“How much life insurance do I need,” is the second most common insurance question, right after, “Which type of life insurance should I buy?”
Buying life insurance is a lot like buying a house in that what you need depends a lot on your family and your financial situation—and for first time buyers, you likely have a lot of questions.
Just like a studio apartment won’t cut it for a family of four, too little insurance won’t provide your family with enough benefit to meet their needs. But if you’re single or married without children, a large insurance policy could eat up funds that may be better spent elsewhere, just like a 5-bedroom home is way more space than you’ll likely use.
So how do you know how much life insurance is the right amount? Follow these steps to get an estimate of how much life insurance you need.
Life Insurance Estimate in 4 Steps:
Step 1: Multiple your income by the number of years your family needs support.
A lot of insurance companies recommend policies with a face value equal to 10x your income. Although this is the simplest way to calculate how much life insurance you need, it doesn’t take into account your specific financial goals, current assets and liabilities, or the actual number of years your family will need support.
By multiplying your income by 10, you provide your family with 10 years of income replacement, assuming no other debts or income, not factoring for inflation. Some insurance agents say that a more accurate estimate is actually 12x-15x your income. The truth is the number of years you should multiply by is the number of years before your children are financially independent.
Let’s assume you have 2 children, ages 7 and 5, and that they won’t be fully financially independent until age 25. In this example, you have 20 more years before your youngest child no longer relies on you financially.
Assuming a $100,000/year income, you would multiply by 20. This equates to $2 million as a base estimate.
What if my children require lifetime support?
If you have children with special needs who require lifetime support, it’s best to buy whole life insurance. Because whole life policies have a guaranteed death benefit payout, regardless of when you pass away, you’ll have peace of mind knowing your family is protected, and you won’t have to worry about outliving your insurance policy.
The amount of insurance needed for lifetime dependents varies based on long-term care needs, life expectancy, and other sources of income like disability, social security and government assistance.
Step 2: Add in college expenses.
One of the most common reasons people with children buy life insurance, aside from helping their family replace lost income, is to cover future college expenses. College tuition costs vary greatly by state and school, so you’ll want to look at current rates for colleges and universities your children are likely to attend. Don’t forget to factor in books and other materials, plus dorm costs if your child will live on campus. A good base estimate is $100,000 per child, although this could be significantly more or less.
For our example, we’ll assume 2 children at $100,000 per child for a total of $200,000. Add this to our estimate from step 1: $2,000,000 + $200,000 = $2,200,000.
Step 3: Add in debts and final expenses.
If you have outstanding debt beyond the mortgage on your primary residence, this will factor into how much life insurance you need. Examples include cars and other vehicles, real estate investment property not yet paid for, credit card debt, business and personal loans, and student loans.
For this example, let’s say you still owe $10,000 on your car, $30,000 on personal or business loans, $5,000 in credit card debt and $35,000 in student loans, for a total of $80,000 in debt.
On top of that, you’ll need to factor in burial expenses and any outstanding medical expenses not covered by insurance. Let’s budget for $20,000 for final expenses.
In total, this adds up to an additional $100,000 in debts and final expenses, bringing total insurance needs up to $2,300,000.
What about my mortgage?
If you pay a mortgage, the balance is often covered with replacement income and isn’t considered an additional cost. For example, if you have enough replacement income to last for 20 years until your children (ages 5 and 7) are financially independent and you bought a house around the time your children were born, your replacement income will cover most, if not all, of your mortgage.
But what if you buy a new house when your children are in their teens?
When there is a big enough difference between replacement income needed to care for loved ones and replacement income needed to pay a mortgage, it may be best to have 2 insurance policies: one to provide your family with income, one to cover your mortgage.
Certain term life insurance policies are created specifically for mortgages; the death benefit decreases each year as pay off more and more of your home.
Step 4: Subtract savings and other liquid assets.
Have money in the bank? This reduces the amount of life insurance you need, as does any money you’ve saved for your children’s college funds, and any existing life insurance. Keep in mind that existing insurance from an employer typically terminates when your employment does; something to consider if you plan on changing jobs or retiring during your insurance term.
For example, if you have $50,000 in savings and $25,000 for each of your two children set aside for college, plus a $200,000 group life insurance policy from your employer, for a total of $300,000, subtract this from your life insurance estimate of $2,300,000 for a total of $2 million.
What about my retirement savings?
If you have retirement savings in a qualified plan like a 401(k), you may factor the amount into your savings to reduce the amount of life insurance you need, but it’s often advised to keep these savings separate.
While the death benefit from life insurance is typically tax-free, the same isn’t true of a 401(k), so the actual payout to your surviving beneficiary depends upon future tax rates, as well as market fluctuations. This can make it difficult to calculate exactly how much your loved ones will receive. Additionally, your surviving spouse may be relying on this income for their own retirement.
