How Much Life Insurance Do You Need?

You might be asking yourself this question: "How much life insurance do I need?"

Some financial advisors will tell you to multiply your annual income by seven. Others will tell you to buy only enough life insurance to replace the income you are expected to make between now and retirement. Some might recommend you buy only enough life insurance to cover your present debts.

While you probably can do all of those calculations in a minute, they won't give you the right answer. Simply put, calculating your life insurance needs takes homework. It requires you to do an inventory of all of your finances, and to think long and hard about how your beneficiaries would maintain their lifestyles without you. You also must consider inflation and, if you have children, future college education costs.

What not to do

What's the wrong way to calculate how much life insurance you need? Here are some common but misguided methods.

1. Multiply your annual salary by seven or eight: While it’s a simple formula, it fails to take into account your individual needs and obligations. Life insurance experts say there’s a good chance you’ll buy too little or too much coverage, simply by using a formula such as this.

2. Calculate your "human life value:" This method gives you the income you will earn from your present age until your retirement age, assuming a rate of interest that represents salary increases throughout that period. The problem is it does not take into account what your beneficiary's specific needs will be. You also end up with a figure that requires you to buy a huge amount of life insurance, possibly more than you may need. "There's all sorts of landmines in this," says Michael Snowdon, an instructor at the College of Financial Planning in Denver. "When you calculate this way, you're working with broad brush strokes."

3. Cover your debts. This involves buying only enough life insurance to cover debts such as your mortgage, student loan bills, or outstanding car notes. This method does not consider any future debts or needs, such as childcare or college education costs.

A classic formula

Many experts say the best way to pinpoint a smart life insurance figure is through a needs analysis, which can be broken down into a simple formula: Short-term needs + long-term needs - resources = how much life insurance you need. Snowdon says this method is "probably the most accurate approach in what is an inaccurate and imprecise science."

Experts advise you do an analysis at least once every three years, or whenever you have had a major life change. For example, if you have a new baby, you have to recalculate college education needs and child-care costs. If you own a home, a mortgage is likely your biggest financial burden. Because your mortgage balance decreases with each payment, it's important to include those revised figures in your calculations.

Five steps to a needs analysis

Step 1
Add up all of your short-term needs. These can be placed into three categories: final expenses, outstanding debts and emergency expenses. Among final expenses are medical, hospital, and funeral expenses, attorney or executor fees, probate court costs (if you do not have a will), and any outstanding taxes that would need to be paid if you died. Among outstanding debts are credit card balances, auto loans, college loans, and all other outstanding bills. Emergency expenses should include a cash reserve for medical emergencies and repairs to your home or car.

Calculating final and emergency expenses can be complicated, because you don't have a crystal ball that tells you how much your medical or hospital expenses will be, or if you even will have any.

Step 2
Next, add up your long-term debts, which include your mortgage and college tuition.

Calculating an education fund is tricky because you have no idea where your children will be going to college. Perhaps the best method is to use the present average college cost in the United States and the number of years away your children are from entering college. The average college costs for the 2002-2003 school year were $4,081 annually for a public, four-year institution, and $18,273 annually for a private, four-year institution, according to The College Board.

The U.S. Department of Education reports college costs traditionally have risen at about 5 percent annually, so you need to figure out what the cost will be when your child goes to college. (To calculate what costs will be in the future, see the last section: “A must-know: the equation for the future value of money.” Also be sure to calculate what the entire education will cost while taking into account the increased costs each year.)

Step 3
Next, calculate family maintenance expenses. These include such necessities as childcare, food, clothing, utility bills, entertainment, travel, and transportation. Calculate this figure based on a year's worth of expenses, then multiply that times the number of years you want to provide this income.
Once you've done that, add your short and long-term debts and your family maintenance expenses.

Step 4
Now that you've tallied all of your income needs, figure out what resources you have to meet them. To do this, add all available savings, stocks, bonds, mutual funds, existing life insurance (such as group life through your employer), and Social Security. You and your spouse can find out how much you'll get through the Social Security Administration (SSA) by visiting the SSA’s website, where you can get an estimate of how much you should have in Social Security benefits. Also add your present salary, and assume 5 percent compounded interest each year if you expect salary increases over time.

It's important to count only liquid assets (those that could be quickly converted to cash) among your resources. You shouldn't count items such as your home or automobile, because selling them for cash when you're gone would mean changing your family's lifestyle.

Step 5
Subtract your resources from your total expenses. The figure you get should represent the amount of life insurance you should buy.

Don't be daunted

Snowdon says the final figure that shows how much life insurance a person needs can be quite alarming. If you end up with an astronomical figure that requires a premium that is too high, he recommends you go through the analysis again and select areas for which you think you can allocate less money.

"Many people will look at the final figure and say, 'I can't do that,'" Snowdon says. "You have to look at it, figure out which is the most crucial, start making adjustments, and go from there."

A must-know: the equation for the future value of money

Calculating your life insurance needs will require two equations you may have picked up in Finance 101: the future and present value of money.

The future value of money equation tells you how much your money will be worth in a given number of years while earning a given rate of interest. This equation is essential if you are calculating how much money you'll need in the future because of inflation, or what your death benefit will be if you choose to invest the money at a given interest rate.

