One of the toughest things to do when you're planning your finances is preparing for the unknown. While things like budgeting aren't easy, at the very least you know how much money you bring in each month, and that you don't want to spend more than that amount! Even when dealing with items like student loans, once you find a plan that's fits your household, the payment is what it is and you go about your day. But with things like life insurance, the process can be a bit more complicated. Not only do you not know when you're going to die, but figuring out what's important to leave for your family can be confusing. To help you with your planning, I've put some tips below that give you an idea of how advisors work with their clients to determine life insurance needs.
Step 1: Add Up Your Final Expenses
Do you want to be cremated or buried? Will you have a large funeral or a private service? If you have a funeral, are there family members you would want to attend who might not be able to afford the trip? Consider all of these scenarios in your planning. Also consider that if you do have a working partner, they may not be up to going back to work immediately, which means their income may need to be replaced while they grieve.
Keep In Mind: based on our experiences with clients, we typically tell them to prepare for between $10,000-$20,000 in final expenses. We also build in 3 months' living expenses into our calculations.
Rationale: even if you have an emergency fund, building in final expenses as well as a few months' expenses will allow your loved ones to take time off to grieve, while keeping their emergency fund intact.
Step 2: Determine What Debts Will Be Repaid
Look through your debt obligations and figure out what you would want paid off if you were to die. Do you want a mortgage or a car loan paid off? Is there a credit card bill you want to pay off for them? Add those items together to find out how much of your coverage is earmarked for debt elimination.
Keep in Mind: be sure to research if any of your debts are automatically discharged when you die. For example, if you have any federal student loans, they will be discharged at your death. Your family won't be responsible for paying them, so this doesn't need to be included in your insurance calculations.
Step 3. Determine Future Funding Needs
Do you have a child whose college you want to be paid for in the event of your death? Is there a donation you'd like to make to a nonprofit or religious organization? All of these items can be built into your insurance planning. For college, research schools your children are interested in attending. Don't just look at the current tuition, but think of how long until they'll need the money. If you're leaving behind a 3 year old who you think might attend a state school that costs $10,000/year today, that may not be the case 15 years from now. Go online and find calculators that can give you an estimate on how much to put aside today, so that by the time they get to college the money hasn't lost it's purchasing power. For example, the parent of that 3 year old may need to put aside $20,000 today to account for 15 years of potential tuition increases at a school that currently costs much less to attend.
Step 4: How Much Income Will Your Family Need?
If you are single and have no children, this may be a simple answer for you. But if you have a partner or people who depend on your income, sit down with them and talk through how much money they would need each month or year if you were no longer around. Don't just look at your budget without them and decide what you think is enough: remember, you won't be here to see whether you're right or wrong! Ask THEM how much is enough, and come to an agreement on an appropriate amount. Once you have that number, it's helpful to know a rule of thumb advisors use for life insurance income planning:
Keep In Mind: many advisors encourage families to only live off of 3% - 5% of insurance proceeds each year.
Rationale: the last thing you want is for your family to run out of money. The 3%-5% rule assumes that if your family has a pool of money and lives off of this amount, they will be able to recover what they've spent by investing their remaining funds. Choosing a small percentage will hopefully allow them to invest their money conservatively, so that they don't have to worry about aggressively chasing returns to recover the funds they're spending each year.
What this means for Insurance Planning: to be clear, this is where people underestimate the most. Let's assume that they spend the highest we'd recommend each year, 5% of the amount you leave behind. This would mean that just to replace $30,000 of income each year, you would need $600,000 of insurance coverage.
Step 5: Subtract Any Existing Protections
Do you already have solid coverage from an older policy? Are you leaving behind a pension that will provide an income to your family? What income will your surviving partner be making? If you do some digging you might find that there are already dollars being provided to your loved ones that could reduce your insurance needs. For example, many people aren't aware that if you have children and die, each child will receive a separate Social Security benefit until they reach age 18. Look through your documents and see if there are any other forgotten coverage already available to your family.
Keep In Mind: with very few exceptions, do not include life insurance at your job in your insurance calculations
Rationale: many life insurance policies offered by employers are not portable, meaning you can't take them with you when you leave that job. Even if your job does let you take that coverage with you when you retire, it is not uncommon for a policy to reduce coverage by certain percentages after a certain age. Because you don't know when you'll die, you can't guarantee that you'll die while working at a particular company, so you don't want a significant portion of the insurance your family needs to be in a policy that might not be available to them. For this reason, we discourage including work coverage in your calculations unless you can confirm that it can be taken with you when you leave that job, and that there are no provisions for reducing coverage in later years.
That's it! Hopefully this helped give you some strategies for determining how much life insurance is right for you, and as a bonus, I've put a sample calculator below so you can see a quick example of how to find the appropriate amount of coverage for your family. Please stay tuned as we post and link to articles that dig deeper into finding the right TYPE of coverage, and how to go about purchasing it effectively.