How Much Life Insurance Do You Actually Need?

How Much Life Insurance Do You Actually Need?

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Choosing your life insurance policy

Once you arrive at a ballpark coverage figure, Steuer suggests letting your individual circumstances dictate whether to use a cash-value whole life (permanent) policy, term life or a combination.

“One tactic I recommend is to separate the planning for your spouse from the planning for your children, because the timeline for needing coverage may differ,” he says. “If you have a 15-year-old child, then you really only need a 10-year term policy to see the child through college. But if you’re 45 and plan to work for another 20 years, your nonworking spouse is going to need a 20-year life insurance policy, at least.”

All three experts caution against falling for the siren song of cash-value life insurance products that promise big investment returns that you might tap into while you’re still on this side of the lawn.

“That’s one of the main reasons people overbuy,” says Steuer. “You want to strip out all the distracters and address your actual need. Don’t expect something from your life insurance that you wouldn’t expect from your other insurance policies.”

Baranoff puts it even more succinctly: “Life insurance is for widows and orphans.”

Should You Use Life Insurance as an Investment?

It’s possible to consider life insurance to be an investment if you have a policy that builds cash value. Cash value policies are generally touted as another way to save or invest money for retirement. These policies help you build up a pool of capital that gains interest. This interest accrues because the insurance company is investing that money for its own benefit, much like banks. In turn, they pay you a percentage for the use of your money.

But it’s important to consider the rate of return that you might earn. If you take the money from the forced savings program and invest it in an index fund, for example, you may realize better returns. For people who lack the discipline to invest regularly, a cash value insurance policy may be beneficial. A disciplined investor, on the other hand, could generate higher returns by putting the money they would pay toward premiums in the market.

Important If you’re considering using a life insurance policy as an investment, check the rate of return and risk profile of the underlying investments to ensure that they align with your financial goals.

What Is a Rule of Thumb for How Much Life Insurance You Need?

There are several rules of thumb you can use for computing the amount of life insurance you'll need. These often involve multiplying your current income by a number such as 10x or the number of years left until retirement. Other rules of thumb involve adding up all expenses and obligations you need for your family.

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How much life insurance do I need?

The answer to the question of, how much life insurance does a person need depends on several factors, including:

  • Your age
  • The ages of your spouse and children
  • Your income
  • Your mortgage and other debts
  • College expenses for your children and/or spouse
  • The bill for final expenses

Your circumstances can vary the amount of insurance you need in a policy, but recommendations from experts also advise thinking about what is most practical for your immediate and future situation.

“You want them to get through this traumatic event with some palatable options, but that’s it,” says Glenn Daily, a fee-only insurance adviser based in New York City. “One famous agent once said the goal of life insurance is to let your family ‘stay in their own world.’ It doesn’t necessarily mean they have to maintain their current lifestyle. Maybe your spouse would decide to do something entirely different.”

While there is no hard and fast rule when it comes to how much life insurance you should purchase, insurance companies and financial planners have devised models to help you gauge what may be beneficial. Three approaches are the most common.

1. The DIME Formula (and 10 Rule)

The old “how much life insurance do I need rule of thumb” was to take your income and multiply it by 10. This was the industry’s standards for many years. However, this fails to account for several things.

Most notably, it does not take into account your family’s living expenses. This could vary wildly if you have one child or four. Moreover, it does not offer protection in the case of one parent being a homemaker.

As grim as it sounds, what happens if both parents die and only one has coverage? The 10 Rule left many questions unanswered. In its place came the Dime Formula, which takes into account the following:

  • Debt and final expenses: Come up with a solid number based on all the debts you owe, and include the costs of final expenses for each parent.
  • Income: For income, a good rule of thumb is to think about how many years your family would need income in your absence. Multiply this number by your annual income.
  • Mortgage: Include the total amount owed on your mortgage and the property taxes assessed. Similar to income, think about how many years your family would need the money for property taxes then multiply your annual tax total by those years.
  • Education: Determine the total cost of educating each of your children through high school as well as college.

Once you come up with that number, double that for both parents. That way, if something were to happen to both, your family would have sustainable income well into the future.

2. Shortfall calculation

The shortfall approach works backward from the annual income you would want to leave your spouse and family for X number of years. After you decide on this target number, subtract all other sources of annual income that will be available to them, such as your retirement accounts, pension, savings, your spouse’s salary and Social Security. The resulting number is the shortfall you’ll want to replace with life insurance.

“People overlook that they’ll likely have other assets,” says insurance literacy advocate Tony Steuer, author of “Questions and Answers on Life Insurance.” “Right now, you may be just starting to save for retirement, but by the time you actually retire, you’ll have $500,000 or $1 million in your retirement plan, so you may no longer need that $500,000 life insurance policy.”

3. Income generator

Some prefer to set their sights on building up a large life insurance investment that would generate earnings to provide a beneficiary with annual income. For instance, $1 million invested using a conservative average annual yield of 4 percent could provide $40,000 a year to a spouse or family in perpetuity.

“While the need for life insurance is temporary for most dependents, there are exceptions, such as a special-needs child who will never be self-supporting, where the need lasts the rest of their life,” says Steuer, who also is the director of financial preparedness for the insurance consumer group United Policyholders.

Daily says that while no single model fits all families, everyone can benefit from test-driving one or more.

“The good thing about looking at the future and not just the present is that you’re going to get some idea of whether your insurance need goes up, down or remains about the same,” he says. “That’s going to have some relevance for what type or combination of insurance you should buy.”

