How to Determine Life Insurance Needs

Most adults grow up and buy life insurance. However, who needs it and how much they should buy can vary dramatically for each person. Furthermore, needs change over time – so if a person has been paying premiums for a policy for decades, he may wake up one day and find he doesn't need it any longer.

This holds true for older couples in which one spouse dies. Once the decedent's policy pays, the spouse may use the cash to pay off the mortgage and any debt, and then live off savings, investments, pensions and Social Security. If the couple doesn't have children or they are already well off, the surviving spouse may no longer need to keep up her own life insurance policy.

For a couple who has excessive debt, such as a large mortgage, student loans, or they have racked up high credit card balances, it could prove helpful to have enough life insurance to pay off that debt should one spouse die. Some families may even include the cost of future college education for their children as part of their insurance coverage. With all of these expenses accounted for, some insured folks joke that they are worth more to their loved ones dead than alive.

Also note that there are circumstances in which spouses purchase policies with different face amounts. For example, a high-income earner may need to purchase a high-dollar amount policy to replace that income for the life of a stay-home spouse. The stay-home spouse, on the other hand, may purchase a policy for a much lower amount since it needs to cover only the costs of childcare and maintaining the home – and only until the children are grown.

A family caring for a special needs child should consult with a financial planning professional when it comes to determining life insurance. At first glance, the logical assumption is that the child would need a high coverage amount since he'll likely need support long after the parents have passed away. However, too much income can disqualify the beneficiary from government benefits such as Supplemental Security Income (SSI), Medicaid, vocational rehabilitation, or subsidized housing. A special needs beneficiary cannot own more than $2,000 in assets to qualify for federal needs-based assistance. That's why it's important to consult with a professional. He or she can help determine if the person who will be responsible for caring for the disabled child should be named the life insurance beneficiary. Or, among other options, it may be prudent to establish a trust as the beneficiary to provide another layer of protection against a caregiver's financial mismanagement.

As a general rule, life insurance is no longer needed once children are grown, out of the house and the couple enters retirement, which is why 20-year term policies are so popular. Term life policies are available for a specific period – typically 10, 20 or 30 years – and the premium amount is guaranteed for the length of that term. This enables a person to purchase the coverage amount needed for as long as he needs it for the least amount of premium.

The alternative is permanent life insurance, which features a component that can build up a cash value savings to help offset higher premiums in the future. Whole life permanent policies also feature an investment component that offers the potential to grow the cash value further.

Bear in mind that life insurance is not designed to be a get-rich-quick scheme for survivors. It's a way to protect individuals who depend on another person's income, and is meant to cover the sudden loss of that income.

For lifetime income replacement, many experts recommend purchasing based on the "four percent rule." For example, if one spouse wants to provide $40,000 a year after his death for the other spouse for the rest of her life, he should purchase a $1 million life insurance policy. In this case, if the survivor invested the insurance payout for a four percent return, it would yield $40,000 a year. If he wanted to provide $100,000 a year for his loved one's lifetime, he'd purchase a $2.5 million policy.

Another common strategy is to multiply the primary earner's income by 15 and purchase a policy with that sum as the death benefit. The insured also should select a term that best represents how he normally would work until retirement. Some experts recommend 15 because that's what it would take to supplant 75 percent of the wage earner's income when invested to yield five percent a year. See how this works, below:

• Husband earns $100,000 a year
• He purchases a $1.5 million policy ($100,000 x 15)
• If the $1,500,000 proceeds are invested for a five percent annual return, this would yield $75,000 of income a year to his beneficiary

One thing to note is that not every beneficiary will invest the full amount of proceeds. If they need the money, many may use the cash windfall to pay off the mortgage and any other debts – even buy a car outright instead of financing it. This would reduce the amount available to invest, so the annual income yield may be significantly less. However, paying off debt eliminates years and years' worth of interest charges, so in the long run this may be a more cost-efficient strategy.

It's easy to talk about needing a million-dollar life insurance policy, but it's important to note that not everyone can qualify for or afford that amount of coverage. Policy face amounts are generally determined by the amount of income the applicant makes at the time or purchase, which is multiplied by a certain number of years – generally the number of years the payout is needed to cover. However, an insurance company is not likely to issue a $4 million policy to someone who earns $40,000 a year. It is typical for insurers to cap proceeds to approximately ten times the applicant's current annual salary. If an applicant's income is low, chances are that's about all he could afford anyway.

Speaking of how much premium is charged, this will vary based on whether life insurance is purchased through an employer-sponsored group plan or is an individual plan. For individual policies, most insurers will subject applicants to a basic health exam, which may include:

• Measuring height and weight
• Blood pressure
• Urine sample
• Blood sample
• An EKG may be administered for older applicants or those seeking a particularly large amount of coverage
• The insurer also may check motor vehicle records

Once all of this information is processed by underwriters, the insurer will quote a premium rate based on whether the candidate is classified as Preferred, Standard, or Substandard. If Preferred, the rate will be less than the average policy holder who is in the same policy class, age, and weight range. The Standard rating applies to people of average health, and a Substandard rating will result in a higher than average premium, because the insurance company believes it is taking more of a risk by accepting a less than healthy applicant for coverage.

Many people are offered life insurance coverage through work, paid for by the employer. Often employer-sponsored life insurance policies may cover anywhere from one to three years' worth of the worker's annual wages. Bear in mind that there are tax implications when an employer pays for more than $50,000 of life insurance for an employee. Also, depending on if the employee is married and has children or other people depending on his income, this may not be nearly enough. In this case, it's important for the worker to purchase an additional policy on his own. He should factor in the amount his beneficiary would receive through the work policy when determining extra coverage, as there's no sense in paying for more than he needs.

One of the best benefits of life insurance proceeds is that they generally are not subject to income tax. However, investment income generated from those insurance proceeds will likely be considered taxable income.

As with all types of insurance, it's a good idea to buy as much as needed, but no more. After all, it doesn't make sense to buy an automobile policy priced for a new, high-end Lexus if the insured drives an old Camry. And homeowners' insurers won't issue a $500,000 policy for a $200,000 house.

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