Most American families realize that they need life insurance, but many struggle to answer the question “how much life insurance do I need?” One of the reasons this is difficult is because the answer changes at each age and stage of life based on your current and expected future income, assets, debts and family living situation. A standard formula will not always give you the correct amount of necessary coverage to buy.
For example, some financial planners and advisors recommend buying 8 to 10 times your annual income, but to advise consumers to buy that much life insurance regardless of other factors would be disastrous. Imagine two families with the same household incomes, but one couple has two children and outstanding student loans while the other has paid off the house and accumulated substantial retirement savings. Would those two families need the same amount of life insurance? I don’t think so.
There are several different factors, strategies, and expenses to consider when determining how much life insurance you need.
How Much Life Insurance Do You Need?
The simplest way to calculate how much life insurance to buy is to think about four categories: mortgages and debts, funeral and burial expenses, education costs, and income replacement.
Mortgage and Debt
Your mortgage payment is likely your single largest monthly expense, so paying it off would considerably decrease the financial burden on your family. Then total your other existing debts or liabilities such as car loans, student loans, personal loans, outstanding credit card balances, and any other large debts. Your surviving spouse may choose not to pay off the mortgage if you have a relatively low interest rate, but at least the option would be available and your family is not forced to sell the home.
Funeral, burial, and related expenses are costing between $10,000 and $15,000 nowadays, and tax-free life insurance proceeds are more readily accessible than money from your estate, especially if estate taxes, probate and liquidity become issues. Be safe and allocate $15,000 to final expenses.
Education and tuition expenses can be difficult to estimate when calculating the cost of enrollment 10 or 20 years down the line. With the cost of college increasing an average 5% per year, be conservative and overestimate your children’s tuition bills to avoid underinsuring yourself. Without financial assistance or a scholarship, a public university may cost $100,000 to $150,000 for a 4-year bachelor’s degree, while a private university may be in the range of $150,000 to $250,000. However, these figures all depend on where you expect your child to attend college and whether or not you want them to take on student debt.
The amount of income that needs to be replaced depends on your household income, lifestyle, and the number of years you want to insure your family. Once you’ve covered your mortgage, funeral expenses, education costs and other major debts, a large portion of your family’s expenditures have been paid for. This means that your dependents could likely survive on 50% to 75% of your current pre-tax income, not accounting for inflation or investment returns.
When insuring stay-at-home parents, insurance experts estimate the annual cost of their services around $50,000 since replacing their contributions in the home would require paying someone for childcare, home maintenance, cleaning, cooking, and other responsibilities.
The strategy with income replacement is to determine how much life insurance you need to buy in order to leave a nest egg your spouse and children can live off of. For instance, if you earn $100,000 per year, divide it in half and multiply $50,000 by the number of years you want to provide protection. If absolutely no interest is earned (which is highly unlikely), your beneficiaries can withdraw $50,000 annually for the term period.
Let’s assume a conservative rate of return of 5% per year and coverage for the next 20 years. In the previous example, you would purchase a $1,000,000 term life policy. In the event of your death, the life insurance company would pay out the $1,000,000 tax-free. At a 5% interest rate, the proceeds would yield $50,000 in interest income each year and your beneficiaries would never need to touch the principle.
How Long Do You Need Coverage?
Another important factor you need to consider is how long you will need your current level of life insurance protection. When you are in your 20s, you will need to be able to provide additional income for your spouse and children for a longer period of time than if you are in your 40s. A 20 or 30 year old may want to buy a 30-year term life insurance policy while a 40 year old would be better off with a 10 or 20-year term period, especially after comparing insurance quotes and realizing age plays a huge role in determining premiums. The older you are, the riskier it is for the company to insure you.
You may also need to consider the needs of your children. If you have a special needs child, then you may need permanent life insurance to support him/her for a lifetime.
Life Insurance Calculator
In the final step, you would combine the figures of each category to get the total amount of life insurance you really need. You can even adjust the figure based on your personal circumstances:
- If your spouse earns a high salary, then consider decreasing your coverage.
- If you currently have no or underfunded savings, pensions, or retirement accounts, increase your death benefit.
- If you have substantial savings, including retirement accounts, investment properties, and a pension, you can decrease the amount needed.
- If a family member has health issues or you expect him/her to develop a medical condition in the future, add to your policy’s face value.
- Based on your family medical history, if you expect to develop an illness in your later years, buy additional coverage now while you are still eligible and can afford it.
- Many employers offer a subsidized or free group life insurance policy for their employees. If you have coverage as a corporate benefit, subtract the death benefit from the amount of insurance you need to buy privately. Nevertheless, beware that if you lose your job, your policy is no longer paid for.
After you buy life insurance, you will need to review your policy after major life events such as marriage, having children, buying a home, acquiring a business, taking on personal debt, or retiring.
In the end, most families will probably end up with a term life insurance policy between $500,000 and $1 million. Some families with high-earnings will need to purchase coverage of more than $1 million. Fortunately, term insurance is the cheapest type of life insurance so affordability shouldn’t be an issue for most families.