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How Much Life Insurance Do I Need?
By Ingrid Case MONEY RESEARCH COLLECTIVE
If your family (or anyone else) relies on your income, you need life insurance. But once you’ve established this, you’ll need to consider how much life insurance you need, and the kind you should buy.
The answers to these questions depend on you, your family and your life insurance needs. Read on to understand:
Table of Contents
- Why do you need life insurance?
- How to calculate how much life insurance you need
- Factors that affect how much life insurance you need
- What is the difference between term and whole life insurance?
- How much life insurance do you need FAQs
- Summary of our guide to how much life insurance you need
Why you need life insurance
It’s a fair bet that everyone who loves you would be sad if you died. Some of them, however — such as your spouse and your children — might also hurt in more material ways if your family relies on your income. And even if you are a stay-at-home parent or don’t earn a wage, your dependents may still rely on services you provide, such as child or elder care, that would be expensive to replace.
Without life insurance, your family might find it difficult to make mortgage payments, afford childcare, support elderly relatives, buy food and other necessities, pay for education or save for retirement.
Life insurance is a way to protect your family if you should die unexpectedly. It can’t take away the pain of losing you, but it can help ensure that the people who love you don’t face financial distress on top of their grief. Having the right life insurance — and enough of it — gives them more financial security than they might otherwise have without your contributions.
How much life insurance do you need?
Once you’ve decided that life insurance makes sense, you need to determine how much coverage it makes sense to buy for your particular financial situation. In this instance, “coverage” means the amount of money, called the death benefit, that the life insurance company would pay your family if you died while the policy was active.
Your family could either spend or invest the death benefit. Which option suits them best should affect the amount of coverage you choose to buy. Let’s say you hope to leave your family $48,000 every year for the next ten years. The math is simple: your death benefit should be $480,000. But if you hope to leave your beneficiaries $48,000 every year in perpetuity, you’ll need a larger death benefit. Invested at 5% rate of return, a benefit of $683,556 earns $48,500 every year.
There are four common methods for calculating how much life insurance you need. It’s best to overestimate those needs a little, to leave room for surprise expenses. However, you should also recognize that a surviving spouse’s income needs will likely decline as children become independent adults and no longer need financial support.
The four methods include the following:
The 10x rule
The so-called 10x rule might be the simplest guideline to decide how much life insurance coverage you need. If you are your family’s highest (or only) wage earner, you simply take your annual salary and multiply it by ten. If you earn $100,000 a year, for instance, you need coverage equal to $100,000 multiplied by 10. This means you would need a life insurance policy with a death benefit of $1 million.
The benefit of using this method to figure out the right amount of life insurance you will need is its simplicity. As a rule of thumb, a sum of 10 times your income will do a lot to help your family maintain its standard of living in the event of your unexpected demise. You can also do the 10x calculation quickly, which allows you to move forward with the process of buying a life insurance policy without delay.
There are two primary disadvantages to this method, though. First, it’s of limited use if you provide your family with valuable unpaid labor such as childcare. Zero times 10 is still zero — and yet the services of a primary caregiver would be very expensive to replace.
Second, this method isn’t at all detailed. Other calculations, while they might take more effort on your part, can offer a more exact estimate of your life insurance needs to ensure financial security for your beneficiaries.
Needs-based calculation
A needs-based calculation gives you a more detailed look at how much life insurance your survivors might require. This method is more comprehensive than the 10x rule because it takes into account your family’s existing financial needs. To use this method, determine the amount of money your family would need to meet immediate financial obligations, then add it to the sum that’s necessary to keep the household running.
Begin by adding up the amount of your outstanding debts, which might include obligations like a mortgage, student loans, outstanding credit card balances or medical debt. Include the cost of immediate future expenses your family will face, such as funeral costs (sometimes also referred to as “final expenses”).
Then estimate anticipated future expenses, including what it would cost to maintain your family’s current standard of living as well as big financial outlays you would have prepared for in life. If you have children, for example, consider the cost of any college education you plan to provide for them.
Subtract savings and other assets you already have, along with any additional income streams or benefits such as Social Security you anticipate your survivors receiving. You can do this manually or use an online calculator like this one.