Now that you have a basic idea of how to calculate an adequate amount of life insurance, consider these FAQs to fine-tune your estimate:
Does my spouse need life insurance too?
It’s best if both you and your spouse have adequate life insurance. There are a number of ways to go about insuring both of you:
- Spouse rider: If you have whole life insurance, add on a rider for your spouse. This is supplemental insurance that offers a payout when your spouse passes away and may be less expensive than adding an additional term or whole life policy.
- Term life insurance policy: You and your spouse likely have different incomes, insurance via group plans from work, outstanding personal, business, and/or student loans, and may contribute differently to bills and mortgage payments. Therefore, how much insurance each of you need will differ (the term of the insurance policy may also be different). Purchasing a separate term policy for your spouse is an efficient way to cover these differences.
- Whole life insurance policy: When you and your spouse each own whole life policies, you increase the power of your family bank by effectively creating two sources of cash flow and liquidity. The cash value of each of your policies can be used for policy loans and may increase your tax-free income. Policies can also be held in an irrevocable life insurance trust (ILIT) for additional tax advantages and to build family wealth for generations.
Stay-at-home spouses need insurance too. Be sure to factor in child care costs, housekeeping and yard maintenance costs, cooking, carpooling, dog walking and other non-paying jobs your spouse assumes. In their absence, you’ll either have to take time away from work or pay someone to do these jobs, costs that are often overlooked during insurance planning.
What if I own a business?
Business owners definitely need life insurance. If you intend for the business to be passed on to your family after you’re gone, make sure you don’t leave them with outstanding debt and factor your business loans into the amount of insurance you need.
You may also want to consider insuring business partners or other key individuals critical to the success of the company. This is called key man or key person insurance and is available as both term and whole life policies. The added benefit of having a whole life policy is that you can use the cash value of the policy for business capital and essentially be your own bank.
What if I’m using life insurance for retirement?
One of the best, albeit lesser known, ways to use life insurance is for tax-free income in retirement. This is done via a whole life insurance policy structured for rapid growth of cash value. The idea is to over-fund the policy without it becoming a Modified Endowment Contract (MEC) to optimize cash value with as little death benefit as possible. Then, in retirement, you withdraw your cash value in the form of tax-free policy loans to fund retirement. The loans are not meant to be repaid and will be deducted from your death benefit when you pass away.
If you plan on using life insurance for retirement, the amount of life insurance you need is based on how much retirement income you need, and can be adjusted to factor in social security payments and/or other retirement funds like an existing 401(k), IRA, or annuity.
What about inflation?
Most financial advisors recommend planning for inflation at a rate of 3% per year. Term life insurance doesn’t hedge against inflation, so you may want to factor in an additional 3% for each year of your term life policy to ensure your beneficiaries are left with a sufficient death benefit. Whole life policies earn a guaranteed rate of return, and policies underwritten through mutual insurance companies are also eligible for non-guaranteed dividends. For these reasons, whole life comes with some built-in protection against inflation.
Is there a maximum amount of life insurance I can buy?
You can’t be insured for more than your net worth. While it’s important to have sufficient coverage, too much term life insurance could mean you’re overspending with little chance of a pay-out, and reduces funds that could better be placed in savings or investments.
The exception is utilizing whole life insurance for cash value. While there is a cap on how much you can be insured for, purchasing additional insurance with a paid-up additions rider can help increase tax advantages, retirement income, liquidity, and cash flow while you’re still living. For these reasons, it may be beneficial to have a larger policy.
What about estate taxes?
Wealthy individuals may find that their estate is too large to qualify for estate tax exemptions, on both federal and state levels, which can eat up some or all of the proceeds from an insurance policy. If this applies to you, a whole life insurance policy can help reduce and/or eliminate estate taxes when properly structured and protect your family. We recommend you speak with your tax attorney and a Wealth Strategist for more information.
What if I need to change my coverage?
Most insurance, both term and whole life, allow you to decrease coverage at a future date. Keep in mind, once you decrease coverage you typically can’t increase it later.
If you think you may need more coverage in the future, consider a term conversion rider for term insurance policies, which lets you upgrade to a whole life insurance policy without additional medical underwriting, or a guaranteed insurability rider for a whole life policy, which allows you to increase coverage at a later date.
How do I find the best policy for my needs?
This article can help you get a good estimate of how much life insurance you need, but to fine tune your policy to meet your financial goals and get the best premium possible, our team is here for you.
At Paradigm Life we can customize a policy to fit your financial situation. Our expert Wealth Strategists are available to answer your questions and show you customized illustrations, outlining an individual plan of action to help you achieve your goals.