A Simple Process for Answering a Complex Question
- Why (almost) everyone needs at least some life insurance.
- Why the most popular “rule of thumb” for how much life insurance to buy is flawed.
- The three-step process for determining how much life insurance you really need.
Buying life insurance can make you feel a little bit like Goldilocks.
Buy too much, and you’re throwing away money on higher premiums for no reason.
Buy too little, and you could leave your loved ones in the lurch if you pass away.
Choosing the right amount of life insurance is critical for keeping your family financially secure, but how much life insurance do you need, really?
Ask an agent who makes a higher commission when you buy more coverage, and you might get an answer that’s not necessarily accurate.
You could also try to figure it out yourself with an online life insurance calculator, but plugging in numbers without really understanding the factors that go into the formula can also lead you to inaccurate results.
When faced with this conundrum, many people want to throw their hands up in frustration and just pick a random number. Of course, that’s no way to plan for your family’s future.
If you’re ready to get the real answer, keep reading!
We’ll provide you with everything you need to know so you can choose the perfect amount of coverage for your family's individual needs.
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Do I Really Need Life Insurance?
If you have a spouse, children, or other dependents who rely on any part of your income, then yes, you should have life insurance. Some people in other situations should also consider buying a life insurance policy.
Before you start calculating how much life insurance you need, it’s important to consider this question:
“Do you actually need life insurance at all?”
If you have a spouse or children, the answer is almost always yes. However, some people who may not need a life insurance policy include:
- Young singles
- Low income earners
- People covered under group insurance
- People who are self-insured
If you fall into one of these categories, don't stop reading yet! Although at first glance it might seem like you don't need coverage, consider the following points:
I'm a Single 20-something; Do I Need Life Insurance?
A young, single person with no dependents might assume that life insurance is a waste of money.
However, a term life insurance policy is far less expensive when you’re young. In addition, if you have any health issues when you get older, it could be more difficult or even impossible for you to get coverage.
Consider, for example that some new life insurance products like Bestow or Haven Life can issue term life policies to some healthy young adults within a half an hour online. (Traditionally, applicants are required to undergo a comprehensive medical exam and weeks of underwriting before getting life insurance.)
If you can afford it, you might consider purchasing a small policy now. You can always elect a charitable organization or a relative as your beneficiary until you’re married or have dependents.
I Don't Earn a Lot; Should I Still Buy Life Insurance?
Life insurance is only good if you can afford to keep it in place.
For low income earners, this can present a real challenge. However, it’s important to remember that life insurance policies will only get more expensive as you get older.
If you don’t think you can afford coverage, take a second look at your budget to see if you can free up enough for a small term insurance policy. For surviving family members, even a small life insurance policy is better than nothing if it gives them a year or two of living expenses after you pass.
If, however, purchasing a life insurance policy will really stretch your budget, then it’s probably best to put the extra money into savings.
I Have Group Life Insurance Through Work; Do I Still Need to Buy More?
If you have a great group life insurance policy through your employer, you might assume that there’s no need to purchase a separate policy.
However, you’ll still want to run through the exercise to determine how much coverage you actually need. This will help you decide if your current policy is sufficient. If it’s not enough, then you can purchase a separate policy to make up the difference.
You’ll also want to confirm that you can keep your group policy if you leave your current employer, and how much it will cost you to do so. If you’re not happy with the answers, this is another reason to consider a separate, private policy.
I'm Financially Independent; Do I Still Need Life Insurance?
If you have plenty of money stashed away to cover your family’s financial needs in your absence, then you might fall into the group of people who actually have no need for life insurance. This would apply to those who are independently wealthy or who have already retired and are financially free.
In addition to the points above, you might also consider whether you want to leave a legacy by making a charitable contribution upon your passing or leaving an inheritance to an important person in your life. In this case, you’ll want to buy a policy with a death benefit equal to the amount you need to meet your goals.
The Flawed “Rule of Thumb” for How Much Life Insurance to Buy
If you start asking family and friends or listening to popular advice columnists, there’s a good chance that you’ll hear about the “rules of thumb” for determining how much life insurance you need. Here's one of the most common rules—and why you want to avoid it!
