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Life insurance can give you peace of mind knowing your loved ones will be protected if you pass away. But how much life insurance coverage do you need? It depends on your current expenses and debt load, the amount of liquid after-tax assets available to your family if you pass away and your financial goals.
Read on to learn more about the different types of life insurance policies and how they work, how much insurance you should carry and how to adjust your policy over time as your needs change.
How Does Life Insurance Work?
Life insurance is similar to other forms of coverage, such as auto or homeowners insurance: You pay the insurance provider an annual premium, and are covered when disaster strikes. Instead of covering your home or car, however, life insurance pays a death benefit to your beneficiaries if you pass away while the policy is active.
Some life insurance policies pay out only when you die, while others accumulate cash value. These funds may be accessible to you in a few forms.
When you apply for life insurance, the company may review your credit (if you're in a state that allows it). Having poor credit does not mean you'll be denied a policy, but a credit-based insurance score can predict the likelihood you'll file a claim and could have an impact on premium costs. It could also prompt the insurance provider to request a medical exam before approving your application.
Types of Life Insurance
When shopping for life insurance, you will notice two basic types of coverage:
- Term life insurance: Most term policies cover you for a period of one to 30 years, and you'll typically pay the same annual premium every year it is active. If you pass away while the policy is active, your beneficiaries receive a death benefit equal to the coverage amount. But if you outlive the policy's original term, you'll have to renew the policy or buy a new one. Term life insurance is the simplest and least expensive type of life insurance.
- Whole life insurance: Whole life is the most common type of "permanent" insurance and provides coverage until the day you die, assuming you make all your premium payments. Unlike term life insurance, whole life policies accumulate cash value that you can withdraw or borrow against, though doing so will reduce the value of your death benefit. You can also use the cash value of your policy to increase your death benefit. If your policy's cash value reaches zero, you will be forced to surrender or cancel the policy.
How Much Coverage Do I Need?
The amount of life insurance coverage you need depends on your financial situation and a few other factors. Some financial advisors recommend purchasing a policy that's 20 or 30 times your annual salary. For example, if your annual salary is $50,000, you might buy a policy for $1 million or $1.5 million.
This approach may not be enough to cover your family's financial needs if you die, however. Consider the following when deciding how much coverage you need:
- Your liquid after-tax assets: Calculate the sum of your savings accounts, pensions, retirement accounts, current life insurance policies and estimated Social Security benefits. If there are other liquid after-tax assets your family will have access to after you die, be sure to include them in your calculation.
- Your household financial obligations and debts: Consider the monthly expenses you're currently responsible for. If you're the sole financial provider for your family, this amount would be equal to your total monthly household expenses. These could include your mortgage, health insurance, child care, utilities, and credit card, auto loan, student loan and personal loan payments.
- Your family's financial needs: Are there any other expenses you would want to be covered if you unexpectedly passed away? These could include wedding expenses and college tuition for your children, as well as your own funeral and burial expenses.
Compute the difference between your liquid after-tax assets and your debts, expenses and family's financial needs. This figure gives you an idea of how much coverage you'll need.
Suppose you have $75,000 in annual household expenses and debts, and want to include an extra $250,000 for other financial needs. This is equivalent to $1.75 million in expenses over 20 years. If you have $150,000 in liquid after-tax assets, you will need $1.6 million in life insurance.
How to Change a Life Insurance Policy
Your life insurance coverage needs may change as time passes and you experience major life events, like marriage or the birth of a child.
Review your policies annually and reach out to your agent to add more benefits to your existing policy or change your coverage amount if needed. Your agent can also help you switch from a term life to a whole life policy.
Evaluate Your Needs Before Making Life Insurance Choices
Life insurance offers the opportunity to protect your loved ones from financial stress if you pass away. The amount of coverage you should carry depends on your current financial situation and how much your loved ones who depend on you would need without your income.
Before purchasing a policy, consult with a reputable insurance professional. The agent can explain your options and help you decide which policy and coverage amount is right for you. As time passes, review your life insurance policy regularly and make adjustments as your needs change.