Insurance

How Much Life Insurance Do I Need?

Recently, I came across an article titled How To Be Broke on $75,000 a Year[1]. As I reviewed the sample budget, one thing that stuck out was the monthly life insurance payment of $100. There seemed to be a lot going on there that didn’t seem prudent.

Who Needs Life Insurance

Life insurance is for survivors, specifically survivors that are financially dependent on you and would be impacted by your untimely demise. This is typically spouses, children, and other dependents. If you’re not breadwinning for a spouse, children or dependents, you probably don’t need life insurance. It may also make sense to insure a stay-at-home spouse that is the primary caregiver for small children to cover child care expenses.

When my father died prematurely over a decade ago, he happened to have a small term life insurance policy that my mother was able to collect. However, my father wasn’t the breadwinner when he passed away; my mother was. The insurance helped my mother transition to single life, but it probably wasn’t necessary.

The example in the article is a single individual and appears to have no dependents. They probably don’t need life insurance. What about future dependents, you ask? Even then, it’s not likely that the insured’s health will change so drastically between now and then that it would make financial sense to start a policy now, rather than later.

What Kind of Life Insurance Do I Need

Term life insurance is the simplest kind of insurance. You select the term or number of years that you want to be insured for. The annual fee is fixed and guaranteed to not increase during the term. In general, the healthier you are and the healthier your family history, the less you will pay. Term life insurance can often be extended beyond the term, but the annual fee is no longer guaranteed and typically balloons. For example, one of my life insurance policies has an annual premium of $290. In 2042, the first year outside of the term, the annual payment will jump to $1,583. In 2043, the year following, the premium is $2,876 and it keeps climbing rapidly from there. I’ll be self-insured at that point.

Another kind of insurance is group insurance, often through an employer. It can often come with a lower price, but it can suffer from a higher price to port it to your own policy, should you leave your employer. I was once speaking with a family member who had gone through a rough patch health-wise and expressed that one of the reasons he stayed with his current employer was because he’d lose the group life insurance coverage. That’s a twist on “golden handcuffs”.

What about all the other kinds of insurance, sometimes called “universal”, “whole life”, “variable universal”, or any other number of beguiling marketing terms? My opinion is that these are typically bad deals for buyers. They often come with high fees and surrender charges, non-guaranteed premiums, and inferior investment outcomes. Why do people buy these? You could say they are sold, not bought, pushed by salespeople (often relatives or “friends”) who get a large commission. Additionally, buyers hate paying out premiums year after year and ultimately getting nothing in return. Do they feel the same about paying for car insurance, feeling they lost if they never total their car? Okay, maybe a little straw-man going on there 🙂

My opinion is to stay away from anything other than term and group life insurance. But then again, I’m no insurance salesman.

The example in the article had a whole life plan, a non-frugal decision, in my humble opinion.

How Much Life Insurance Do I Need?

The example individual in the article had a $1,000,000 plan. We already established that the individual didn’t need it in the first place. But let’s assume they had dependents. Was this an appropriate amount of insurance?

In 2009, I was a young father with a wife and three children, all dependent on my income. I was insured through MegaCorp’s group life insurance plan, but wanted to supplement MegaCorp’s insurance plan with my own term life insurance plan. But how much did I need?

To determine how much, I used the DIME formula: add together the debts, income replacement for 30 years, mortgage and education of my children. Then, subtract current assets such as retirement accounts, college savings, and other life insurance. I also threw in the Social Security death benefit since I had enough credits to qualify at the time. I ignored my own student loan balance because they are forgiven if you die before they are paid off.

The number I came up with was $300k. I chose a 30-year term, at which point I figured I’d self-insure.

I actually repeated the process in 2012, adding another policy, this time with my wife as the policy holder and me as the insured. The term was the same, 30 years, and while the face value was the same at $300k, the premium was lower by $20/year. I no longer needed the group insurance at MegaCorp, and when I left MegaCorp at the end of 2012, I didn’t need to port it to an individual policy. My current employer gives everyone a minimum of $50k of coverage for free. You voluntarily opt for more, but I don’t need to with my other plans.

It’s an Art, not a Science

So let’s look at the example, again assuming that there are dependents in play so we come up with a non-zero need. For kicks, let’s give ‘em 2 kids.

Debts (car, credit) $4,000
Income ($75k * 18 years when both kids are grown) $1,350,000
Mortgage $207,200
Education for two kids ($50k * 2) $100,000
Total DIME $1,661,200

 

Let’s look at the other side of the equation, assets and other insurance.

First, the 401(k). In the example, they’re putting in over $3k year. We’ll assume no match and no growth during the last three years (my number) that they’ve contributed. That gives a rough balance of $9k.

Next, they don’t have much left over from their other expenses, so they probably have zero savings.

We’ll assume that our example also has a bare minimum group life contract at work for $50k.

Lastly, we’ll assume they qualify for a Social Security death benefit. You can log into https://www.ssa.gov/ to see what your specific death benefits would be. I’m lazy here, so I’ll give them $1,000 per month.

