By Kevin M. Reardon, CFP®Buying life insurance can be a tricky proposition. While virtually everyone realizes that it is a necessity, purchasing the life insurance policy that will work best in your particular situation is not always the easiest thing to do.
Your life insurance needs often depend on a number of factors, including whether you're married, the size of your family, the nature of your financial obligations, your career stage, and your goals.
There are a number of approaches you can use to figure out how much insurance you should have. One method, called the "family needs approach," focuses on the amount of life insurance it would take to allow your family to meet its various financial obligations and expenses in the event of your death.
Family needs approach
With the family needs approach, you divide your family's financial needs into three main categories:
• Immediate needs at death, such as cash needed for estate taxes and settlement costs, credit card and other debts including mortgages (unless you choose to include mortgage payments as part of ongoing family needs), an emergency fund for unexpected costs, and college education expenses.
• Ongoing income needs for expenses related to food, clothing, shelter, and transportation, among other things. These income needs will vary in amount and duration, depending on a number of factors, such as your spouse's age, your children's ages, your surviving spouse's capacity to earn income, your debt (including mortgages), and whether you'll provide funds for your surviving spouse's retirement.
• Special funding needs, such as college funding, charitable bequests, funding a buy/sell agreement, or business succession planning.
Once you determine the total amount of your family's financial needs, you subtract from this total the available assets that your family could use to defray some or all of their expenses. The difference, if any, represents an amount that life insurance proceeds, and the income from future investment of those proceeds, can cover.
For example: John and his wife, Wendy, are estimating the appropriate amount of life insurance to buy on John's life. They first estimate their immediate needs as follows:
• Final medical expenses: $5,000
• Estate settlement costs, including funeral and burial expenses: $37,500
• Debts, including credit cards and mortgages: $317,000
• Emergency fund: $100,000
Subtotal: $459,500
Next, they estimate ongoing income needs, such as:
• Providing for their dependent children's needs for a period of time: $500,000
• Wendy's income needs until her retirement: $450,000
• Wendy's retirement income needs: $380,000
Subtotal: $1,330,000
Adding the sub totals together, John and Wendy estimate that, should John die, their family would need $1,789,500. They then determine that assets available to offset their needs include:
• Bank savings: $40,000
• Investments: $220,000
• Retirement assets: $250,000
• Existing life insurance on John's life: $300,000
Subtotal: $810,000
The difference between their family needs ($1,789,500) and their available assets ($810,000) equals their life insurance need ($979,500).
Review your coverage
Trying to figure out how much life insurance is enough isn't always easy, and that amount will likely change with your changing circumstances. By examining your family's anticipated expenses during various periods after your death, you get a more realistic estimate of your life insurance needs.
Unfortunately, many people underestimate their insurance needs and are underinsured. Often, the purchase of life insurance is based on cost instead of what's needed. By the same token, it's possible to have more insurance than you need. You may have purchased a large policy during a particular point in your life, and then didn't adjust your coverage when your insurance need was reduced.
Both of these circumstances are reasons to review your insurance coverage periodically with your financial professional. Doing so can reveal opportunities to change your levels of coverage to match your current and projected life insurance needs.
Kevin Reardon, CFP® is a financial planner and president of Shakespeare Wealth Management, Inc.® in Brookfield. He is also a member of the National Association of Personal Financial Advisors (NAPFA).
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