One of the most popular rules of thumb for how much life insurance to buy is to choose a multiple of your current salary. The common advice used to be that choosing a death benefit that’s 10 times your salary is sufficient. Then, a popular financial advisor began to tout the benefits of increasing this to 20 times your salary. The thought behind this is that your surviving spouse can invest the death benefit and earn a 5 percent annual rate, which will produce an annual income equal to your salary. This would allow your family to maintain their standard of living without ever having to touch the principal.
For example, assume you earn $50,000 per year and purchase a $1,000,000 life insurance policy. If you were to die tomorrow and your spouse invested that money, a 5 percent return would give him or her $50,000 per year for life without the need to ever touch the principal.
Unfortunately, this advice is overly simplified and inherently flawed. First, it doesn’t factor in the impact of inflation. If the current inflation rate is 3 percent per year, $50,000 in today’s value would only have the purchasing power of approximately $36,000 in just 10 years. To keep up with the demand of $50,000 per year in expenses, your family would have to withdraw an additional $14,000 from the principal each year. As the principal amount goes down, there’s also less available to generate the next year’s income. It’s easy to see that using this calculation method will eventually lead to the depletion of the entire account well before your family’s needs have ended.
Secondly, this rule of thumb assumes that your family will be able to invest in a portfolio that gives them 5 percent in earnings every single year. Knowing what we do about current interest rates and market fluctuations, it’s clear that this is another major flaw. Sequence risk also tells us that having one or two years of poor returns soon after your spouse starts taking withdrawals can have a catastrophic effect on the account’s ability to ever bounce back.
Finally, the “multiple of salary” rule of thumb doesn’t take into account any “hidden expenses” or other sources of income that your family may be eligible to receive (more on both of these topics later). This over-simplification makes it very likely that you'll greatly either overestimate or underestimate your life insurance coverage needs.
The 3-Step Process for Determining How Much Life Insurance You Need
Luckily, there's a better way to determine how much life insurance you actually need. It takes a little bit more effort, but when it comes to protecting your loved ones, you’ll want to get it right. It’s impossible to predict your exact life insurance needs to the penny, but the following steps will help you estimate your ideal amount with greater accuracy.
Step 1: Determine How Much Financial Support You Contribute to Your Family
If you have a spouse and/or dependents, at a minimum, you’ll want to ensure that your death benefit plus other sources of income will cover the amount that you’re currently contributing to your family’s finances. In addition to your salary and bonuses, don’t forget to include the cost of services you provide for your family. Examples may include childcare, filing the family’s taxes, or maintaining the lawn and pool.
You’ll also need to add in any “hidden income.” This is money you’re contributing to the family that doesn’t come in the form of a paycheck. Examples may include the employer-paid portion of your medical benefits, your 401(k) match, and other perks of your job that benefit your family.
It should be noted that a stay-at-home spouse also needs life insurance even though he or she doesn’t have an “income” to replace. If the stay-at-home spouse were to pass away, at a bare minimum, the surviving spouse would need to cover the cost of childcare. When calculating the amount of coverage needed, consider the cost of replacing all of the jobs this spouse does at home. You may also want to add in some extra cushion to cover the potential loss of income from the wage earner while he or she mourns the loss of the spouse and helps the children adjust to their new reality.
Once you have this number, multiply it by the number of years your family will need coverage if you were to die today. You may want to plan for coverage until your youngest child turns 18, until your spouse reaches retirement age, or throughout the surviving spouse’s entire life expectancy. This is a matter of personal preference and your financial resources.
Next, consider other expenses your family may incur as they adjust to living without you. Is there a chance they’ll want to relocate, or your spouse will decide to pursue higher education or a new career? It’s important to ensure that they have enough of a financial cushion so they’re free to make good decisions without worrying about how they’ll pay for it.
Finally, add in enough to cover your final expenses. This includes the cost of your funeral services, burial, taxes owed, and the cost of administering and closing your estate. In many cases, $15,000 is a sufficient amount to cover these costs. However, the amount you'll need will depend on your individual circumstances and your personal preferences.
Step 2: Consider Current Assets and Other Sources of Income
Now that you have an idea of the “financial value” you bring to your family, it’s time to back out your current assets and other sources of income that will help offset these costs. One of the most common is Social Security Survivor’s Benefits. If you have children under the age of 18 and your spouse earns less than the maximum amount, these payments can be significant.
