How to Know When You Have Too Much (or Too Little) Life Insurance

by Miranda Marquit

Money Shirt
Image source: Rob Lee


One of the best things you can do for your family is to have adequate life insurance so that your loved ones are provided for if you should pass. This is especially important if you have a spouse and/or children that rely on your income. However, in spite of what many life insurance companies want you to believe, it is possible to have too much life insurance. But, of course, you don't want to have too little insurance, either. The key is to figure out what you want the money from the life insurance to accomplish and plan accordingly.

Do You Have Too Much Life Insurance?

Changes to life circumstance might mean that you have too much life insurance. Or you might have had too much life insurance all along. A life insurance policy that has a larger payout than you need can cost you extra money. Here are three signs that you have too much life insurance:

  1. Your family will be filthy rich if you die: Sure, you want your family to be provided for. But do they need to upgrade to a mansion if you pass on? Figure out how much your family would need to live on if you died. If you make $50,000 a year, and have little debt, a $5 million insurance policy is probably overkill. One way you can figure out how much capital you need to generate your yearly salary is to take your yearly income and divide it by 0.04. This assumes a 4% rate of return if the capital is placed in a relatively low risk vehicle. (Of course, there is no guarantee that this rule of thumb will work out, since returns are based on market conditions, and you rely on it at your own risk.) In our example, you would need $1,250,000 in insurance to cover your family's needs (50,000/0.04) - assuming you aren't planning on paying off your debt as well.
  1. You no longer have dependents: If your children have moved out and your own spouse has passed on, you might not need very much life insurance at all. If you have a large enough estate, though, you can help your heirs by getting enough life insurance to help pay estate taxes. You can also get a small amount of life insurance to cover funeral expenses. If your life insurance policy is expiring soon, re-evaluate your needs before renewing at the same payout amount. It may be more than necessary.
  1. You have other sources of income: Those with multiple income streams may not need as much life insurance. If the goal of life insurance is to replace your income, you may have too much if you have alternative income streams. Income from dividend paying investments, royalties and other sources are likely to still be there after you pass. Additionally, if you have a good nest egg built up, and your spouse works, you might not need as much life insurance as you have. Take into account where money will come from for your loved ones, and only replace what will actually be gone if you die.

Before you purchase a large amount of life insurance, consider your family's financial situation and needs, and consider that you might be better off with a smaller policy.

Does Your Family Have Too Little Life Insurance?

Worse than spending too much money over a period of decades to pay for too much life insurance is leaving your family high and dry. You do want to make sure that your family will be able to live in reasonably comfort after you are gone. Here are three indications that you might not have enough life insurance:

1. Your death would bring utter financial ruin to the family: While your family doesn't need to end up extremely wealthy upon your death, if your loss would financially devastate your family, you don't have enough life insurance. Your life insurance policy should provide enough money for your family to replace your income if you die. At least, your life insurance should cover the expenses of your funeral plus the monthly expenses that are required to keep your family solvent. Another way to calculate the bare minimum you need for insurance is to determine how long your family will need replacement income if you died tomorrow. Many families calculate this number according to how much longer there will be children at home. If your youngest is 5, you will need the money to last 13 years. If your family expenses amount to $50,000 a year, you will need $650,000 worth of coverage for it to last that long - as long as you don't think inflation will be an issue.

2. There isn't enough to cover your debts: One of the best things you can do for your loved ones is to make sure that debts can be paid off upon your death. This is especially true if you want your family to remain in your home. Consider how much it would take to pay off all of your debts, including your mortgage. If your life insurance payout wouldn't cover that amount, you might have too little.

3. Your stay at home spouse isn't covered: Many couples make the mistake of thinking that a stay at home spouse doesn't need to be covered by life insurance. In the name of saving money, you might not get a policy to cover the life of someone who doesn't bring home a salary. Unfortunately, this is somewhat shortsighted. Many couples forget that a stay at home spouse provides services that you would have to pay for if he or she wasn't doing them. If your stay at home spouse dies, you will still need to keep working. But if you have kids, who will watch them after school? You may need to hire a nanny, or send them to daycare - and that costs money. You might not have time to do the cooking and cleaning every day, and may want to hire someone to help with these tasks. Consider what these extra services might cost, and get enough life insurance coverage on your stay at home spouse to help meet these expenses should it become necessary.

There are a number of rules of thumb associated with determining insurance coverage. The important thing is to identify your goals, and what you hope a life insurance payout will be able to do for your family, and choose a policy that will most likely accomplish your financial hopes for your family.

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