How Much Life Insurance Do I Need?
Life insurance is a financial arrangement between you and an insurance company wherein you agree to pay premiums (regular payments) and the company, in turn, gives a sum of money to beneficiaries upon your death. This contract ensures your loved ones receive financial support via a “death benefit” when you can no longer provide for them.
Life insurance is also sometimes a strategic part of broader financial planning in that it’s an efficient way to transfer wealth and can help you build savings and protect your income. So, how much do you need, exactly, and what should you consider when purchasing a policy?
As a one-size-fits-all answer to these questions quite frankly doesn’t exist, let's dig into some details so you can make an informed decision that protects your loved ones.
Types of life insurance: term vs. permanent
Before calculating how much life insurance coverage you should buy, you'll need to decide between the two primary types: permanent and term.
Permanent life insurance provides lifelong coverage so long as premiums are paid. It’s often a financial tool of sorts, as many policies include an investment component that builds cash value from a portion of premiums. This cash can grow over time and perhaps be used in the future for loans, withdrawals, and/or funding retirement needs.
Term life insurance offers coverage for a specific period—10, 20, or 30 years, for example—and protects dependents during your working years or while significant expenses (e.g., a mortgage or college tuition) are in play. Should you survive the term, the policy expires without paying out unless it's renewed (with some policies requiring a medical exam for renewal, which can affect the premium).
Which life insurance option is right for you?
When trying to answer this question, first consider the duration of coverage you’ll need:
A term policy is perhaps the best choice if you need coverage for a specific period of time—such as until your children graduate college. This option is often more affordable and straightforward than its permanent counterpart.
Consider permanent insurance if you want coverage that will last a lifetime and grow in cash value, which can help cover end-of-life expenses and provide an inheritance.
See this article for more information: Should I buy term or permanent life insurance?
Then, take a look at your financial goals:
Term insurance usually suffices for temporary needs, such as covering a mortgage or an educational period.
Permanent insurance is perhaps preferable for long-term financial planning that involves considerations such as estate taxes or leaving a legacy.
Consider future financial challenges and/or significant upcoming expenses. How might your financial responsibilities evolve over the next decade or two? If your needs change, you can perhaps convert a term policy into a permanent one—making sure to understand all terms and potential fees involved before signing on the dotted line.
Finally, it’s never a bad idea to seek out professional advice. Life insurance products are often complex, making personalized guidance and expert insight from a financial advisor that much more helpful.
Calculating how much life insurance you need
When it comes to safeguarding the financial future of your loved ones, you certainly don't want to come up short. Thankfully, you can enlist the help of several strategies to calculate how much life insurance you need: considering the benefits of each to isolate the one that will best meet your unique needs and challenges. These include…
Manual calculation
This simple formula is an excellent starting point. It works like this:
Life Insurance Coverage = Total Financial Obligations – Liquid Assets
Sum up your financial obligations as a first step, including:
Mortgage balance: The total remaining balance on your home mortgage
Other debts: All other debts such as car loans, credit cards, and personal loans
Future needs: Future costs such as college tuition for your children and funeral expenses, which average about $8,000
Annual salary: Estimating the number of years you want to replace your income and then multiplying your current yearly salary by that number
Replacement of services: (If applicable), the cost to replace services a stay-at-home parent might provide (e.g., childcare)
Subtract any liquid assets you have from this total, including savings accounts, current life insurance policies, and existing college savings funds; the remaining amount is how much life insurance coverage you need.
DIME formula
The DIME (debt, income, mortgage, education) formula is another way to calculate a minimal but sufficient coverage amount and works as follows:
Debt and final expenses: Total all your debts (excluding your mortgage) and add estimated funeral costs.
Income: Estimate the number of years your family would need support if you were to pass away unexpectedly, multiplying your current annual income by this number.
Mortgage: Determine the total amount required to pay off your mortgage completely.
Education: Calculate estimated costs for your children's schooling and higher education expenses.
While the sum of these figures is another starting point, the DIME formula does not automatically subtract the life insurance and savings you already have (unlike the manual calculation mentioned earlier). It also doesn’t factor in the value of unpaid contributions from a non-working spouse, which are often significant.
Income × 10
Another rule of thumb is the “income times 10” method whereby you multiply your annual income by 10 and purchase life insurance coverage to that amount (e.g., if you earn $80,000, you'd buy an $800,000 policy).
While this is perhaps the simplest method, it's oversimplified in that it doesn't consider your family's unique financial needs. A modified version of this rule also exists, calling for you to multiply your income by 10 and tack on $100,000 per child.
Standard-of-living method
This method, just as the name suggests, aims to help your family maintain their current lifestyle in the event of your death.
To start, determine the annual income they would need to maintain their current standard of living without any financial strain, and then multiply that number by 20: leading to a figure that would allow survivors to withdraw 5% of the death benefit annually to cover living expenses while preserving the principal amount via investments.
This approach is a little more comprehensive in that it considers your family's specific needs and way of life.
Years-until-retirement method
You can also try the years-until-retirement calculation on for size:
Life Insurance Coverage = Current Annual Income × Years Until Retirement
The goal here is to ensure your family continues to have financial support throughout your working years, with the death benefit replacing your annual income.
Key considerations when buying life insurance
Life insurance is personal; the type and policy amount depends on your financial situation, your family's needs and desires, and your overall goals.
Consider these factors when exploring your options to make a well-informed decision:
Age: As life insurance premiums increase as you get older, buying a policy when you're younger is often a cost-effective strategy (even if you currently have no dependents).
Income: Those with a high income may need a larger policy to maintain their family's standard of living in the absence of earnings.
Your partner and children: This information will help you estimate how many years of income replacement you may need to provide for your dependents.
Debts: Consider your home mortgage, car loans, student loans, and other debts when choosing a life insurance coverage limit (remembering these debts often don’t disappear after death).
Future expenses: Should you anticipate substantial costs ahead for your children and/or spouse, factor these into your coverage amount as well.
In sum: how much life insurance you’ll need
On the hunt for personalized advice so you can choose the right life insurance plan for your family? Feel free to book a no-obligation consultation with us today!
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and is not intended to provide specific tax advice or recommendations for any individual or business.
Variable universal life insurance/variable life insurance policies are subject to substantial fees and charges. Policy values will fluctuate and are subject to market risk and to possible loss of principal. Guarantees are based on the claims-paying ability of the issuer.
Both loans and withdrawals from a permanent life insurance policy may be subject to penalties and fees and, along with any accrued loan interest, will reduce the policy’s account value and death benefit. Withdrawals are taxed only to the extent that they exceed the policy owner’s cost basis in the policy, and loans are typically free from current federal taxation. A policy loan could result in tax consequences if the policy lapses or is surrendered while a loan is outstanding.
