How much life insurance do you need?

June 13, 2014

Last week’s column dealt with the question, “Do you need life insurance?” Hopefully, it provided you with some ideas. This column addresses the question, “How much life insurance do you need?”

There are a few simple methods one can use to estimate life insurance needs, and these may work if your situation is, indeed, simple. A very basic tool used to measure life insurance need is the multiple of income method. A common rule of thumb says that your insurance coverage should be equivalent to 6 to 8 eight times your yearly salary in order to cover your needs. So, for example, if you earn $80,000 per year, you should have between $480,000 (6 x $80,000) and $640,000 (8 x $80,000) in life insurance coverage.

A somewhat more precise measure is called income plus expenses. This rule calculates your insurance need to be equal to five times your gross annual income plus the total of any mortgage, personal debt, final expenses, and special funding needs e.g., college education. For example, assume that you earn a gross annual income of $80,000 and have expenses totaling $200,000. Your insurance need would be $600,000 ($80,000 x 5 + $200,000).

There are other more comprehensive methods available to calculate life insurance need. Overall, these methods are more detailed than the rules of thumb discussed above, and they provide a more comprehensive view of your insurance needs.

The income replacement calculation is based on the theory that the family income earners should buy enough life insurance to replace the loss of income due to an untimely death. Under this approach, the amount of life insurance you should purchase is based on the value of the income that you can expect to earn during your lifetime. This takes into account such factors as inflation and anticipated salary increases, as well as the interest that the lump-sum life insurance proceeds will generate.

Yet another method is the family needs approach. This one requires you to purchase enough life insurance to allow your family to meet its various expenses in the event of your death. Under the family needs approach, you divide your family’s needs into three main categories:

  • Immediate needs at death – cash needed for funeral and other expenses
  • Ongoing needs – income needed to maintain your family’s lifestyle
  • Special funding needs – college funding, bequests to charity and children, etc.

Once you determine the total amount of your family’s needs, you purchase enough life insurance, taking into consideration the interest that the life insurance proceeds will earn over time, to cover that amount.

The above-mentioned calculations are for taking care of dependents after the demise of the breadwinner; however, there are several other needs for life insurance. One is estate preservation and liquidity needs. Let’s say that you currently have an estate worth $2 million. This is not unusual in this area when you consider that you have to add up all of your assets e.g., bank accounts, stocks, bonds, mutual funds, pension plans, business & practice values, real estate, your home, and any life insurance that you have not removed from your estate.

In 2014, every person may leave, or give away up you $5.34 million without owing any estate tax. As a practical matter, that means that under the new rules about 99+ percent of all estates will not owe any federal gift/estate tax. The exemption amount is indexed for inflation each year. Unlike legislation enacted in the last several years, there is no sunset provision for these amounts; indexed for inflation, they will stay in force until Congress changes them again.

One popular feature of the current estate law is that spouses can combine their estate tax exemptions, effectively letting married couples give away, or leave more than $10 million without owing tax. The new law makes this feature, called “portability” by tax experts, permanent.

However, if you do owe any estate tax, the rate is 40 percent, but rather than have your estate pay out the cash, you may want to consider setting up an irrevocable life insurance trust. The trust purchases life insurance on you (this keeps it out of your estate) and, if married, your spouse, through a second to die policy. At your demise, the insurance company pays the money to the trust and the trust uses the money to pay your estate tax. This way, the estate does not have to pay the estate tax with dollars because the death benefit will always be greater than the premiums paid.

While there are many, many reasons to have life insurance, there are many, many calculations you can use to determine how much coverage you need. The key is to find the right one.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann, CFP® is a registered representative with and securities and insurance offered through LPL Financial. Member FINRA/SIPC. He can be reached at 600 East Crescent Avenue, Suite 104, Upper Saddle River, NJ 07458, 201-291-9000.