Life insurance coverage may depend on your financial goals and needs.
Death, just like taxes, is inevitable, though most people may not be keen to dwell on it. But ensuring that you have the right financial resources in place, including life insurance, is important if you have loved ones who depend on your income. Life insurance can help cover funeral and burial expenses, pay off lingering debts, and make managing day-to-day living expenses less burdensome for those you leave behind.
If you don’t have life insurance, or you do but are unsure about whether your policy is sufficient, here’s how to evaluate your coverage needs.
What Is Life Insurance?
Life insurance is an agreement in which an insurance company agrees to pay a specified amount after the death of an insured party, as long as the premiums are paid and up to date. This amount is called a death benefit. Policies give insured people the assurance that their loved ones will have peace of mind and financial protection after their death.
Life insurance falls into two different categories: whole and term. Whole life policies are a type of permanent life insurance, meaning you’re covered for life as long as your premiums are paid. Some whole-life policies offer an investment component that allows you to build cash value, taking the premiums you pay and investing them into the market.
Term life insurance, on the other hand, covers you for a set term. For instance, you may purchase a 20- or 30-year policy, depending on your age and how long you need coverage. Some policies allow you to renew your coverage after a certain expiration date, while others require a medical exam to do so. Between term life and whole life insurance, term life tends to offer cheaper premiums.
Who Needs Life Insurance?
Life insurance can be a helpful financial tool to have, but buying a policy doesn’t make sense for everyone. If you're single and have no dependents with enough money to cover your debts as well as the expenses related to death—your funeral, estate, attorney fees, and other expenses—then you may not need life insurance. The same applies if you have dependents as well as enough assets to provide for them after your death.
But if you’re the primary provider for your dependents or have a significant amount of debt that outweighs your assets, then insurance can help ensure your loved ones are well taken care of if something happens to you. Having a life insurance policy could also make sense if you own a business or owe cosigned debts, such as private student loans, for which someone else could be held responsible if you pass away.
Keep in mind that life insurance by itself doesn’t cover every situation. For example, a standard life insurance policy won’t pay any disability benefits if you become disabled, nor will it cover long-term nursing care costs. But you can purchase disability riders or long-term care insurance riders for an additional premium cost that can cover those types of scenarios.
Age and Life Insurance
One of the biggest myths that life insurance agents perpetuate is that you’ve missed the boat if you fail to sign up for a policy when you’re young. The industry leads us to believe that life insurance policies are harder to get the older you become. Insurance companies make money by betting on how long people will live.
It’s true that insurance is cheaper when you are young. But that doesn’t mean qualifying for a policy is easier. The simple fact is that insurance companies want higher premiums to cover the odds on older people, but it is very rare that an insurance company will refuse to cover someone who is willing to pay the premiums for their risk category. That said, get insurance if and when you do need it. Do not get insurance because you are scared of not qualifying later in life.
Should You Use Life Insurance as an Investment?
It’s possible to consider life insurance to be an investment if you have a policy that builds cash value. Cash value policies are generally touted as another way to save or invest money for retirement. These policies help you build up a pool of capital that gains interest. This interest accrues because the insurance company is investing that money for its own benefit, much like banks. In turn, they pay you a percentage for the use of your money.
But it’s important to consider the rate of return that you might earn. If you take the money from the forced savings program and invest it in an index fund, for example, you may realize better returns. For people who lack the discipline to invest regularly, a cash value insurance policy may be beneficial. A disciplined investor, on the other hand, could generate higher returns by putting the money they would pay toward premiums in the market
What Is the Minimum Amount of Life Insurance You Need?
A large part of choosing a life insurance policy is determining how much money your dependents will need. Choosing the face value—the amount that your policy pays if you die—depends on a few different factors. As such, the minimum amount of coverage you need may be very different from what someone else requires. Financial experts often recommend purchasing 10 to 15 times your annual income in coverage, although your personal number may be higher or lower. Here are some of the most important considerations for choosing a minimum amount of life insurance.
Life insurance can be used to pay off outstanding debts, including student loans, car loans, mortgages, credit cards, and personal loans. If you have any of these debts, then your policy should include enough coverage to pay them off in full. So if you have a $200,000 mortgage and a $4,000 car loan, for instance, you need at least $204,000 in your policy to cover your debts. But don’t forget the interest. You should take out a little more to settle any extra interest or charges as well.
