Alan Moore is one of the brightest of the crop of young financial advisors out there. The founder of Serenity Financial Consulting in Milwaukee, he has a wide-ranging expertise in personal finance, from 401(k) strategies to starting a small business. His thoughts on the vital question of how much life insurance you need:
How much life insurance do you actually need? Statistics drive insurance, such as how long a person is likely to live. Much simpler math helps you figure out how much coverage you need.
If someone depends on you financially, you need to have life insurance. Life insurance policies come in many shapes and sizes.
A good conservative estimate for the yearly income that a lump sum generates is 4%. For instance, if you leave your partner $1 million of life insurance, that produces about $40,000 of annual income for the rest of your loved one’s life. This assumes the income grows with inflation each year and your partner has a low chance of ever running out of money.
Determine how much income your partner needs to maintain his or her standard of living if you die tomorrow. Now multiple that number by 25. That’s how much total money you need to leave your partner to provide for the person financially. Included in this total are your investment accounts, savings and retirement plans. Don’t include your home, since it is hard to get income out of the value of real estate.
Let’s say your partner needs $100,000 of annual income. The required annual income multiplied by 25 equals $2.5 million. Subtract the $1 million in savings you have. So you need $1.5 million in life insurance to ensure that your partner has enough.
A life insurance plan of $1.5 million seems like a lot, but remember that it will only produce around $60,000 of yearly income. Your $1 million in savings will produce the other $40,000. Does that mean you should run out and buy a $1.5 million policy? Not quite. There are a couple of other things to consider.
1. Can your partner earn money? If your partner has the ability to earn $50,000 of annual income, then you don’t need to leave him or her enough to produce $100,000. The partner’s ability to earn an income reduces the amount of insurance you need.
2. How long do you need to provide for? The 4% rule is a general guideline for providing your beneficiary with enough money to live almost indefinitely off of the income that it produces. You won’t necessarily have to leave this much. When deciding on life insurance policies, ask yourself whether you need to provide income for your partner’s entire life, or just long enough to hit the reset button after you are gone. Your spouse might start a career or remarry to someone who can lend support.
At the very least, you want to leave enough money so that your partner isn’t worried about how to pay the bills after your death. The more money you leave helps protect the spouse for a longer time. This has to be balanced with the cost of the life insurance today.
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