401(k) balance $9,000
Savings $0
Group Life at Work $50,000
Social Security Death Benefit (18 years) $216,000
Total Assets and Insurance $275,000

 

$1,661,200 – $275,000 = $1,386,200

In reality, I think this is too much. You’ll notice that the biggest thing in the DIME numbers is the income replacement. But a significant portion of that income is taxes, which we don’t need to replace. Additionally, the mortgage value will decrease over time while the retirement savings and other savings will increase.

But really, how much life insurance is a pretty personal choice of how much risk you want to take.

Conclusion

I hope to never use my life insurance. But I also don’t have a crystal ball. Anyone with dependents should have some life insurance to cover the unexpected.

How did you decide how much insurance to have? I’d love to hear about it in the comments.

Hasta luego!

 

 

[1] As a side note, there were other issues with the article, including the math. The internet was wrong! I posted this as a comment to the article, but it never got moderated. Sharing it here for posterity:

Thanks for the post. I’m trying to make sense of the tax numbers and struggling. Wouldn’t $75k have a net tax of $333 per each of the 26 pay periods?

  $12,200 standard deduction x 0% 

+ $9,875 x 10% or $987.50

+ $40,125 x 12% or $4,815

+ $12,975 x 22% or $2,854.50

Total Tax: $8,657 or $332.96 per each 26 pay period (2020 numbers)

Also, the medical and 401(k) is pre-tax (as you pointed out), but the numbers don’t seem to reflect that. I believe they should drop the SS/Medicare to $195/pay period and the income tax to only $259 per pay period. Assuming the rest of the “budget” stays the same, that leaves you with take-home pay of $2,095 each pay period.  That’s nearly $300 per month, not $7.

Like you, I too am surprised/not surprised how people can earn respectable salaries but still seem to not have any left after paying the bills. Whether it’s an extra $7/month or $300/month, some folks spend it all, and then some.

Thanks again for the thought provoking post.

8 thoughts on “How Much Life Insurance Do I Need?

  1. I got my first real life insurance policy in grad school. $1M 15Y policy for $290/year. I figured that we’d be FI after 15Y, which is coming to fruition. I may drop it sooner.

    How’d we arrive at $1M? I computed at the coverage / premium ratio for a bunch of coverage amounts and found that $1M was the sweet spot for value. $1M is a bit more than we need right now but oh well.

    I’d compute desired insurance amount = desired insurance income / 0.05 = desired insurance income * 20. $50k/year of insurance income * 20 = $1M. That could be sustained for quite a few years, but not infinite given that it’s significantly higher than the 4% or 3% “rules.”

    1. Thanks for sharing. That’s a great, simple calculation that probably makes more sense than the traditional calculators. For most folks, the “desired insurance income” would become the next hurdle.

  2. I am pretty sure my employer offers one full year of salary if I get clipped. I should probably tell my wife, though, because I am sure there is some paperwork she wouldn’t know about. I don’t currently purchase anything off the market.

    “You could say they are sold, not bought, pushed by salespeople (often relatives or “friends”) who get a large commission.”

    I like this. We should get a bunch of bloggers together to start having “Tupperware” or “Thirty One” bag parties but sell whole life insurance instead. Make a killing!

    Your notes on term life, group, and universal are in line with what I have gathered from over the years (i.e. podcasts, etc). My mom had a small insurance policy from General Motors (I think through my Dad’s retirement), that basically covered the funeral and a few other minor things. None of us knew we had it, so it made some of that piece easier considering how rough everything else was. Before it happened, I used to hear about colleagues losing family members, but never really thought through what that actually meant. Sounds weird, I know. Very sorry for your loss.

    Do they really provide you the anticipated balloon payment for 20 years out? Actuaries are amazing.

    Max

    1. Collecting the information prior to any unexpected, early demise is pretty important. When my dad passed, he was running his small business out of a free Hotmail account. No one knew his password and Hotmail support wouldn’t help recover it for free accounts. We were able to extract it from a copy of Outlook Express that he’d once entered it into, but there was a point where we thought we’d lose access to all the communications for the business. An envelope with “open in case of my early demise” would have been super helpful.

  3. Appreciate this breakdown. Life insurance is the missing puzzle piece to my personal finance war chest. I know my union offers +/- $100k if I’m killed on the job, and a few grand for lost limbs, but definitely nothing that would come close to what I’d need if I met an early demise before having enough that we could self insure. I keep kicking this can down the road.

    Thanks for writing this…now to get this task on my to do list.

  4. Thanks for the post, David. I didn’t get any insurance until after I had my first kid. As soon as I had a kid I felt the need to make sure he was going to be okay and same thing happened when we had a second little bundle of joy. Therefore, like you, I considered my debt, income, mortgages (rental properties included), and their education. However, I also added a little extra to ensure their mother, my wife, would still be okay to continue to take care of them. As I only want the best for my family but hopefully they never have to use it!

    1. Thanks for stopping by.

      I agree on never wanting to have to use it! Same with my car and home owners insurance.

      It took me a little longer than you to get my ducks in a row. My first child came right before graduate school when we were as poor as church mice. Insurance was pretty far from my mind at that point.

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