Life Insurance-How Much and What Kind Do I Need? 4/8/07
Stewart H. Welch III, CFP, AEP
Founder, The Welch Group, LLC
Life Insurance-How Much and What Kind Do I Need?
“Life Insurance- How Much and What Kind Do I Need?”
This week, I start a series of discussions around the core of financial planning—insurance. In each column, I’ll outline the key issues and recommend what steps you need to take in order to make certain that your coverage is complete for each area including life, health, disability, homeowners, auto and liability insurance.
When considering your life insurance needs, there are two primary questions you should ask:
How much life insurance do I need? Before I explain the ‘how much’, let’s answer the ‘who’. Who needs to own life insurance? The primary purpose of life insurance is to replace income for dependents should a primary income-earner die prematurely. If you don’t have dependents, you generally don’t need life insurance. For example, if you are single and have no children, you probably don’t need life insurance. If you are the income-earner and have dependents, consider buying 15 to 20 times your gross annual income. For example, if you are married with two children and you earn $100,000 per year, consider buying $1.5 million to $2.0 million minus the value of your existing investments and savings. This should provide sufficient money to replace the lost income and provide some funding for future expenses such as periodic replacement of vehicles, college education, and weddings. If both spouses work, use this same formula to determine the insurance need on each spouse. If one spouse stays at home, buy enough life insurance on that spouse to cover hiring someone, such as a nanny, to do the home duties. Typically $100,000 to $250,000 is sufficient. In nearly all cases, buying life insurance on children is unnecessary. It falls into the category of ‘nice to have’ not ‘need to have’.
What kind of life insurance should I buy? Life insurance can be divided into two basic categories: term insurance and cash value insurance. Term insurance is ‘pure’ insurance, like fire insurance on your home. You pay a premium. If you die during the premium coverage period, your family collects the face amount of the policy. If you don’t die, the insurance sends you a premium notice allowing you to extend the coverage for another period of time. With cash value insurance, you essentially pay the term insurance premium plus additional funds that the insurance company then invests on your behalf. Depending on which type of cash value policy you choose, you may invest in mutual funds (Variable Life), interest rates that adjust yearly (Universal Life), or the general assets of the insurance company (Whole Life). For most people, term life is the best choice because if you have dependants you’ll need a lot of insurance and term is typically less than 10% of the cost of a cash value policy. For example, a 40-year-old male buying $1,000,000 15-year level term policy would pay a premium of $450 per year compared to about $6,000 per year for Universal Life.
What you should do now. First, review your existing life insurance to determine if you have enough coverage based on my formula in #1 above. Next, determine if your current premiums are competitive by going to the