Other possible sources of income that are often overlooked include:
- Employer-sponsored life insurance policies
- Policies purchased through an organization or association
- Vested pension death benefits
While you’ll want to consider these sources of income when choosing your life insurance coverage amount, it’s important not to rely completely on job-related death benefits. If something happens with your employment and then you pass away, you could inadvertently leave your family unprotected.
Any assets your family currently has, like college savings plans, investments, and your emergency fund can also be used to offset the total need calculated in step one.
Step 3: Consider the Family’s Other Financial Goals
While the calculation above will cover the absolute minimum your family will need to get by upon your passing, many people like to plan for other important goals as well. Below are some of the factors you may wish to consider.
1. Surviving Spouse’s Expenses After Children Turn 18
Just because your children have met the age of majority, this doesn't mean that your family will no longer need financial assistance. Many parents continue giving their children some kind of financial support after they're technically “adults,” and your surviving spouse will still have expenses to cover as well.
Assume that at the time you die your spouse is 36 and your child is two years old. While you may have factored in Social Security Survivor’s Benefits when determining your coverage need, these will end when your child turns 18. At that time, your spouse will only be 52.
He or she will need income to cover expenses between age 52 and the time that Social Security Retirement Benefits kick in. The earliest you can file for a reduced early benefit is age 62. This means that your spouse will have 10 years of expenses without the benefit of additional income. While you could assume that your spouse will simply get a job to cover their expenses, there’s a chance that he or she could become disabled or otherwise unable to work. If you want the peace of mind in knowing your spouse will remain financially secure, you'll want to factor in enough coverage to get him or her through that time period.
2. Home Mortgage and Debt Pay-Off
When calculating the necessary life insurance amount, some planners suggest adding enough to pay off the home’s mortgage balance. This will reduce the chances that your spouse could be faced with the prospect of losing the family home. If this is a goal, you’ll want to add the unpaid balance of your mortgage to your total death benefit amount.
If the family has other debts, like vehicles and personal loans, you may wish to factor in these pay-off amounts as well. If not, another option is to ensure that the amount your family will inherit can generate enough monthly income to keep making the outstanding loan payments.
3. Caring for Dependents
If you have minor children and/or aging parents, you’ll probably also want to factor in the cost of their care. Upon your passing, not only will there be less income coming in, but it’s more likely that your spouse will need to outsource some or all of the responsibilities of caring for dependents as he or she returns to work. This can come with a hefty price tag and failing to factor it in can ruin your family's financial plan.
4. College Expenses
If you’re planning for your children to go to college, you may also want to add enough money to your death benefit to cover these costs. Assuming an expense of $15,000 per year for four years (the approximate cost of an in-state public college), you might assume an additional death benefit of $60,000 will be enough. However, the cost of college is rising at a rate much higher than the overall inflation rate. It’s currently near 8 percent. Assuming your child is 14 years away from college, the amount of death benefit you would need to add is closer to $183,000.
5. Cosigned Loans
If someone other than your primary beneficiary has cosigned on a student loan, vehicle loan, or other obligation that you hold, make sure you don’t forget about this obligation. If the entire balance of your life insurance goes to your spouse or another beneficiary, he or she is under no obligation to make the person who cosigned your loan whole. This means that they’ll be left with the entire bill and no way to seek compensation.
When purchasing your policy, ask if you can designate specific amounts to certain beneficiaries. If not, you can either buy another small policy to cover this person until your loan is paid off or you can leave them money through your will. Remember, however, that beneficiary designations supersede your will. This means that if you leave a life insurance policy to your spouse, he or she will get 100 percent of that money. Your co-signer will only get the money designated by your will if there is enough money left in your estate to cover it.
6. Surviving Spouse’s Retirement
The basic formula discussed above doesn’t factor in any savings for the surviving spouse’s retirement. While he or she will receive Social Security Retirement Benefits, that’s rarely enough to maintain a comfortable standard of living. You could assume that your spouse will get a job and contribute to the company 401(k). However, as previously mentioned, there’s also a chance that this won’t be possible due to disability or other factors. If you want to make sure your spouse is taken care of no matter what, you’ll want to include a buffer to cover the amount needed for retirement savings.
