Here’s How to Figure Out How Much Life Insurance You Need
Q: How much insurance should I have? I was recently married and have been considering acquiring life insurance. We do not have any children, and I cannot really find any information on how much I should get. — Marcus Smail
A: It’s a smart move to get life insurance if you have a spouse or other family members who depend on you and your income, especially if you don’t have a large savings account.
Figuring out how much insurance you should buy basically boils down to answering one question: How much income do your survivors need if you’re gone?
Of course, to know this you’ll need to first look at your debt, monthly spending, monthly savings, and your long-term savings goals, as well as your expected funeral/estate settling costs. Steven Weisbart, senior vice president and chief economist at the Insurance Information Institute, recommends using this calculator from Life Happens, which walks you through the process by allowing you to input those details, as well as play with the estimated inflation rate and after-tax investment yield to get a recommended figure for the amount of life insurance you need.
Weisbart suggests getting coverage equal to 10 times your annual income, if you can afford the premiums. “Anything less doesn’t provide much transitional time for your surviving spouse or children,” he says. “You don’t want to put them under time pressure while they try to adjust to life without you.”
This approach, which is focused on income replacement, generally results in a large amount of insurance coverage. Another approach people use when determining life insurance needs is to focus instead on buying enough insurance to keep their financial obligations from causing a hardship to their survivors. “They’d look at the mortgage, car leases, and other commitments they’ve made and figure out how much their family would need to cover those bills without their income,” Weisbart says.
Keep in mind that you may already have some life insurance coverage through your employer and that your spouse and children may be eligible for Social Security survivor benefits, depending on how many credits you have earned at the time of your death. Any funds stored away in retirement accounts or other savings vehicles can also be factored in to lower the total amount of insurance coverage you’ll need.
Before you decide to purchase a policy and select a coverage amount, it is a good idea to meet with a fee-only certified financial adviser, who can tell you if the amount you estimated using the calculator is, in fact, correct for your situation and family. An adviser can also help you decide what kind of life insurance you should purchase and the amount you should expect to pay for it. Says Weisbart: “It’s good to talk through this with someone who has done this a couple of thousand times before and who can really guide you.”
Be sure to revisit your life insurance coverage amount when major life events occur, such as the birth of a child, divorce, or when you become empty-nesters, as your coverage needs will likely alter.
How Much Life Insurance Do I Need?
You can’t pinpoint the ideal amount of life insurance you should buy down to the penny. But you can make a sound estimate if you consider your current financial situation and imagine what your loved ones will need in the coming years.
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In general, you should find your ideal life insurance policy amount by calculating your long-term financial obligations and then subtracting your assets. The remainder is the gap that life insurance will have to fill. But it can be difficult to know what to include in your calculations, so there are several widely circulated rules of thumb meant to help you decide the right coverage amount. Here are a few of them.
Rule of thumb No. 1: Multiply your income by 10.
“It’s not a bad rule, but based on our economy today and interest rates, it’s an outdated rule,” says Marvin Feldman, president and CEO of insurance industry group Life Happens.
The “10 times income” rule doesn’t take a detailed look at your family’s needs, nor does it take into account your savings or existing life insurance policies. And it doesn’t provide a coverage amount for stay-at-home parents.
Both parents should be insured, Feldman says. That’s because the value provided by the stay-at-home parent needs to be replaced if he or she dies. At a bare minimum, the remaining parent would have to pay someone to provide the services, such as child care, that the stay-at-home parent provided for free.
Rule of thumb No. 2: Buy 10 times your income, plus $100,000 per child for college expenses
Education expenses are an important component of your life insurance calculation if you have kids. This formula adds another layer to the “10 times income” rule, but it still doesn’t take a deep look at all of your family’s needs, assets or any life insurance coverage already in place.
Rule of thumb No. 3: The DIME formula
This formula encourages you to take a more detailed look at your finances than the other two. DIME stands for debt, income, mortgage and education, four areas that you should consider when calculating your life insurance needs.
Debt and final expenses: Add up your debts, other than your mortgage, plus an estimate of your funeral expenses.