The present value of money equation tells you what your money is worth before it has been invested for a given number of years at a given rate of interest. This is important if you have an amount of money you need in the future, and you need to know how much life insurance coverage you should buy now.

If this sounds complex to you, don't fret. As long as you have a calculator (preferably a financial calculator, which is used by accountants and finance professionals), these equations are no sweat.

Here's how the future value of money equation works: Say that average college education costs are $20,000 annually for a private four-year institution, and you want to figure out how much it will cost in four years if college costs keep going up 5 percent per year. You would multiply 20,000 by 1.05 (1 represents the present cost, and .05 is 5 percent inflation) four times (or 1.05 to the fourth power).

So your equation would be this:

20,000 x (1.05)4
or
20,000 x (1.05)(1.05)(1.05)(1.05)
The answer is $24,310.13.

Accidental Death and Dismemberment Insurance

Accidental Death and Dismemberment Insurance (AD&D) can provide benefits, but is it necessary? The additional cost and limited protection offered by accidental death and dismemberment insurance make its purchase difficult to recommend.



About Accidental Death and Dismemberment Insurance
Generally, you can purchase AD&D insurance as a separate policy or as rider (endorsement) on a basic life or health insurance policy. Its name states exactly what it covers; accidental death and dismemberment. However, there are limitations on the coverage. These limitations make accidental death and dismemberment insurance less useful, although it is also usually relatively inexpensive.

The first thing to consider is whether AD&D insurance is a good deal for you. Is it likely you will have to use it? In most cases, life, health, and disability insurance already cover situations AD&D protects against. It can double, or at least add to, the amount of money you receive in case of a covered accident, but it may be wiser and more cost-effective to put the money you'd be paying towards the premium into a standard life or other insurance policy instead. Dave Roush, CEO of Insurance.com, warns consumers that "AD&D is a very, very limited form of insurance. When it comes to insurance, you want to be covered and protected in all instances, not just certain ones."

What Does AD&D Cover?
In the event of a fatal accident or an accident that results in you losing your eyesight, speech, hearing, or a limb, AD&D will pay you or your beneficiaries a specified amount. However, there are stipulations to the coverage. To receive benefits related to an accident, your injuries or death must occur within three months of the accident date. Also, you will only collect benefits if your death or injuries are proven, direct results of the accident.

Dismemberment coverage works on a "per-member" basis. If you lose one member (a hand, foot, limb, sight in one eye, speech or hearing), the insurance company will usually pay 50 percent of the full benefit. If you lose two members, you will receive the whole benefit. Coverage amounts for partial or complete paralysis vary, but are usually 25 or 50 percent.

Optional coverages sometimes include hospital stay coverage after an accident, and spouse and children coverage.

Typical exclusions of AD&D coverage include death during surgery, resulting from a mental or physical illness, bacterial infection, hernia, or a drug overdose. In addition, many policies do not cover risky activities such as skydiving, car racing, and involvement in a war. "It is important to read the fine print when applying for this kind of policy. While it may seem like you're getting better and more adequate coverage, in reality, you're not," reports Roush.

Where to Buy AD&D
AD&D policies are generally underwritten by major insurers and can be purchased through credit card offers or credit unions. Some major life or health insurance companies may include or offer AD&D in their group health or life insurance plans. AD&D coverage can also often be purchased as a separate policy.

Is Accident Protection Worth It?
Accidental death and dismemberment insurance can be a good supplement to a life insurance policy. Depending on the amount of coverage needed, AD&D insurance premiums average around $60 per year. Even with the low cost of accidental death and dismemberment insurance, many would prefer to use the money they could be paying for the policy and put it towards more health or life insurance coverage. Also, since most people die from other causes than accidents, buying AD&D doesn't seem to make a lot of sense.

An accidental death policy (minus dismemberment coverage) is a similar policy to consider. If, for example, you had a $100,000 life insurance policy and you added an accidental death rider, and you were killed in a covered accident, your beneficiary would get $100,000 from your life insurance and $100,000 from you accidental death insurance.

Will It Really Help?
If you're working in a high-risk job, such as construction, the AD&D policy may be a good idea, although high-risk jobs result in higher premiums. It is inexpensive accident coverage, and it won't hurt to have the extra coverage. However, realize that an accidental death and dismemberment policy is extremely specific and thus unlikely to pay a benefit. If you already have a life insurance policy, purchasing a larger benefit amount might not cost much more, and it will cover more circumstances.

Top 10 Things to Know About Life Insurance

We all recognize the importance of life insurance. After all, we want to make sure that our loved ones are taken care of when we die. But before you run out and purchase a policy, do some research ahead of time. That way, you'll be sure to get the best possible coverage at the right price. Here are some helpful tips to get you started :

1. Shop around
2. Never buy more coverage than you need
3. The healthier you are, the better the rates
4. Buy sooner rather than later
5. Realize the importance of periodically reviewing your coverage
6. You don't necessarily have to pay a commission
7. You may be paying more for monthly premium payments
8. Don't rely solely on the life insurance offered by your employer
9. Tell the whole truth and nothing but the truth
10. Buying more is sometimes cheaper