One of the biggest factors for life insurance is to replace income. If you are the sole provider for your dependents and bring in $40,000 a year, for example, you will need a policy payout that is large enough to replace your income, plus a little extra to guard against inflation.
To err on the safe side, assume that the lump sum payout of your policy is invested at 8%. You will need a $500,000 policy just to replace your income. This is not a set rule, but adding your yearly income back into the policy ($500,000 + $40,000 = $540,000 in this case) is a fairly good guard against inflation. Once you determine the required face value of your insurance policy, you can start shopping around. There are many online insurance estimators that can help you determine how much insurance you will need.
Obviously, there are other people in your life who are important to you, and you may wonder if you should insure them. As a rule, you should only insure people whose death would mean a financial loss to you. The death of a child, while emotionally devastating, does not constitute a financial loss because children cost money to raise. The death of an income-earning spouse, however, does create a situation with both emotional and financial losses.
In that case, follow the income replacement calculation with his or her income. This also goes for business partners with whom you have a financial relationship. For example, consider someone with whom you have a shared responsibility for mortgage payments on a co-owned property. You may want to consider a policy for that person, as that person’s death will have a big impact on your financial situation.
Methods of Calculating Life Insurance
Most insurance companies say a reasonable amount for life insurance is six to ten times the amount of annual salary. If you multiply by ten, if your salary is $50,000 per year, you'd opt for $500,000 in coverage. Some recommend adding an additional $100,000 in coverage per child above the 10x amount.
Another way to calculate the amount of life insurance needed is to multiply your annual salary by the number of years left until retirement. For example, if a 40-year-old currently makes $20,000 a year, they will need $500,000 (25 years × $20,000) in life insurance.
The standard-of-living method is based on the amount of money that survivors would need to maintain their standard of living if the insured party dies. You take that amount and multiply it by 20. The thought process here is that survivors can take a 5% withdrawal from the death benefit each year—the equivalent of the standard-of-living amount—while investing the death benefit principal and earning 5% or better. This type of calculation is sometimes known as human life value (HUL) approach.
Another methodology is called DIME (debt, income, mortgage, education). This is meant for a minimal amount of coverage that will cover family expenses in the event of an untimely death. With the DIME approach, your coverage should be enough to cover all of your outstanding debts (including your mortgage), pay for your kids' education, and replace your income for as many years until your children reach 18 years old.
What Is a Rule of Thumb for How Much Life Insurance You Need?
There are several rules of thumb you can use for computing the amount of life insurance you'll need. These often involve multiplying your current income by a number such as 10x or the number of years left until retirement. Other rules of thumb involve adding up all expenses and obligations you need for your family.
Is Life Insurance Needed After Age 60?
While life insurance is often intended to replace the economic loss of someone with a family to support in the event of their untimely death, it can be purchased by those whose children have grown up as well. This can be done for several purposes, including giving an inheritance, establishing a trust upon death, contributing to a charity, or if the older individual is a key employee or partner in a business. Still, many insurance companies only offer term policies for those aged 18-65. But depending on the insurer and type of policy, you can even get coverage initiated as old as age 80. Note, however, that life insurance premiums increase the older you are when you purchase the policy.3
What Happens to My Life Insurance if I Lose My Job?
If you lose your job and have private life insurance that you purchased on your own, so long as you continue paying your premiums, you will have coverage. If the insurance was provided as a group plan through your employer, you will typically lose that coverage after one month after being terminated.
Can I Cash out My Life Insurance Policy?
If you own a permanent life insurance policy that accrues cash value (such as whole life or universal life), you can often borrow against or withdraw some or all of that value. The death benefit will typically also decline proportionally to the amount you take out of the policy. If you surrender the entire amount, you will lose all of your coverage.
The Bottom Line
If you need life insurance, it is important to know how much and what kind you need. Renewable term insurance is generally sufficient for most people, but you have to look at your own situation. If you choose to buy insurance through an agent, decide on what you’ll need beforehand to avoid getting stuck with inadequate coverage or expensive coverage that you don’t need.
As with investing, educating yourself is essential to making the right choice, so be sure to do your research to ensure that you acquire the best life insurance possible. Locate and compare life insurance quotes to determine which deal would best suit your unique needs.