The Retirement Corporation of America

Figuring Out How Much Life Insurance You Need

LIFE INSURANCE IS intended to enable your beneficiaries, typically your loved ones, to maintain their lifestyle.

Still, most people only tend to buy as much life insurance as they can afford, not as much as they really need, especially in the worst-case scenario—if they should die tomorrow. So that's why you should start figuring how much life insurance you should buy now.

Step 1: Look at where you are financially. You'll want to consider a few things here before you go on:

•  Are you the sole breadwinner? Or does it take both your income and your spouse's to cover your living expenses today, maintain an emergency fund equal to at least three months of your earnings and still save and invest for tomorrow?

•  If you answered "yes" to that question, you both need life insurance—each one worth at least five times your respective annual incomes.

•  Most insurance experts recommend carrying coverage that would give your family five years' worth of income protection. So if your spendable income is currently $50,000 a year, that would require $250,000 of life insurance.

Step 2: Consider what debts, besides funeral expenses, your family would have to settle up after one or both of you are gone.

•  Is the mortgage paid off on your house?

•  Do you owe money to the IRS in back taxes?

Buying enough insurance to pay these kinds of debts will leave more for your family's monthly living expenses.

Step 3: Add in enough money for college. Figure on $100,000 for four years at a state college.

Step 4: Add an emergency fund of $10,000 for unanticipated expenses.

Step 5: Add in funeral expenses if you want enough insurance to cover the cost. A typical burial can easily cost $5,000 to $10,000 these days, cremation something less, not including the cost of a burial plot and headstone.

Just picking term vs. whole life isn't the end of it. That opens the door to what kind of term and/or what kind of whole life. Here are your options:

Types of Term Insurance

Most insurers offer three kinds of term policies. What's best for you depends on your situation. Always check a term policy that claims to offer a "maximum premium guarantee." After the initial term expires, rates are rarely guaranteed. The projected rates quoted in sales materials are typical of what the company expects to charge in the future, not what it could charge.

•  Annual Renewable Term. As its name implies, you have to renew this kind of policy every year. That means annual increases in your premiums, but the death benefit stays the same. You only have to pass a physical exam once to qualify.

•  Level Premium Term. You pay more for this, but your premiums stay fixed for five, 10 or 20 years. At the end of the period, you have to take another medical exam to renew your policy.

•  Convertible Term. You have to renew your policy every year. But you get the option of converting it to a longer policy in the future. You may be able to convert it to another term policy, to a whole-life policy or be given your choice. This kind of term insurance typically requires the lowest initial cash outlay. It's a good choice for young people who can't afford to get into longer-term policies now but expect to be able to handle those premiums later.

Types of Whole-Life Insurance

Here you have even more choices. But there are only three good reasons to buy whole life:

1. It stretches out the cost of insuring yourself over your lifetime.
2. It's a kind of forced-savings account.
3. Your premiums usually stay level.

You can surrender any kind of whole-life policy and take its cash value anytime. Or you can leave the policy intact and just borrow against your "cash buildup" at very low rates.

Ordinary Whole Life. Most people are familiar with this kind of plain vanilla policy. Part of your premium goes to fund the death benefits it provides your beneficiaries while the insurance company invests the rest for you.

Interest-Sensitive Whole Life. Your premiums are fixed in the early years. But if your cash value grows faster than the insurance company assumes it will, you can use the excess to reduce your premiums.

Universal Life. You get much more flexibility with this kind of insurance than you do with either term or ordinary whole life. You can increase the death benefit if you're willing to pay higher premiums. The drawback is the insurance company still invests your cash value for you and pays you very little interest on it.

Variable Life. You get to control where your cash value is invested, typically in your choice of stocks, bonds or money market funds offered by the insurer. That makes this kind of policy complex because both its death benefit and your cash value will fluctuate with the funds' investment returns. Your premiums are typically fixed.

Second-to-Die Life. These policies insure two lives—usually a husband's and wife's—and pay off only when the last one dies. Consequently, they cost much less than policies that only insure one life. Most companies also give you a "split" option that lets you switch to two single-life policies if you get divorced. But you may have to pass another medical exam.

First-to-Die Life. They insure two or more lives and pay off at the first death. Most such policies are universal life. This kind of insurance can be more economical for a married couple than buying two single-life policies. They typically cost between 20% and 30% less.