How to choose life insurance coverage amounts

Life insurance amounts are often chosen by feel: a round number that sounds large, a multiple of salary someone mentioned, or whatever the employer's group plan provides. Those numbers can be close by accident, but they are not built from the household's actual situation. The purpose of the death benefit is specific. It replaces what the insured person's death would take away from the people who depend on them, and it pays the costs that death would create or accelerate. That can be calculated.

The calculation is a needs analysis, and it takes an hour with the right documents. This guide works through it in order, then covers how term length, a non-earning spouse, business interests and existing coverage change the answer. It applies in Arizona, Nevada, Utah and Idaho alike, since the arithmetic does not depend on the state.

What to gather

The analysis needs a clear picture of obligations and of the resources that would already exist.

• Take-home income for each earner, and the household's monthly spending with and without the insured person.
• The mortgage balance and remaining term, and balances on car loans, student loans and credit cards.
• Expected future costs: childcare until the youngest child is in school, college savings goals, and support for an ageing parent.
• Savings, retirement accounts and investments that the survivors could draw on.
• Every existing life policy, including group coverage through an employer, with the death benefit and whether it ends when the job does.
• An estimate of final expenses: funeral, medical bills not covered by insurance, and estate settlement costs.

Step one: add up the immediate costs

Start with the money the household would need soon after a death. That includes final expenses, the balances on debts the survivors would want or need to pay off, and an emergency reserve to cover the months when income stops and paperwork takes time. Whether to include the whole mortgage is a household choice. Paying it off lowers monthly spending permanently; leaving it and replacing enough income to keep paying it can require less coverage if the mortgage rate is low. Decide which you prefer and build the number that way.

Step two: calculate the income the household would need to replace

Work out what the survivors would need each year, not what the insured earns. Take the household's spending without the insured person, subtract any income that continues from a surviving spouse's work, and the difference is the annual shortfall. Then decide for how many years it must be covered: until the youngest child is independent, until the surviving spouse reaches retirement, or for another period that fits the family.

Multiplying the annual shortfall by the number of years gives a rough figure, but it overstates the need slightly because a lump sum earns something while it is drawn down, and it understates the need if inflation is ignored. A reasonable approach for a household plan is to treat the investment return and inflation as roughly offsetting, and to adjust if the period is long. Social Security survivor benefits may pay something toward a surviving spouse caring for young children and toward the children themselves; include an estimate from your own Social Security statement rather than a guess.

Step three: add future goals and subtract what already exists

Add the costs that would still come later: college for each child to the level the family intends, childcare the surviving parent would now need to pay for, and any commitment to a parent or a relative with a disability. Then subtract the resources the household already has: savings and investments the survivors would use, retirement accounts that would pass to the spouse, and existing life insurance.

Be careful with group life insurance through an employer. It usually ends when the job ends, is often a fixed multiple of salary, and can be expensive or impossible to convert. Count it, but do not let it be the whole plan unless the employment is secure and the amount is adequate on its own.

Step four: match the amount to the right kind of policy and term

The needs analysis gives the total death benefit today, but most needs shrink over time. The mortgage falls, children grow up, and retirement savings build. Term life insurance matches that pattern: it covers a fixed period at a level premium and costs far less per dollar of death benefit than permanent coverage. Some households ladder several term policies of different lengths, so coverage steps down as the obligations do.

Permanent life insurance, such as whole or universal life, fits needs that do not end: final expenses, estate liquidity, a lifelong dependant, or funding a business buy-sell agreement. Buying a large permanent policy for a temporary need often leaves the household underinsured because the premium limits how much it can afford.

Common mistakes

The following are where coverage amounts most often go wrong.

• Using a salary multiple without checking it against actual debts, children and savings.
• Not insuring a spouse who stays home, whose childcare and household work would cost money to replace.
• Relying solely on employer group coverage.
• Choosing a term that ends before the youngest child is independent or the mortgage is paid.
• Buying less coverage than needed because a permanent policy was chosen for a temporary need.
• Never revisiting the amount after a birth, a new house, a divorce or a business purchase.

A worked example

Suppose a couple in Chandler have two children aged four and seven, a $350,000 mortgage, and $20,000 of car and credit card debt. He earns $90,000 and she earns $50,000. If he died, the household would need about $60,000 a year beyond her income for fifteen years, or $900,000, and $100,000 for the children's college. Adding $30,000 of final expenses and emergency reserve and the $20,000 of other debt, and choosing to keep paying the mortgage rather than paying it off, gives $1,050,000. They subtract $100,000 of savings and his $180,000 group policy, which leaves $770,000. He buys a $750,000 twenty-year term policy. Her analysis, including childcare the family would need to pay for, comes to $500,000, and she buys a twenty-year term policy for that amount. The figures are hypothetical; the method, not the round numbers, is what they should take from it.

How to use this

Send us the figures from the list above and we will work through the needs analysis with you, show term and permanent options for the amount it produces, and compare them across the carriers we represent in Arizona, Nevada, Utah and Idaho. If the coverage you already have meets the need, we will tell you that and suggest when to revisit it.