As with much else in personal finance, there’s a rule of thumb for how much life insurance you require: a death benefit that’s equal to 5 to 10 times your annual income. But that’s a wide range of payouts and may not reflect your particular financial situation, meaning the formula could too easily prompt you to buy significantly more or less insurance than you really need.
For a better calculation, it’s best to take stock of your assets, debts and the ongoing income needs of your family. With respect to financial obligations, there are three factors that typically have the largest impact on the amount of life insurance you need.
Your Current Debts
Covering these is often a priority as they can be passed on to your spouse and loved ones in certain situations.. You should take into consideration the amounts you owe on your mortgage, auto loan, credit card balances and other personal loans. Depending on how your finances are organized, whether there are cosigners on any of the loans and if you want your family to keep any of the assets used as collateral, you may not need to include all or just some of these loans when calculating your life insurance needs.
Consider your housing situation, for example. Typically, you’ll want to include an outstanding mortgage in your life insurance calculations, as you probably won’t want to subject your family to the stress and cost of a move following your death. There are exceptions, however. If you don’t live with a partner, your children have their own homes or your home is currently worth more than your outstanding mortgage balance, you may not need to include the mortgage in your math.
Again, there’s a simple rule of thumb here: To merely assume that what you make now is what your family will need every year in the future and plan a death benefit accordingly. A better course, though, is to actually evaluate your family’s ongoing expenses, now and in the future, along with their savings needs.
You can make an approximation of that amount by adding the following figures together:
- Children: Estimate the amount of money you spend on your children (the average is around $13,000 per child per year, though this figure varies by age). Multiply this figure by the number of years until your children are likely to move out of the family home, or at least no longer be dependent on you financially.
- Spouse: Subtract the cost of your children and mortgage from your annual household budget, assuming you keep one (if you don’t, it might be a good time to develop one). Multiple this figure by the number of years you expect your spouse to live. For reference, a woman who is currently 35 would be expected to live to 86, according to the Social Security Administration, while a 35-year old man would be expected to live to 82.
Paying for College
Typically, education costs are one of the largest expenses that needs to be accounted for when purchasing life insurance. According to The College Board, the annual all-in cost (including tuition, fees, room and board) of sending a child to college this year is:
- $20,090 for a public in-state college
- $35,370 for a public out-of-state college
- $45,370 for a private nonprofit college
By adding together your current debts, income replacement needs and future financial obligations, you have a figure that represents the maximum amount of life insurance you might need.
Naturally, you next need to total your assets and any other sources of family income (take the after-tax income of the “family workers” and multiply it by the number of years they intend to work). Your total assets calculation will be subtracted from your total financial obligations in order to determine your actual life insurance needs.
When adding together your current assets, be careful to include them all, including brokerage accounts, savings accounts and any existing life insurance policies. However, exclude retirement accounts, such as a 401(k) or IRA, unless you’re old enough that these are readily available.