Income: Decide for how many years your family would need support, and multiply your annual income by that number. The multiplier might be the number of years before your youngest child graduates from high school. Use this calculator to compute your income replacement needs:
Mortgage: Calculate the amount you need to pay off your mortgage.
Education: Estimate the cost of sending your kids to college.
The formula is more comprehensive, but it doesn’t account for the life insurance coverage and savings you already have, and it doesn’t consider the unpaid contributions a stay-at-home parent makes.
How to find your best number
Follow this general philosophy to find your own target coverage amount: financial obligations minus liquid assets.
- Calculate obligations: Add your annual salary (times the number of years that you want to replace income) + your mortgage balance + your other debts + future needs such as college and funeral costs. If you’re a stay-at-home parent, include the cost to replace the services that you provide, such as child care.
- From that, subtract liquid assets such as: savings + existing college funds + current life insurance.
To illustrate, let’s look at a fictional couple: Jason and Heather. They have two children, ages two and five. Jason makes $75,000 a year, and Heather is a full-time stay-at-home mom. They have a $150,000 balance on their home mortgage, owe $16,000 on two car loans and have $3,000 in credit card debt.
Jason has group life insurance equal to double his annual salary, and Heather has none. Together, they have $20,000 in a savings account and $10,000 in their kids’ college funds.
The couple decide that they want 30-year term life insurance policies. By the end of the term, their children will be adults, their mortgage will be paid off, and, if they stick to a savings plan, the remaining spouse will have a retirement nest egg.
To calculate his life insurance needs, Jason would add his obligations:
- $1.2 million for income replacement ($75,000 times 16, the number of years before his youngest child graduates from high school)
- $150,000 for the mortgage balance
- $19,000 for debt ($16,000 in car loans, plus $3,000 in credit card debt
- $200,000 for two childrens’ college educations
- $7,000 for final expenses — approximately the median cost of a funeral with a casket, according to the National Funeral Directors Association
This totals $1,576,000. From this, Jason would subtract:
- $20,000 in savings
- $10,000 in the kids’ college funds
- $150,000 of group life insurance
This means that Jason should buy a $1.4 million ($1,396,000) term policy.
Here’s how a calculation would work for Heather. Her obligations would include:
- $100,000 to replace the child care that she now provides, until the kids are teenagers
- $150,000 for the mortgage balance
- $19,000 for debt
- $200,000 for two children’s college educations
- $7,000 for final expenses
This totals $476,000. From this, she would subtract $30,000 to account for the couple’s savings and their kids’ college funds. Her final estimated life insurance need is $450,000 ($446,000).
Heather might also want to figure income replacement into her policy, says Johanna Fox Turner, a partner of Milestones Financial Planning and president of Fox & Co. CPAs, Inc., in Mayfield, Kentucky. She notes that the surviving parent might want to quit work to take care of the kids for a few years — in which case, the stay-at-home parent’s policy should include income replacement, rather than child care costs, for those years.
Tips to keep in mind
Keep these tips in mind as you calculate your coverage needs:
- Rather than planning life insurance in isolation, consider the purchase as part of an overall financial plan, says certified financial planner Andy Tilp, president of Trillium Valley Financial Planning near Portland, Oregon. That plan should take into account future expenses, such as college costs, and the future growth of your income or assets. “Once that information is known, then you can map the life insurance need on top of the plan,” he says.
» Learn more: Read about the differences between whole life and term life insurance.
Don’t skimp. Feldman recommends buying a little more coverage than you think you’ll need instead of buying less. Remember, your income likely will rise over the years, and so will your expenses. While you can’t anticipate exactly how much either of these will increase, a cushion helps make sure your spouse and kids can maintain their lifestyle.
Consider buying multiple, smaller life insurance policies, instead of one larger policy, to vary your coverage as your needs ebb and flow.
- Talk the numbers through with your spouse, Feldman advises. How much money does your spouse think the family would need to carry on without you? Do your estimates make sense to him or her? For example, would your family need to replace your full income, or just a portion?
