07 am
Ironically, no. As we get to retirement, it’s because we are able to retire that we don’t need life insurance anymore. The “retirement” is the end game.
Although, I hear what you are saying regarding having a windfall for the kids since you will be closer to death anyway. I’ll have a think.
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Sam,
Even if you are debt free and have no dependants, you might consider having insurance on your life (but not in your name) – to help heirs with estate taxes. I’ve read many horror stories of families losing land, inherited IRA money, and other assets that have been in the family for generations because the owner passed without planning well to mitigate the tax situation.
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Financial Samurai Reply:
January 19th, 2012 at 5:43 pm
What about just selling the asset to pay for the tax bill?
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I have most of my insurance through my employer which is a bit risky. If I leave, I’m uninsured and also read lately that sometimes employer-sponsored insurance isn’t as strong or supportive of policies (i.e. they try to weasel out of paying). Not sure how much of a problem that is since the example I read was someone that died drunk driving, but evidently, it’s easier for them to get out of paying out policies than a routine insurer?
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My employer allows up to 8X gross income as life insurance and up to 3X spouse’s income. I have opted for maximum on both of them.
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We have carried life insurance for many years – there are children and the age difference between them is large. About three years ago, when the whole financial awakening of mine began, I looked and saw that we have been paying far too much for too long, for cover that was insufficient – because we didn’t review the situation for years. When we change, the logic we followed is very similar to the one you illustrated. Best thing thought would be for us to be OK for a long time yet; regardless we are prepared.
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