Because life insurance by default is bundled with an emotional dimension, it is a hard topic to look at objectively. Insurance agents may try to leverage the emotional dimension to try to sell you more insurance than you need, but it’s important to remember that no life insurance payout will compensate for grief. So when deciding how much life insurance you should take out, put blinders on and momentarily ignore the emotional dimension of potentially losing a loved one or of yourself passing away.
How Much Do You Need?
Don’t wear a tuxedo to the beach or a bikini to a black tie dinner.
In other words, don’t over-cover, but don’t under under-cover either.
Like all insurance products, the more life insurance coverage you buy, the more you’ll pay in premiums. So don’t get sucked in by a big juicy seven digit number that hopefully will never be cashed in anyway. Instead realistically evaluate who actually depends on you financially, and what they actually need if you passed away.
Deciding how much coverage you need is a personal choice, but you may need less than you think. Often insurance agents suggest taking out enough insurance to replace the covered individual’s entire income for several years. However don’t automatically opt for this coverage. While it would be nice to potentially replace an entire income, this is going to mean high premiums in the mean time, which can strain your budget in other ways. Rather, focus on how much your dependents actually need to maintain a stable financial situation.
If You’re Single With No Kids
Barring any exceptional circumstances, you likely don’t need any life insurance if you’re single and kid-less. Assuming nobody is depending on you financially now, nobody will need a payout if you die.
If You’re Single With Kids
If you haven’t already done so, figure out who will become primary caretaker of your kids in the event of your passing. You may want to have a discussion with them about what they would need if you passed. There may be needs that you haven’t thought of, and there may be needs that one of you thought were important, but really weren’t necessary.
For example, if you are relying on your parents to become caretaker in your absence, they may need financial help cover the increased expenses of raising kids full-time, in which case you might need modest coverage. On the other hand, you may be able to leave other assets (retirement and other savings, home equity, etc) that would help cover these costs. Or they may be financially comfortable enough to be able to absorb this cost with no additional payout.
If You’re Married With No Kids
If you’re married without kids, you likely don’t need life insurance. Barring chronic disease, disablement, etc, your spouse will be able to take care of themselves if you die. Likewise, you’ll be able to take care of yourself if your spouse dies. Sure, this may mean downsizing to a slightly smaller place, selling a vehicle, etc. But essentially you’re just going back to the single life.
If You’re Married With Kids
This is where life insurance might start making sense. Raising kids costs money, and that financial burden doesn’t get cut in half when one parent dies. If anything, the burden increases, since you now also have half the amount of waking hours to split between raising your kids and earning an income. If your kids are younger, your now reduced income may need to cover child care too.
However, don’t jump to conclusions! You may need more coverage than you think you need. But you might be able to get by with much less than you assume. Try to imagine your potential financial scenario as best as possible if you or your spouse were to die (remember, momentarily ignore the emotional dimension).
It might even help to draw up a mock budget. Perhaps you’d be just fine living off of a single income. This may especially be the case if all your kids are in school and childcare is no longer an issue. This may also be the case if both you and your spouse make a healthy income and only live off a small portion of it (saving or giving the rest). You may be completely debt free with a simpler lifestyle. It is not unheard of to be saving well over 50% of your income. Also evaluate whether there are expenses you’d be willing to reduce or eliminate for the sake of affordability.
If your single income mock budget covers all your needs, then you don’t need much life insurance, if any at all. Otherwise, use your mock budget to figure out just how much insurance you need. If debt payments are weighing down your budget, perhaps you simply need to take out enough insurance to wipe out your debt (including your mortgage). This would leave you with significantly reduced expenses. On the other hand, maybe you really do need to replace the second income. Figure out how many years you’ll still have the kids in the house. Multiply your income shortfall by that many years.
What About Funeral Costs?
One common argument for life insurance is funeral costs. ‘Funerals are expensive, so I want to make sure I leave my kids with money to pay for my funeral.’ True, funerals can be expensive. But not that expensive. Funerals fall in the ballpark range of $10,000.
If you’ve already decided you need insurance for the above reasons, throw in an extra $10,000 coverage. You don’t want funeral costs to strain an already strained financial situation. But otherwise, consider alternative ways of covering funeral costs. If you have a positive net worth, you assets will likely more than cover your funeral costs. If you do have negative net worth, funeral costs should be the least of your worries. Your premiums are much better spent getting you out of negative territory (ie, paying off debt). Note that debts do not pass to your heirs, but they will erase your life insurance benefit, so if you buy life insurance when you’re deep in debt, you’re essentially buying it for your creditors, not your kids.
The only exception is if you are older and have locked-in lower premiums from when you were younger. In this case, you’re best off sitting down with a financial adviser who can evaluate your situation on an individual basis.
What Kind of Life Insurance Do I Need?
So you’ve determined that you do in fact need life insurance. But there are two kinds of insurance- whole life and term life insurance. Your insurance agent may try and sell you whole life insurance. They may try very aggressively (they typically make more money on whole-life insurance). But assuming you are buying life insurance for the reasons discussed above, you just need term life insurance.
Term life insurance just covers you for a certain period of time (the term of the policy). Typically the terms range between 10 and 30 years. Term life insurance is much cheaper and only covers you for when you need to be covered. Once your term life insurance is up, your kids will be out of the house and you won’t need coverage anymore.
With whole life insurance, it is no longer a question of if the policy will pay out, but when. Furthermore, whole life insurance tries to be a hybrid between insurance, and investment and a tax shelter, which makes it more confusing, less efficient and much more expensive. Don’t try to make life insurance do more than it’s supposed to do. If you have 5 million to leave to heirs, or 23,000/year to sock in retirement, we can start talking exceptions.
Remember the Purpose of Life Insurance
Of course, the unlikely event of losing your spouse would be hard. And losing an income makes it even harder. But it’s important to remember what life insurance is and isn’t. Yes, it is absolutely vital that you have enough coverage to protect you from financial catastrophe. But there’s no sense in paying for too much life insurance and sticking yourself with high monthly payments that you’ll hopefully never see a return on.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.