Rules of thumb exist that say you should be insured for between six and 10 times your annual earnings. But these ranges can be very wide and don’t take into account your unique situation. The best approach to determine how much life insurance you need is to engage in some financial planning. Start by answering the following questions:
How much per year will your survivors need to live on, and for how many years? Expenses may be greater if, for example, you have young children who require day care; expenses may be smaller if there are no dependent children among your survivors.
How will that number be affected by inflation? Remember, we’re talking about what could be a long period of time. At an inflation rate of 3% a year, a dollar loses 15% of its value in just six years, and about 25% after a little more than 10 years. Imagine the impact of a 25% pay cut, and you’ll begin to appreciate the vital importance of factoring inflation into the equation.
Will your surviving spouse be able to work, and if so, how much will he/she earn? The amount your surviving spouse earns should reduce the life insurance coverage you need, but in an uncertain economy it may pay to err on the conservative side when estimating a surviving spouse’s earning power.
Should you think of retiring large family debts? You can reduce the amount of money your surviving spouse has to earn by providing enough in life insurance to retire such debts as credit card balances, college and personal loans, and your mortgage.
How will college expenses be paid for your children? In addition to providing for daily living expenses, consider how higher education bills — if there are any — will be paid. Should you only provide enough in life insurance benefits to make up for annual contributions to a college fund, or should you provide enough for four years of college?
How will your surviving spouse’s retirement be funded?One less person to provide for means the price of your spouse’s retirement will be less. When considering how much life insurance coverage to buy, however, you should evaluate whether you policy benefits need to make up for contributions you were planning to make until you retired.
What rate of return can your surviving spouse expect to receive? Where will the unused proceeds of your life insurance benefits be invested? The rate of return they earn will make a big difference in how long they last — which can make a big difference in how much coverage you buy.