As I stated in the last Life Insurance Blog entry, how much coverage to purchase is the most commonly asked life insurance question. What I’m going to do now is first give you the answer to the question, then give you an example, and then let you perform a needs analysis of your own. Ready? Let’s get started. Many brokers, agents, and advisers may tell you that the correct answer to the question is to simply purchase an amount equal to times your current annual income. Others may say to buy only enough life insurance to replace the income you are expected to make between now and retirement. Yet, others may suggest purchasing only enough life insurance to cover your present debt. While you can probably do all of these calculations quickly and easily, they won’t give you the right answer.
To determine the right amount of insurance to ask for when you request your life insurance quote, keep this in mind: the goal of life insurance is to ensure that your loved ones will maintain their current standard of living after you’re gone. After all, life insurance isn’t for those that die; it’s for those that live.
The best way to determine the appropriate amount of life insurance is through a “needs analysis,” which can be broken down into a simple formula: (short-term needs + long-term needs – assets = amount of life insurance needed). I recommend performing a needs analysis annually, or whenever there has been a major life change (child birth, major purchase, etc.). A needs analysis can be completed in four steps:
STEP 1: DETERMINE SHORT-TERM NEEDS
Make a list of what would become your family’s short-term needs in your absence. At a minimum the list should include the following:
- Final Expenses: Outstanding medical and hospital bills, funeral expenses, attorney fees, executor fees, probate costs, estate taxes, etc.
- Outstanding Debts: Mortgage, credit card debt, auto loans, student loans, etc.
- Emergency Expenses: Cash reserve for medical emergencies, auto repair, etc.
STEP 2: DETERMINE LONG-TERM NEEDS
Next, make a list of what would become your family’s long-term needs in your absence. At a minimum the list should include the following:
- Family Expenses: Typically, family expenses include childcare, food, clothing, utility bills, entertainment, travel, and transportation. Multiply the amount of family expenses times the number of years that you would like to provide this income (family expenses x number of years).
- College Tuition for Your Children: Because there is no way to predict what college tuition will be when a child reaches college age, I recommend using the current annual tuition cost multiplied by 4 (four years of college) then multiplied by the number of children ((current average annual tuition x 4) x (number of children)).
- Income Replacement: Gross annual income for seven years is the standard when determining income replacement, which is what I recommend (gross annual income x 7). However, a strong argument can be made for replacing annual income until the insured would have reached retirement age (gross annual income x years to retirement).
STEP 3: DETERMINE ASSETS
Next, make a list of what assets you already have in place that can be applied toward providing for your family’s financial needs your absence. It’s important to count only liquid assets (those that could be quickly converted to cash) among your resources. You shouldn’t count items such as your home or automobile, because selling them for cash when would mean changing your family’s lifestyle. At a minimum the list should include the following:
- Savings Accounts.
- Stocks.
- Bonds.
- Retirement Accounts: Although your retirement account is payable to you upon retirement, it is also payable to your beneficiary in the event of your death.
- Investment Properties.
- Residual Income: Commissions, commission renewals, annuity payments, structured settlements, etc.
- Existing Life Insurance: Many people have limited life insurance policies through employers, built into loans, etc., that can be added into the equation.
- Future Social Security Payments: You may visit the Social Security Administration’s website (www.ssa.gov) to determine an estimate of how much you have earned in Social Security benefits. To keep things on an even keel, be sure to multiply the annual SSA income benefit amount times the number of years you chose to replace your annual income in Step 2.
STEP 4: DO THE MATH
Finally, take the totals from the first three steps and substitute them into the financial needs formula (short-term needs + long-term needs – assets = amount of life insurance needed).
Now, let’s put you to the test. Let’s say that Mr. Jones dies suddenly at the age of 42 leaving behind a wife and two children. At the time of his death Mr. Jones was earning $40,000 annually that he would like to replace for seven years, has no liquid assets other than an earned Social Security benefit of $7,200 annually that will be paid to his wife, and a life insurance policy through his employer worth $10,000. Mr. Jones’ untimely death created $22,000 in final expenses that must be added to $32,000 of existing debt, and a mortgage of $80,000. Mr. Jones’ wish was to put both children through college (estimated at $15,000 annually per child), provide $10,000 in emergency cash, and $5,000 annually for 5 years for family expenses. How much life insurance should Mr. Jones have purchased?
If your final answer is $508,600 then pat yourself on the back. You’re now ready to do your own needs analysis and request your Tennessee life insurance quote.