This is always the hardest question to answer when purchasing life insurance.
One problem is that our lifestyles are in constant flux.
One day you can be a carefree single person with no financial obligations, ten years later you may have a family that counts on you to be the main breadwinner.
There are rules of thumb that advise purchasing 7 or 10 times your annual income in life insurance and there are financial calculators that tell you to the dollar how much life insurance you need.
The problem with these methods of determining how much life insurance you need is that they rarely take your individual situation into account and they cannot possibly take into account your tolerance for risk and uncertainty.
Here are some questions that you should answer when considering the purchase of life insurance that can help you determine how much insurance to buy: #1 - Who depends on me financially and/or who will be financially affected if I die? In most instances this is an easy question to answer because we can easily think of who lives off of our paychecks and who are business partners are.
The hardest part is imagining how these people's lives will change once you are no longer part of the picture.
Before I lose you, let me explain my last statement with an example.
A couple without children purchases a home.
After adding up their mortgage payment, taxes, insurance, and all the other extra expenses that go along with home ownership, they realized that all of their monthly expenses were higher than each of our individual incomes.
As long as they were both living and working, they could easily afford their monthly expenses, but if one of them were to pass away, then the other would fall well short.
Most financial calculators and life insurance agents would have told them that they needed enough life insurance on each of them to cover those uncovered expenses for the surviving spouse.
Before they go and buy life insurance for each of them to help cover those living expenses they need to ask themselves what their lives will look like after the other spouse is gone.
If the wife is gone, will the husband even want to continue living in the house.
He may want to sell it and move into a smaller house or an apartment.
Maybe it would be too large and too much work for him to maintain.
Maybe he would just need a smaller policy so that he could handle the bills while he sells the house.
Maybe it is a special house and they both know they will keep it no matter what and so they will need enough life insurance to cover the monthly shortfall for an extended period of time.
If and when they have children, the entire discussion changes and they will have to reevaluate.
The moral of this story is that you need to decide amongst all the parties involved what you think the financial situation will be like after you pass away.
#2 - What are the financial needs of those who will be affected if I die? This is another question that is hard for a rule or a financial calculator to answer.
I am going to use another example to illustrate my point.
In my example, there is a married couple with two kids.
The wife works and the husband stays at home with the children.
The family is trying to decide how much life insurance they need to buy on the wife's life.
In the best-case scenario, they would buy enough so that the husband would never have to go back to work.
The amount they need would be equal lifetime's worth of income.
If they can afford the premiums for that amount of insurance, then they are done.
What if the husband decides that he will need a transition period, but he will probably return to work and be able to support the family on his own a couple of years after his wife dies?Under that scenario, they would need to purchase significantly less life insurance on the wife (maybe a face amount equal to two or three times the wife's annual income).
What if the husband decides that he will go back to work, but he will probably need to go back to school and get a college degree in order to support his family the way he would want to in his wife's absence?Under this scenario, they may need to purchase enough life insurance to provide for the families living expenses for five or six years.
The list of scenarios is infinite, but those are the types of things that you need to consider in order to get the most from your life insurance purchase.
If you can afford the premiums, then I would always advise aiming towards the more conservative scenario and buying more life insurance.
That being said, you do need to realize that the money you spend on life insurance for your future reduces the amount you have to spend and save in the present.
You never know exactly what your family is going to want after you die, but you should discuss it and determine the best you can.
If you knew how everything was going to work out, then you wouldn't need life insurance in the first place.
#3 - What can I afford? If an agent ever tells you to buy as much life insurance as you can afford, then calmly back out of his office, get in your car, and drive away.
What you do need to do is answer questions #1 and #2 above and then decide if you can afford that amount?If you can't, then you do need to purchase as much of that amount as you can afford.
The question of what you can afford is up for debate and something that you need to seriously consider.
If I look at my family's budget today, then the amount I could afford would be nothing.
We designate every dollar we get towards bills, fun, insurance, savings, etc.
Every dollar has a purpose.
What you need to do at this point is rank everything that you spend money on and decide where life insurance ranks.
Is the financial security that life insurance provides worth more than cable TV, eating out twice per week versus once per week, or the car one-step up?If the answer is yes, then you may have just found a little more money for life insurance.
Is it worth not being able to pay the light bill, eating generic ice cream, or taking a brown bag lunch everyday for the rest of your life?If the answer is no, then you may have to stop there because you have found the amount you can afford.
I would recommend ranking everything you spend money on and work from the bottom and see how much of the insurance that you need based on your answers to questions #1 and #2 you can truly afford.
#4 - What is my estate planning and estate tax situation? For most people, this is not an issue.
If you do have a large amount of assets, then you may need to protect your assets from estate taxes.
At this point you will probably need to seek the counsel of a trusted, professional financial advisor who understands the tax implications of large estates.
You will also need to seek the aid of financial advisor with life insurance questions if there is a business partnership or family business that would be affected by a death of one of the partners.