7. Financial Cushion
Finally, you'll have more peace of mind if you factor in a comfortable financial cushion. This can allow your family to maintain a sufficient emergency fund, give them more flexibility to make life decisions, and/or allow them to enjoy some discretionary spending. Whatever the reason, not having to count every penny can help relieve some of the stress your family will inevitably face upon your passing.
Deciding whether to increase your death benefit to cover the above goals will depend in large part on your family circumstances and the cost of the policy. You may wish to price out several different death benefit amounts so you can determine how much of a cushion you can reasonably afford.
Other Considerations Before You Buy Life Insurance
Now that you have a good idea of how to determine your family’s life insurance needs, you might want to run right out and buy your policy. Before you do, consider these final tips.
1. Understand Your Financial Plan
Buying life insurance shouldn’t be done in isolation. Your family’s insurance coverage is only one part of a well-designed financial plan. Whether you’re doing your own planning or working with an advisor, make sure the amount and type of life insurance coverage you’re considering is appropriate for the “big picture.”
2. Don’t Underestimate Your Needs
Although your life insurance estimates are based on your current income, remember that both your income and your expenses are likely to increase over the years. It’s often a good idea to bump up your number a little bit rather than keep the margin for error too tight. As long as the premium fits within your budget, a little bit of extra coverage usually isn’t a bad idea.
3. Talk with Your Spouse
Before you buy your policy, go through the numbers with your spouse. Make sure your estimates and their expectations line up. You may find that your spouse has some thoughts about what he or she would do if you passed away and how much that would cost.
If you find out, for example, that your spouse would prefer to sell the family home and live in a bungalow, move across the country to be closer to family, or would undergo some other major lifestyle change. If this is the case, you’ll want to factor these changes into your estimates. Since the purpose of your life insurance policy is ultimately to secure your family’s financial future, it’s important that you have a clear understanding of what that future might look like.
4. Consider Breaking Up Your Policies
Instead of purchasing one large life insurance policy, it’s often a good idea to break your coverage up into several smaller policies. This will give you some flexibility to lapse policies in the future if you find that you no longer need as much coverage. You can also buy policies with different terms, so your coverage automatically adjusts according to your family’s anticipated needs. For example, you may want to purchase a 30-year policy to cover your spouse’s expenses until retirement, then purchase a separate 10- or 20-year policy to cover your children’s college expenses.
Taking this approach can lower your overall cost, give you more flexibility, and allow you to name different beneficiaries depending on the ultimate purpose of each policy.
5. Consider a Longer Term
When in doubt, it’s often better to choose a longer term. For example, if you’re looking at a 20-year vs. 30-year term policy and both are affordable, then choosing the longer term will give you some additional certainty. If you choose a 20-year term and then find out that you need more coverage, buying a new policy at that time will be far more expensive. Even worse, if your health has changed significantly, you might not be able to get coverage at all.
6. Don’t “Set it and Forget it”
You might think that once you’ve purchased a life insurance policy, the only thing you have to do is keep paying the premiums. However, this is not the case. Life isn’t static, and as things change, so can your coverage needs. It’s a good idea to go through the calculation exercise every few years to ensure that your coverage amount is still sufficient and that you’re not carrying too much coverage. This is particularly important any time you go through a major life change like a marriage, divorce, addition of a child, or a death in the family.
It’s also critical to check your beneficiary designations periodically to ensure they still reflect your wishes. The last thing you want to do is accidentally leave a death benefit to an ex-spouse or inadvertently exclude a child who was born later in life.
Like almost everything involved in your financial plan, there’s no exact answer to the question of how much life insurance you need. There are many variables, and no one has a crystal ball to see the future. However, following the tips provided and discussing your life insurance plan with your spouse and/or your financial advisor will help you make an accurate estimate. Once you have a clear estimate of how much insurance you need, learn how to choose the best online term insurance broker.
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Thank you for including insurance for stay-at-home spouses! Please don’t forget to take their future income into consideration as well. Most stay-at-home spouses go back to work eventually and might end up making significant financial contributions to their families.