How Much Life Insurance Should You Carry?

Very few people enjoy thinking about the inevitability of death. Fewer yet take pleasure in the possibility of an accidental or early death. If there are people who depend on you and your income, however, it is one of those unpleasant things you have to consider. In this article, we'll approach the topic of life insurance in two ways: First we'll point out some of the misconceptions, then we'll look at how to evaluate how much and what type of life insurance you need.

Buying life insurance doesn't make sense for everyone. If you have no dependents and enough assets to cover your debts and the cost of dying (funeral, estate lawyer's fees, etc.), then it is an unnecessary cost for you. If you do have dependents and you have enough assets to provide for them after your death (investments, trusts, etc.), you still do not need life insurance.

However, if you have dependents (especially if you are the primary provider) or significant debts that outweigh your assets, you likely will need insurance to ensure your dependents are looked after if something happens to you.

One of the biggest myths aggressive life insurance agents perpetuate is "insurance is harder to qualify for as you age, so you better get it while you are young." To put it bluntly, insurance companies make money by betting on how long you will live. When you are young, your premiums will be relatively cheap. If you die suddenly and the company has to pay out, you were a bad bet. Fortunately, many young people survive to old age, paying higher and higher premiums as they age (the increased risk of them dying makes the odds less attractive).

Insurance is cheaper when you are young, but it is no easier to qualify for. The simple fact is insurance companies will want higher premiums to cover the odds on older people, but it is a very rare that an insurance company will refuse coverage to someone who is willing to pay the premiums for their risk category. That said, get insurance if you need it and when you need it. Do not get insurance because you are scared of not qualifying later in life. (For related reading, see: How old should you be to get life insurance?)

Many people see life insurance as an investment, but when compared to other investment vehicles, referring to insurance as an investment simply doesn't make sense. Certain types of life insurance are touted as vehicles for saving or investing money for retirement, commonly called cash-value policies. These are insurance policies in which you build up a pool of capital that gains interest. This interest accrues because the insurance company is investing that money for their benefit, much like banks, and are paying you a percentage for the use of your money.

However, if you were to take the money from the forced savings program and invest it in an index fund, you would likely see much 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, has no need for scraps from an insurance company's table. (For related reading, see: Is Life Insurance a Smart Investment?)

Insurance companies love cash-value policies and promote them heavily by giving commissions to agents who sell these policies. If you try to surrender the policy (demand your savings portion back and cancel the insurance), an insurance company will often suggest that you take a loan from your own savings to continue paying the premiums. Although this may seem like a simple solution, keep in mind that if the loan is not paid off by the time of your death, it will be subtracted from the death benefit.

Term insurance is insurance pure and simple. You buy a policy that pays out a set amount if you die during the period to which the policy applies. If you don't die, you get nothing (don't be disappointed, you are alive after all). The purpose of this insurance is to hold you over until you can become self-insured by your assets. Unfortunately, not all term insurance is equally desirable. Regardless of the specifics of a person's situation (lifestyle, income, debts), most people are best served by renewable and convertible term insurance policies. They offer just as much coverage, are cheaper than cash-value policies, and, with the advent of internet comparisons driving down premiums for comparable policies, you can purchase them at competitive rates.

The renewable clause in a term life insurance policy allows you to renew your policy at a set rate without undergoing a medical exam. This means if an insured person is diagnosed with a fatal disease just as the term runs out, he or she will be able to renew the policy at a competitive rate despite the fact the insurance company is certain to have to pay a death benefit at some point.

The convertible insurance policy provides the option to change the face value of the policy into a cash-value policy offered by the insurer in case you reach 65 years of age and are not financially secure enough to go without insurance. Even if you are planning on having enough retirement income, it is better to be safe, and the premium is usually quite inexpensive.

A large part of choosing a life insurance policy is determining how much money your dependents will need. Choosing the face value (the amount your policy pays if you die) depends on:

• How much debt you have. All of your debts must be paid off in full, including car loans, mortgages, credit cards, loans, etc. If you have a $200,000 mortgage and a $4,000 car loan, you need at least $204,000 in your policy to cover your debts (and possibly a little more to take care of the interest as well).

• Income replacement. One of the biggest factors for life insurance is for income replacement. If you are the only provider for your dependents and you bring in $40,000 a year, 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% (if you do not trust your dependents to invest, you can appoint a trustee or select a financial planner and calculate his or her cost as part of the payout). Just to replace your income, you will need a $500,000 policy. 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.

• Insuring others. 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 we went through earlier with his or her income. This also goes for any business partners with which you have a financial relationship (for example, shared responsibility for mortgage payments on a co-owned property).

Most insurance companies say a reasonable amount for life insurance is six to 10 times the amount of annual salary. Another way of calculating 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 man currently makes $20,000 a year, under this approach, the man will need $500,000 (25 years x $20,000) in life insurance.

The standard of living method is based on the amount of money the survivors would need to maintain their standard of living if the insured died. You take that amount and multiply it by 20. The thought process here is the survivors can take a 5% withdrawal from the death benefit each year (which is equivalent to the standard of living amount) while investing the death benefit principal and earning 5% or better.

If you are getting life insurance purely to cover debts and have no dependents, there is another way to go about it. Lending institutions have seen the profits of insurance companies and are getting in on the act. Credit card companies and banks offer insurance deductibles on your outstanding balances. Often this amounts to a few dollars a month and in the case of your death, the policy will pay that particular debt in full. If you opt for this coverage from a lending institution, make sure to subtract that debt from any calculations you are making for life insurance—being doubly insured is a needless cost.

If you need life insurance, it is important to know how much and what kind you need. Although generally renewable term insurance is sufficient for most people, 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 you don't need. As with investing, educating yourself is essential to making the right choice. (For related reading, see: Is Your Employer-Provided Life Insurance Enough?)