- Consider buying multiple, smaller life insurance policies, instead of one larger policy, to vary your coverage as your needs ebb and flow. “This can reduce total costs, while ensuring adequate coverage to the times needed,” Tilp says. For instance, you could buy a 30-year term policy to cover your spouse until your retirement and a 20-year term policy to cover your children until they graduate from college. Compare term life insurance quotes to estimate costs.
- Turner recommends parents of young children choose 30-year versus 20-year terms to give them plenty of time to build up assets. With a longer term, you’re less likely to get caught short and have to shop for coverage again when you’re older and rates are higher.
Debt and income replacement calculators
Use the calculators below to get a sense of how much life insurance coverage you’d need to replace your current salary and any debts you’re carrying.
How Much Life Insurance Do You Need?
Use our formula to cut through the confusion.
By Kimberly Lankford, Contributing Editor
August 15, 2010
Unpredictable investment and job markets are rough on retirement planning. They also complicate the issue of how much life insurance is right for you.
Standard formulas — such as buying coverage equal to eight to ten times your annual income — are inadequate shortcuts. Online calculators are apt to tell you to raise your coverage by $1 million even if you already have insurance. The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but it’s silly to say that someone with four young children should have the same coverage as empty nesters with no mortgage and a substantial retirement fund.
Low inflation and a recovering stock market may tempt you to low-ball your life-insurance needs. But other financial realities, such as puny yields on reinvested lump-sum benefits, may require that you have more coverage, not less. And you’ll likely experience life events that call for changes in your insurance: marriage, parenthood, homeownership, college expenses and retirement. Instead of relying on rules of thumb, you’re better off taking a systematic approach to figuring your life-insurance needs. That’s easier than it sounds, as you’ll see from the following process, because it “truly is an art as well as a science,” says Tim Maurer, a financial planner in Hunt Valley, Md., and coauthor of The Financial Crossroads (Companion, $25).
A simple strategy. The purpose of life insurance is to allow your family members to pay the bills and live their lives as planned despite your absence. That’s why some experts and most online calculators sponsored by the insurance industry seek to figure the chunk of investment capital it would take to replace all of your income for 20 years or longer, held securely in Treasury or municipal bonds and certificates of deposit. With savings yields low and the prospect of longer life expectancies in retirement, this approach tends to aim high, especially if you assume raises and promotions. “You can find people who are extremely minimalist with insurance recommendations,” says Maurer. “But I see an overabundance of people who end up justifying more insurance than I think is reasonable.
Instead, he offers a simple strategy to calculate how much coverage to buy and to form a plan that’s easy to update. The idea is to assess whether you need extra coverage or different policies only after you project your life-insurance needs as the sum of four categories.
Final expenses. A funeral, burial and related expenses tend to cost $10,000 to $20,000. Your beneficiaries may be able to get the tax-free proceeds from insurance faster than if they waited for money from your estate. Use $15,000 as a ballpark number.
Mortgages and other debts. Total your mortgage balance, car loans, student loans and any other debts that would be a heavy burden on your survivors. They may choose not to retire the mortgage, especially if the interest rate is low, but the money should be available so that they won’t face the prospect of being forced to sell.
Education expenses. This calculation can be tricky because you need to consider the cost of college at the time your kids enroll. But Maurer devised a simple solution. College costs have been rising by about 5% a year, which is the same rate he conservatively expects life-insurance proceeds to grow over time. He recommends looking up current costs for colleges you’re considering, deciding whether you want the insurance to cover all or a portion of the tab, and adding the amount in today’s dollars to your life-insurance calculation.
Income replacement. Once you cover funeral expenses, debts and education, your family won’t need to replace 100% of your income — and that’s where the art part of the calculation comes in. Maurer recommends covering 50% of current pretax earnings until retirement. You can translate this into a target lump-sum benefit by dividing it by 0.05. For example, if you earn $100,000, divide $50,000 by 0.05, which works out to $1 million. That assumes the insurance benefits will earn 5% a year over the long haul, a conservative back-of-the-envelope figure.
