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With two small children, how much life insurance should a couple have? - Anita H.
Anita is wise to be concerned with life insurance. If either or both parents die, insurance could be vital to her children's well being. To decide how much insurance is needed, there are two basic methods that can be used. The first is to replace the income of the deceased. A second method is to buy enough insurance to cover your expenses. Your choice will depend on your present financial situation.
Look at the expense method if you struggle to pay your bills. Otherwise replacing the lost income should be sufficient. There are calculators to do the number crunching. However, it's hard to know whether they're giving a good answer if you don't understand the process. There is no perfect answer. You would need to see into the future to get a perfect answer. You'd need to know your longevity, investment return, and future inflation rates, which can only be estimated. So just try to get reasonably close. For the life insurance to replace income method, we'll assume a family where only one parent works. That way we can do one illustration when you lose a spouse that draws a paycheck and another one for the person that works inside the home. Generally speaking, you'll want to replace all of the income that's lost when an employed spouse dies. More precisely, you'll only want to include the after-tax pay and make adjustments for expenses (like a second car) that are incurred earning that income. Don't forget to add the value of health insurance or other employee benefits to the income number. Now you have an amount of income that needs to be replaced each year, but life insurance is often paid in a lump sum. We're going to assume that she'd invest the life insurance proceeds and spend the income that it generates. How can we calculate how big a lump sum that's needed to create a specific annual income? It's simple division. Take the amount of annual income you want and divide it by the investment return you'd expect to earn on the lump sum (i.e. life insurance proceeds). For instance, if $50,000 a year is needed and it's possible to earn 5% on the money, a lump sum of $1,000,000 ($50,000 divided by .05 = $1,000,000) is needed. That $1,000,000 would provide $50,000 to spend each year without touching her principle. The investment return that you use will make a big difference in the calculation. For instance, if she assumed a 7% return, she'd only need $714,000. What rate is realistic? Probably something between CDs on the low end and the long-term stock returns (8 to 10%) on the high end. It is best to overestimate your needs a little. Yes, you'll be buying and paying for a little more insurance than you need. But if you underestimate, you won't realize your mistake until it's too late.
The target is a little harder to figure if a stay-at-home spouse dies. Unless there's someone like a grandparent who could move in and take over, the survivor will need to pay to have things done, which can get expensive. If you add up laundry, cleaning, cooking, day care and a hundred other chores, you have an idea of what the at-home spouse's "salary" is that needs to be replaced. Then calculate like you did for employed spouse. Another way to look at the problem is to have enough insurance to cover your expenses. The calculation is the same. Just use expenses instead of income in your calculation. Insurance companies will often encourage you to buy enough insurance to pay off your mortgage or other debts. That's nice, but it's not really necessary. Be sure to consider inflation. Even a modest 3% inflation rate will cut the amount your income will buy in half every 24 years. So if you lose a spouse in your 30s, your dollar will lose half its value before you retire. Consider what would happen if both parents die while the children are small. Hopefully they have someone who's agreed to raise their children. If so, the question becomes how much is needed to allow the children's guardians to house the children plus the extra expense of feeding, clothing and schooling the children Finally, make sure that the insurance policy is set up properly. Choosing the correct owner and beneficiary can have important consequences.
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Gary Foreman is the founder of The Dollar Stretcher frugal living website and newsletters including Financial Independence, a step-by-step approach to achieving your financial goals.
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