Here’s a simplified example: If you have $20,000 in savings, and if you owe $120,000 on your mortgage and $5,000 on a car loan, you’ll need a policy benefit of at least $105,000 to cover your outstanding debts ($120,000 + $5,000 – $20,000). If you expect to need income replacement for 10 years and you earn $50,000 a year, add $500,000 ($50,000 × 10) to that total. Add those two figures together and you get a total of $605,000. Your policy death benefit should be at least this amount.
Human life value
The human life value method estimates how much money you would likely earn in the remaining years of your natural life, assuming that you die of old age. This is an actuarial approach that considers your age, gender, likely retirement age, annual wages and potential future increases, and employment benefits.
This formula for determining how much life insurance you need is typically calculated in a way that preserves the principal of the lump-sum payout as much as possible. That principal is invested and your survivors rely on the returns that money generates, which means you also need to consider both what investment return you expect to receive and the expected rate of inflation in order to figure out how big that lump sum needs to be.
Begin by adding up your likely future income between now and when you plan to retire. If you’re at the very beginning of your career, you might include potential increases in income, which you can estimate by looking up the average salary for your industry and geographic area.
Subtract a reasonable estimate from the total to account for your own living expenses and annual income taxes (or just subtract 30% of your current income, which gives you a rough approximation of the same thing). Decide how long your family will need your earnings replaced, then use a life insurance calculator to determine the lump-sum payout that will generate the income your loved ones need.
If you’re 40 years old, plan to retire at 65 and earn $65,000 a year, you’re worth $48,500 a year to your family after deducting taxes and your own living expenses. Assuming that your lump sum benefit will grow at 5% annually, you’ll need a benefit of $683,556 to pay your family $48,500 every year for 25 years.
The DIME method
DIME is an acronym that stands for debt, income, mortgage and education. Add the numbers of your family needs in each category to find the amount of life insurance benefit coverage you should buy.
Let’s say that you earn $50,000 a year and want to replace that income for your family for 10 years after your death. Say your mortgage balance is $60,000, you owe $5,000 on a car loan and you’d like to set aside $100,000 for your children’s education. Adding those numbers — $500,000 for 10 years of income replacement plus $165,000 to cover current and future expenses — means you need a life insurance death benefit of $665,000.
Factors that affect how much life insurance you’ll need
Your personal finances will determine how much life insurance you’ll need. Factor in how much you earn, how much your spouse or partner earns, whether your family has savings or other income sources, and for how long you’d like to replace your income.
You also need to know how much you can afford to pay in premiums. You might not be able to afford all the life insurance coverage you would ideally have. That’s okay. Some coverage is better than none at all, so buy what you can afford.
Term versus whole life insurance
The two main types of life insurance are term life insurance and whole life insurance. You will need to determine which is a better option for your individual circumstances and based on what you can afford in life insurance costs.
Term life insurance provides coverage for a set number of years, which is called the term. For instance, if you buy a 20-year term life insurance policy today, it would pay out if you die within the next 20 years. After that point, you stop paying those life insurance premiums and the policy terminates. So if you die in year 22 — two years after the policy ends — your family won’t get a death benefit.
Whole life insurance covers you for the rest of your life and is the most common type of what’s known as “permanent life insurance.” This type differs from term life insurance because it includes a cash value component in addition to the death benefit. You also may be able to use life insurance policies of this type as part of your overall financial plan because of the investment opportunities some policies offer.
Not surprisingly, whole life insurance is more expensive than term life insurance because whole life insurance is intended to cover you for a longer period of time. But term life insurance might be all you need, especially if you just want coverage during the time when your children are growing up.
FAQs about how much life insurance you need
Summary of our guide to how much life insurance you need
Life insurance can soften the financial blow in the event of your death to the people who depend on your income. Factors to consider include your income, other income sources (such as a spouse’s income), savings and other assets, debts and future financial obligations (such as funeral expenses and college tuition). Multiple methods can help you determine how much life insurance coverage you need. Four common strategies are as follows:
- The 10x rule
- Needs-based
- Human life value
- DIME (debt, income, mortgage and education)