Add all four categories to estimate how much life insurance is appropriate, then tweak the number to reflect personal circumstances. You might increase it if you don’t have a pension, but you could decrease your coverage if your spouse earns a substantial salary. If you or a family member has a troublesome medical history, add $100,000 or even $250,000. If you’re the one with the medical condition, you’ll find it tough to buy additional coverage later at a price you can afford.
For most families, this exercise will work out to an amount in the high six-figures, possibly even $1 million or more. But don’t be frightened. With term insurance, boosting your death benefit by hundreds of thousands of dollars should cost just a few hundred dollars a year.
For example, a healthy 40-year-old male nonsmoker might be considering a 20-year, $500,000 term policy for $360 per year. But he could buy $850,000 of coverage for $576, or a $1-million policy for $645, says Byron Udell, owner of AccuQuote, which represents dozens of life insurers. Women pay less — just $311 per year for $500,000 in coverage and $558 for $1 million. It’s not as easy as it used to be to qualify for the absolute lowest rates. You can get prices from dozens of companies at www.accuquote.com or www.lifequotes.com .
The time factor.Also consider how many years you’ll need insurance. If you’re in fine physical shape, you can buy a new policy and lock in the price for 20 years. Because prices for term have been dropping steadily, you may not pay much more to extend your coverage if you reshop in, say, five years.
Some term policies come with the right to convert to permanent life insurance, which you can keep for the rest of your life regardless of health. Premiums will be higher than for term at the beginning, but they usually remain level indefinitely. The best reason to consider whole-life or universal-life insurance isn’t the accumulating cash value, although that’s part of the deal. The real issue is whether you’ll need coverage beyond 20 or 30 years — or after age 65, when term gets expensive. You might want permanent insurance, for example, if you need to protect kids with special needs who will always rely on you (or your estate) for support, or if you want to leave money to a school, charity or your children and you don’t expect to afford it any other way.
You need more life insurance if you.
Tie the Knot.Your new spouse might depend on you even if he or she earns as much or more than you do.
Have a Child.It takes a lot of money to raise a child–and it doesn’t get any cheaper if you’re not around.
Buy Your Dream House.When you settle into your family’s permanent home, guard against its loss in case tragedy strikes.
Are About to RetireNo more insurance from work. If you die, your spouse could lose pension and some Social Security income.
Term vs. permanent: Get the best of both
Term insurance is popular because almost everyone can afford plenty of it. Some young people buy the amount of permanent insurance that fits their budget, rather than the protection they need. That’s not smart.
But it can make sense to combine term and permanent insurance with multiple policies or by buying a convertible-term policy and making a series of conversions over the years. One advantage of a convertible-term policy is that insurers don’t require a new medical exam when you make the conversions. That essentially gives you a pass if you gain weight, develop high blood pressure or even survive a bout with cancer.
Northwestern Mutual Life provided this example for a 27-year-old man who starts by paying $317 for $500,000 of term insurance, and then gradually converts it to whole life $100,000 at a time. If you shift $100,000 to whole-life at age 28, your annual premium would jump to $1,300. If you shift another $100,000 at age 31, your premium would rise to $2,600. Your premium would gradually increase whenever you shift money to the whole-life policy, topping out at $7,200 at age 40, for the entire $500,000 of whole-life insurance.
As long as the insurer remains strong and solvent, the policy’s cash value will rise every year, as will the death benefit. By age 65, in this example, the benefit is projected to be $990,000 and the cash value $475,000, which can be borrowed, withdrawn or tapped to keep the policy in force without paying additional premiums.
This kind of flexibility is attractive to Nirmal Bivek, a 32-year-old banker in Atlanta, who bought slightly more than $1 million in life-insurance coverage when his 3-year-old daughter, Sarina, was born. Bivek has already converted some of the coverage to whole life and expects to convert more of it as his income grows.
He added more insurance when he and his wife, Vijal, were expecting a second child and when they bought a vacation home. “I’m in good health now and term is cheap,” says Bivek, “so I’m buying as much as I can now and converting it over time.”