One problem is that our lifestyles are in constant flux.
One day you can be a carefree single person with no financial obligations, ten years later you may have a family that counts on you to be the main breadwinner.
There are rules of thumb that advise purchasing 7 or 10 times your annual income in life insurance and there are financial calculators that tell you to the dollar how much life insurance you need.
The problem with these methods of determining how much life insurance you need is that they rarely take your individual situation into account and they cannot possibly take into account your tolerance for risk and uncertainty.
Here are some questions that you should answer when considering the purchase of life insurance that can help you determine how much insurance to buy: #1 - Who depends on me financially and/or who will be financially affected if I die? In most instances this is an easy question to answer because we can easily think of who lives off of our paychecks and who are business partners are.
The hardest part is imagining how these people's lives will change once you are no longer part of the picture.
Before I lose you, let me explain my last statement with an example.
A couple without children purchases a home.
After adding up their mortgage payment, taxes, insurance, and all the other extra expenses that go along with home ownership, they realized that all of their monthly expenses were higher than each of our individual incomes.
As long as they were both living and working, they could easily afford their monthly expenses, but if one of them were to pass away, then the other would fall well short.
Most financial calculators and life insurance agents would have told them that they needed enough life insurance on each of them to cover those uncovered expenses for the surviving spouse.
Before they go and buy life insurance for each of them to help cover those living expenses they need to ask themselves what their lives will look like after the other spouse is gone.
If the wife is gone, will the husband even want to continue living in the house.
He may want to sell it and move into a smaller house or an apartment.
Maybe it would be too large and too much work for him to maintain.
Maybe he would just need a smaller policy so that he could handle the bills while he sells the house.
Maybe it is a special house and they both know they will keep it no matter what and so they will need enough life insurance to cover the monthly shortfall for an extended period of time.
If and when they have children, the entire discussion changes and they will have to reevaluate.
The moral of this story is that you need to decide amongst all the parties involved what you think the financial situation will be like after you pass away.
#2 - What are the financial needs of those who will be affected if I die? This is another question that is hard for a rule or a financial calculator to answer.
I am going to use another example to illustrate my point.
In my example, there is a married couple with two kids.
The wife works and the husband stays at home with the children.
The family is trying to decide how much life insurance they need to buy on the wife's life.
In the best-case scenario, they would buy enough so that the husband would never have to go back to work.
The amount they need would be equal lifetime's worth of income.
If they can afford the premiums for that amount of insurance, then they are done.
What if the husband decides that he will need a transition period, but he will probably return to work and be able to support the family on his own a couple of years after his wife dies?Under that scenario, they would need to purchase significantly less life insurance on the wife (maybe a face amount equal to two or three times the wife's annual income).
What if the husband decides that he will go back to work, but he will probably need to go back to school and get a college degree in order to support his family the way he would want to in his wife's absence?Under this scenario, they may need to purchase enough life insurance to provide for the families living expenses for five or six years.
The list of scenarios is infinite, but those are the types of things that you need to consider in order to get the most from your life insurance purchase.
If you can afford the premiums, then I would always advise aiming towards the more conservative scenario and buying more life insurance.
That being said, you do need to realize that the money you spend on life insurance for your future reduces the amount you have to spend and save in the present.
You never know exactly what your family is going to want after you die, but you should discuss it and determine the best you can.
If you knew how everything was going to work out, then you wouldn't need life insurance in the first place.
#3 - What can I afford? If an agent ever tells you to buy as much life insurance as you can afford, then calmly back out of his office, get in your car, and drive away.
What you do need to do is answer questions #1 and #2 above and then decide if you can afford that amount?If you can't, then you do need to purchase as much of that amount as you can afford.
The question of what you can afford is up for debate and something that you need to seriously consider.
If I look at my family's budget today, then the amount I could afford would be nothing.
We designate every dollar we get towards bills, fun, insurance, savings, etc.
Every dollar has a purpose.
What you need to do at this point is rank everything that you spend money on and decide where life insurance ranks.
Is the financial security that life insurance provides worth more than cable TV, eating out twice per week versus once per week, or the car one-step up?If the answer is yes, then you may have just found a little more money for life insurance.
Is it worth not being able to pay the light bill, eating generic ice cream, or taking a brown bag lunch everyday for the rest of your life?If the answer is no, then you may have to stop there because you have found the amount you can afford.
I would recommend ranking everything you spend money on and work from the bottom and see how much of the insurance that you need based on your answers to questions #1 and #2 you can truly afford.
#4 - What is my estate planning and estate tax situation? For most people, this is not an issue.
If you do have a large amount of assets, then you may need to protect your assets from estate taxes.
At this point you will probably need to seek the counsel of a trusted, professional financial advisor who understands the tax implications of large estates.
You will also need to seek the aid of financial advisor with life insurance questions if there is a business partnership or family business that would be affected by a death of one of the partners.
