Prefer to listen rather than read? Pair this post with Deliberate Money Moves Podcast: Only Own Life Insurance to Replace Income for Those Dependent on You.
Life insurance is used to pay for things you would pay for yourself if you were alive to do it. Therefore, we only want to buy insurance to replace actual income you expect to earn during your lifetime.
I know this is not a happy topic and is something that you probably don’t want to think about much. The good news is you don’t really have to.
Term life insurance can be very cheap and once you’ve put it in place, you likely won’t have to think about it much ever again. Just like any insurance, we should be happy to pay a small premium in case the unthinkable happens.
That leaves us with two questions. How much insurance should you buy and how should it be structured?
How Much Insurance Should You Buy?
I like to use two methods to estimate how much insurance a person might want to buy.
First, since we are replacing income, let’s simply estimate how much income would be lost if you were to die today. Then, we apply a discount to that amount because if we have insurance in place today and you pass away, we’ll be able to invest the proceeds for future needs. This gives us the maximum amount of life insurance you should consider buying.
Next, consider how much money it would take to pay your spouse’s and your children’s expenses if you were to pass away. This amount should be lower than your income because you’re not around to eat and we don’t have to pay for your retirement anymore.
Now that you know how much money is needed, subtract current savings and future earnings of the surviving spouse and you have the minimum amount of life insurance needed, assuming the surviving spouse would maintain their current lifestyle.
Comparing these two figures gives you a range of how much life insurance to consider buying.
How Should the Insurance be Structured?
We know we want term insurance which simply says — if you die during the term of the contract your beneficiary gets the amount of insurance purchased.
But what happens if you live for another 20 years and then die with just 5 years to retirement? Does your spouse really need the full 25 working years of income? Likely not.
We can buy contracts with different terms to both cut the cost of insurance and know that we aren’t over insured.
Here’s how this might work. Let’s say you require $2 million of life insurance, and you are 40 years old. You might buy two policies, each for $1 million and have the terms be 10 and 20 years.
This way, you have the full $2 million of coverage for the next 10 years, until you are 50, and then the first contract would expire leaving you with $1 million of coverage until age 60.
Scenarios to Consider: Important Turning Points in Your Life
- You might want to be sure you have maximum coverage until the kids are out of college and then step down to a lower level.
- You might want to be sure your life insurance expires at your expected retirement date when you won’t have any extra income to insure.
The point here is to consider what you actually expect to happen in your life and buy life insurance to match.
I want to again stress that ALL the life insurance I’m talking about here is term insurance, the cheapest kind.
Only in very rare circumstances should you consider universal or whole life policies which try to combine insurance and investment solutions. These policies almost never work the way you expect. Also, almost no one needs life insurance all the way past retirement, so these permanent life insurance products are usually just not necessary.