You might be asking yourself this question: "How much life insurance do I need?"
Some financial advisors will tell you to multiply your annual income by seven. Others will tell you to buy only enough life insurance to replace the income you are expected to make between now and retirement. Some might recommend you buy only enough life insurance to cover your present debts.
While you probably can do all of those calculations in a minute, they won't give you the right answer. Simply put, calculating your life insurance needs takes homework. It requires you to do an inventory of all of your finances, and to think long and hard about how your beneficiaries would maintain their lifestyles without you. You also must consider inflation and, if you have children, future college education costs.
Many experts say the best way to calculate the amount of life insurance you need is through aneeds analysis, which can be broken down into a simple formula: Short-term needs + long-term needs - resources = how much life insurance you need. Snowdon says this method is "probably the most accurate approach in what is an inaccurate and imprecise science."
Experts advise you do an analysis at least once every three years, or whenever you have had a major life change. For example,
if you have a new baby, you have to recalculate college education needs and child-care costs. If you own a home, a mortgage is likely your biggest financial burden. Because your mortgage balance decreases with each payment, it's important to include those revised figures in your calculations.
Step 1
Add up all of your short-term needs. These can be placed into three categories: final expenses, outstanding debts and emergency expenses. Among final expenses are medical, hospital, and funeral expenses, attorney and executor fees, probate court costs, and any outstanding taxes that would need to be paid if you died. Among typical outstanding debts are credit card balances, auto loans, college loans, and all other outstanding bills. Emergency expenses should include a cash reserve for medical emergencies and repairs to your home or car.
Calculating final and emergency expenses can be complicated, because you don't have a crystal ball that tells you how much your medical or hospital expenses will be, or if you even will have any.
Step 2
Next, add up your long-term obligations, which include your mortgage and college tuition.
Calculating an education fund is tricky because you have no idea where your children will be going to college. Perhaps the best method is to use the present average college cost in the United States and the number of years away your children are from entering college. The average college costs for the 2003-2004 school year were $4,694 annually for a public, four-year institution, and $19,710 annually for a private, four-year institution, according to The College Board. These tuition costs represent an increase of 14.1% and 6%, respectively.
Despite these somewhat higher increases, the U.S. Department of Education reports college costs traditionally have risen at about 5 percent annually, so you need to figure out what the cost will be when your child goes to college. (To calculate what costs will be in the future, see the sidebar regarding the future value of money equation. Also be sure to calculate what the entire education will cost while taking into account the increased costs each year.)
Step 3
Next, calculate family maintenance expenses. These include such necessities as childcare, food, clothing, utility bills, entertainment, travel, and transportation. Calculate this figure based on a year's worth of expenses, then multiply that times the number of years you want to provide this income.
Once you've done that, add your short and long-term debts/obligations and your family maintenance expenses together.
Step 4
Now that you've tallied all of your income needs, figure out what resources you have to meet them. To do this, add all available savings, stocks, bonds, mutual funds, the death benefit payable under existing life insurance (such as group life through your employer), and Social Security. You and your spouse can find out how much you'll get through the Social Security Administration (SSA) by visiting the SSA's Web site, where you can get an estimate of how much you should have in Social Security benefits.
"Many people will look at the final figure and say, 'I can't do that.'" |
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 after you die would mean changing your family's lifestyle.
Step 5
Subtract your resources from the amount of capital needed to meet your family's total financial needs. The figure you get represents the amount of life insurance you should buy.
Snowdon says the final figure that shows how much life insurance a person needs can be quite alarming. If you end up with an astronomical figure that requires a premium that is too high, he recommends you go through the analysis again and select areas in which you think your family can get by with less money.
"Many people will look at the final figure and say, 'I can't do that,'" Snowdon says. "You have to look at it, figure out which is the most crucial, start making adjustments, and go from there."
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