This is a subject that most people would just prefer to ignore. After all, it requires you to face your own mortality and then make some hard decisions about how you want to provide for your family after your death. A recent study found that 39% of surviving families did not have any life insurance. Of those who had insurance, the average amount was just 2.1 times personal income. Thus, two-thirds of surviving spouses felt that there was a devastating or major impact on their family's personal situation after their spouse's death (Source: National Underwriter, July 5, 2004).
Many rules of thumb indicate how much life insurance you should purchase, such as five to seven times your annual income. While that might sound like a lot of insurance, it may actually understate your needs. In order to distribute the Victim's Relief Fund to surviving families of those lost on September 11, the U.S. Department of Justice estimated the economic loss for individuals, based on various ages, incomes, and number of dependent children. Their tables calculated settlements ranging from four times to as much as 50 times income. For instance, the loss for a married 40 year old with two minor children (newborn and nine years old) earning $150,000 annually was calculated as $2,822,558 (Source: U.S. Department of Justice). From those figures, other income sources were deducted, such as government benefits, investments, etc.
Thus, when calculating your life insurance needs, don't focus on rules of thumb. Rather, go through a detailed analysis of your insurance needs. In addition to the loss of your income, address issues such as:
- What standard of living do you want to provide for your dependents? Do you want to provide the same standard of living, including things like vacations and club memberships?
- Do you want to provide for college educations for your children?
- If your spouse doesn't work, do you want that lifestyle to continue. or do you expect your spouse to work after your death? If you expect your spouse to work, what is a reasonable amount of income to expect him/her to earn?
- Do you need to consider the support of elderly parents or other relatives?
- How long must your family live off the insurance proceeds? Will your current retirement fund provide enough income for your spouse to live on after retirement, or do you need to provide income until his/her death?
- Do you want to pay off a mortgage or other debt with insurance proceeds?
- Do you have estate tax considerations that you want to address with life insurance?
- Have you factored in a reasonable rate of inflation?
Once you have thought through these issues, you can calculate an amount of life insurance that will help you achieve these goals.