Can You Have Too Much Life Insurance?
The purpose of life insurance is to ensure your loved ones—especially any dependents, like children—are financially taken care of, your debts are paid off, and any funeral expenses are paid for. Now, what “providing for dependents and loved ones” includes will be different for each person, but below are some questions to ask yourself and a few calculations you can do to avoid buying too much life insurance.
You want to avoid going overkill on life insurance because buying too much means higher-than-need-be monthly premiums that can limit the budget you have to live on and to invest for the future (like retirement or college savings).
For the sake of simplicity, we will only be discussing the over purchasing of term life insurance, and not whole or universal life insurance policies. If you’re not sure of the difference, pause here and do some quick research online to get the most out of this article.
How much is enough?
To determine the just-right amount of life insurance to purchase, consider the following:
- Death expenses. According to the National Funeral Directors Association, the average cost of death expenses in the U.S., including a funeral and burial, is $7,000 – $10,000. If you’re considering cremation, the cost is significantly less. If you want something more exotic, like having your ashes turned into a diamond, firework, artificial ocean reef, tree, or vinyl record, be sure to look into these costs.
- Your debts. After death, a person’s estate is responsible for paying off their debts, including credit card debt, personal loans, and car loans. The estate uses assets like a life insurance policy to pay them off. Many people count their mortgage in this debt calculation, but here are a few words of caution: if you only have 10 years left on your mortgage and you have a 20- or 30-year term insurance policy (meaning the policy will cover monthly mortgage payments for those years), you have too much coverage. And, despite what many insurance sales’ people will say, there’s no need to pay off your remaining mortgage in one lump sum upon death—you can have a smaller policy with lower a monthly premium that will cover the ongoing monthly payments until the end of the mortgage.
- Replacing income. This is the main reason for purchasing life insurance: to serve as income replacement for your spouse and dependents. Calculating your replacement income, however, involves more than just looking at your current take-home pay and adding it up over the term of your policy (the number of years it will pay out).
First, life insurance is tax free, so you only need to replace your after-tax income to allow your family to maintain their current standard of living if you pass away.
Second, you won’t need to replace your personal direct expenses—food, clothes, gas, gym membership, etc.—when looking at the family budget you want to maintain. However, you will want to weigh this against the trend of rising living expenses and prices over time (i.e. inflation). So while many people choose to replace 75 percent to 90 percent of their after-tax income to account for subtracting their personal direct expenses, you could leave those expenses in to build a cushion against inflation of prices for the rest of your family’s expenses.
Third, don’t forget to account for the estimated Survivor Benefits payout from Social Security in your calculations. If you’re eligible for these benefits, it can help support your family and reduce the amount of life insurance you need. The caveat is that this payout from Social Security will almost definitely decrease in the near future, with the longevity of the program in question.
Fourth, as difficult and awkward as the conversation may be, it’s important to speak with your spouse about their possible desire or chance of remarrying in the case of your demise. There is a very real possibility they may want to remarry, meaning they won’t be dependent on your life insurance payments as replacement income.
Fifth, and lastly, if you have a sizeable amount of money already saved or invested that generates interest, you might not need as large a policy, or a policy at all, to replace your income. Calculate out what you expect to make each year from now until retirement using the considerations above and then see if your savings/investments will offer a similar income for those left behind.
With all of these careful considerations in mind, you’ll be more likely to choose a life insurance policy that fits you and your family’s needs perfectly—neither under nor over purchasing.