How Much Will It Cost?

The cost of life insurance is determined by age, health and lifestyle. Alex is in good shape and wants a 20-year term life insurance plan with a death benefit of $400,000. How much will he pay? Around $18 a month—less than what he spends on coffee every month!

Dave recommends term life insurance because it’s affordable. You can get 10–12 times your income in your payout, and you can choose a length of term to cover those years of your life where your loved ones are dependent on that income.

Yes, this life insurance calculator is for you

But I have life insurance through work…

Nice one! But you still need coverage that will follow you wherever you work. When you leave your current job, you won’t be insured and your family won’t be protected. If you wait until you leave your job to search for life insurance coverage, you’ll probably end up paying more because you’ll be older. Plus, employer-paid policies usually don’t replace as much lost income as people really need.

But I’m a stay-at-home parent…

Just because you’re not generating income doesn’t mean you’re not generating value for the family—value that would have to be replaced if you weren’t around. If something happened to you, imagine the cost of hiring caregivers to attend to the needs of your children. Your partner would have to hire someone to do everything you do now, from childcare to cooking and shopping. That doesn’t come cheap, so make sure you don’t undervalue your contribution to the family by skipping life insurance.

But I work out and eat lots of kale…

Awesome—you’re immortal! Oh wait, you’re not. Death comes to all of us, even to the svelte and vegan. We’re not saying you should stop taking care of yourself, just that you should think of having life insurance as one of the ways you take care of yourself. It’s often the most health-conscious people who are the most reluctant to shop for life insurance, even though they may be eligible for reduced premiums as a reward for their healthy lifestyle. Take advantage of the lower life insurance cost available to you by virtue of your exemplary diet and exercise habits.

General rules of thumb for determining how much life insurance you need

While you don’t know the future and you can’t foresee every possible expense your family might face in your absence, there are a few straightforward ways to start estimating your number:

1. Human Life Value*

Some financial representatives calculate the amount you need using the Human Life Value philosophy, which is your lifetime income potential: what you’re earning now, and what you expect to earn in the future.

In its simplest form, the philosophy suggests that you multiply your income by a variable based on factors such as age, occupation, projected working years, and current benefits. As with every individual, the amount of recommended insurance you purchase depends on many factors. A simple way to get that number, however, is to multiply your salary times 30 if you are between the ages of 18 and 40. The calculation changes based on your age group, so please refer to the chart:

 Age

Maximum Life Insurance

18-40

30 times income

41-50

20 times income

51-60

15 times income

61-65

10 times income

66-70

1 times net worth

71-80

1/2 times net worth

81+

case by case

2. Multiply your income by 10 – and add college for each child

This approach is almost as easy to figure out as the first rule, but also helps plan for opportunities like college for your children. How much should you add for each child? College isn’t cheap: you should account for somewhere between $100,000 and $150,000 per child. If you split the difference – and have 2 kids – that’s an extra $250,000.

3. Use the DIME formula

DIME stands for Debt, Income, Mortgage, and Education – the four big factors to consider when making a more detailed estimate of your life insurance needs:

Debt: Total all your debts other than your mortgage. Car payments, credit cards, student loans – even personal obligations such as money you may have borrowed from a sibling to put a down payment on your house. On top of all that, add about $7,000 for funeral expenses.

Income: How much do you make a year? And how many years will your family need that money? It’s a hard question to answer, but a good place to start is determining how many years until your youngest child graduates high school. For example, if you make $50,000 and have nine years until your youngest graduates high school, put down $450,000 for income.

Mortgage: Look at your last statement and get the pay off amount. If you have a second mortgage or HELOC (Home Equity Line of Credit) add that in as well (if you haven’t already included it in the debt section above).

Education: The anticipated cost for sending each of your children to college. As we said before, figure between $100,000 and $150,000 per child.

Add those four factors all up and that’s your number. You can also make adjustments (i.e., subtract) for any current savings and life insurance you already carry. The DIME method takes a little more work, but it’s also more precise – and you can probably get all the numbers you need in an hour or so by going through your files at home.

What’s left out?

The example leaves out some potentially significant unmet financial needs, such as

  • The surviving spouse will have no income from Social Security from age 53 until 60 unless the deceased buys additional life insurance to cover this period. It could be assumed that the surviving spouse will obtain a job at or before this time, but she could also become disabled or otherwise unable to work. If life insurance were bought for this period, the additional amount of insurance needed would be about $335,000.
  • Some people like to plan to use life insurance to pay off the home mortgage at the primary income earner’s death, so that the survivors are less likely to face the threat of losing their home. If life insurance were bought for this goal, the additional amount of insurance needed is the amount of the unpaid balance on the mortgage.
  • Some people like to provide money to pay to send their children to college out of their life insurance. We may assume that each child will attend a public college for four years and will need $15,000 per year. However, college costs have been rising faster than inflation for many decades, and this trend is unlikely to slow down. If life insurance were bought for this goal, the additional amount of insurance needed would be about $200,000.
  • In the example, no money is planned for the surviving spouse’s retirement, except for what the spouse would be entitled to receive from Social Security (about $1,200 per month). It could be assumed that the surviving spouse will obtain a job and will either participate in an employer’s retirement plan or save with an IRA, but she could also become disabled or otherwise unable to work. If life insurance were bought to provide the equivalent of $4000 per month starting at age 60 until 65 and $3,000 per month from 65 on (because at 65 Medicare will make carrying private health insurance unnecessary), the additional amount of insurance needed would be about $465,000.

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