When buying life insurance, it can be tough to wade through all the different plans and features and determine what is the precise need of you and your family. You don't want to purchase too little insurance, and run the risk of leaving your family with too little in the event of your unlikely demise. At the same time, however, you don't want to purchase too much and have your family's lifestyle crimped by a too-large monthly payment.
Life insurance is a financial product, and buying it is like any other major purchase — you should carefully consider the benefits and the costs of what you're buying, and then purchase the product that best suits your needs and your budget.
When deciding how much life insurance to purchase, you should first consider the types of plans that are available. Whole life policies, the oldest and most common forms of life insurance, charge insureds a fixed fee for life and pay out the face amount to the named beneficiary upon the insured's death, or to the insured if he or she reaches age 99. Universal life insurance offers more flexibility with regard to premiums and payment dates, but the premiums are not set and can rise, and many customers have been disappointed to learn that their policies have become unaffordable as they aged. Term insurance will pay out a benefit if you die within a span of years, but generally at the end of the term the insurance expires and you get nothing back from it.
Each form of insurance has distinct advantages and disadvantages which we'll go into in another article, but having a basic idea of the parameters of each type of insurance is important before deciding how much insurance you should purchase.
Most life insurance companies use the human life value concept when determining the level of insurance an insured may need to purchase. This approach typically uses a multiple of five to eight times your annual income to settle on a sum. This formula is pretty good, but you should take into account some other factors when determining the level of coverage you need.
The amount of life insurance you purchase should be sufficient to provide enough money to pay your debts, cover your funeral expenses and provide your family with adequate income to maintain their lifestyle with the loss of your income. When determining this number, you should take into consideration other assets such as your home, business, or other investments you may own, as well as what Social Security may provide your survivors. (Caveat: Social Security benefits may vary in time, as the retiring baby boom population puts more strain on the system.)
In general, you need your life insurance policy to generate about 70 percent of your salary per year to take care of your family's needs over time. Going over that amount may saddle you with premiums that are too high for your real needs.
Here's an example of a good calculation of how to calculate how much life insurance you may need to purchase. Let's say you're 45 and you earn $50,000 per year. By going over your family budget, you determine that you need at least $48,500 per year to support your family. You also determine that this income would need to be replaced until you would have been 65 — retirement age. Allowing for a five percent discount rate, the current rate of your future net salary amounts to about $683,556. This means that you need $683,556 to invest to ensure that your family gets that $48,500 per year they need. Beyond that, you should also factor in expenses related to settling your outstanding debts and funeral expenses.
When purchasing a life insurance policy, make sure you get one with a premium you can afford comfortably, and make sure you understand the terms of the premium so you won't be caught by surprise by a rate hike you can't afford. Life insurance is important, but it's not as important as being able to live your life with reasonable comfort.
One inducement that may tempt you into buying a larger (or smaller) amount of insurance than you might need is the fact that in most cases, life insurance benefits not taxable income. However, you do need to take into consideration any estate tax your family may have to pay on your assets or business when purchasing life insurance.
Like most complex investments, your best bet when purchasing life insurance is to consult with a professional — and don't be afraid to seek a second opinion. Making a decision is important, but making an informed decision is more important.
Also, don't be afraid to shop around. You're buying a product, not making best friends with someone. Make sure you find and purchase the policy that best fits you and your family. Keep your eye on the bottom line, not on how nice the agent is or how well they dress. This is a business decision, keep it that way.