Life Insurance

How Much Life Insurance Do You Actually Need?

How Much Life Insurance Do You Actually Need?

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While life insurance is rarely required, it often becomes a consideration when you begin a family or have loved ones that depend on you financially. In these cases, how much life insurance you need is directly tied to your reason for purchasing a policy. If you have a mortgage and are the primary earner for your family, you would need a much larger life insurance policy than if you just wanted to cover your end-of-life costs. A simple rule of thumb is that you should buy enough life insurance to cover all major upcoming financial obligations, assuming your family also had access to your liquid assets.

How to Calculate the Amount of Life Insurance You Need

A commonly shared rule of thumb for determining your life insurance needs is to purchase a policy with a death benefit equal to 5 to 10 times your annual income. While this is a quick formula, it’s unlikely to reflect what your actual needs are. The amount of financial protection your family would need changes over time as children finish school and debts are paid.

A better rule of thumb is to add together your current and future financial obligations, then subtract all assets that would be liquidated if you pass away.

How to Calculate Debts & Financial Obligations

Financial obligations can typically be divided into the categories of: current debts, income replacement and future expenses.

Current debts typically would include a mortgage, auto loan, credit card balance and other personal loans. Depending on how your finances are organized, you may not need to include all of these loans when calculating your life insurance needs. For example, an outstanding mortgage should usually be accounted for in your life insurance death benefit, as you don’t want your family to have to move following your death. On the other hand, if you don’t live with a partner, your children have their own homes and your house’s current value is greater than your outstanding mortgage balance, you may not need to include it.

It can be challenging to determine how much life insurance you would need as income replacement, as an accurate figure would require you to evaluate your family’s ongoing expenses, future expenses and savings plan. You can do a simple approximation by adding the following figures together:

  • Children: Estimate the amount of money you spend on 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 move out.
  • Spouse: Subtract the cost of your children and mortgage from your annual household budget. Multiple this figure by the number of years you would expect your spouse to live. For reference, a woman that 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.

Since this is an approximation, the figure you come up with is likely higher than your family’s actual needs. However, you still need to account for your family’s upcoming expenses. These may include the cost of sending your children to college, your spouse purchasing a new car, paying for an elderly parent’s long term care or even helping fund a child’s wedding.

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.

How to Calculate Your Assets

The next step is to add together your assets and other sources of income. This figure will be subtracted from your total financial obligations in order to determine your actual life insurance needs.

When adding together your current assets, you should include brokerage accounts, savings accounts and any existing life insurance policies. However, you should exclude retirement accounts, such as a 401(k) or IRA.

Also, if your family has multiple earners, take their after-tax income and multiply it by the number of years they intend to work. Include this in the sum of your assets.

What Kind of Life Insurance Do You Need?

Once you’ve calculated how much life insurance you need at the moment, you should calculate how long you’ll need this amount of coverage. This is important because the cost of a life insurance policy is correlated to the number of years it lasts, since you’re more likely to pass away during the period of coverage.

For each financial obligation, you should determine whether it’s time-specific or time-independent. A time-specific cost would only impact your family during a particular period of time. As an example, if your child is 12, you would expect that their college costs were handled within the next 10 years. A funeral is a common time-independent obligation, as it’s a cost that could happen at any point.

For most families, the majority of projected expenses are time-specific. If this is the case, we would recommend term life insurance as it’s the cheapest type of policy and offers for a particular amount of time. Term policies can range from 5 years to 35 years in length and can provide over $1 million in death benefits.

If you have costs that aren’t limited to a specific period of time, there are two main options:

  • Buy term life insurance and save - Term life insurance is significantly less expensive than permanent coverage. If you can save enough money to simply cover the expense, just buy additional term coverage for the amount of time it will take to do so.
  • Buy permanent life insurance - While whole life insurance is the most common form of permanent coverage, it’s quite expensive because it has a cash value investment component. If you just want a lifelong policy to cover all your financial obligations, guaranteed universal life insurance has the best rates and coverage can last until you’re 121.

Whether you buy term or permanent coverage, just make sure that premiums are level for the entire length of the policy. When this isn’t specified, the insurer can raise your rates and you may not be able to afford the coverage later, even though it’s still needed.

When Do You Need Life Insurance?

There are few situations in which you would actually need life insurance, but a large number of reasons why you might want it. The only times life insurance might be required are:

  • If you’re taking out a sizable loan and the lender requires coverage as a form of collateral. In these cases, you’ll want the death benefit to be equal or greater than the loan. You can use a collateral assignment so the lender will only be paid back the outstanding debt while you beneficiary will receive the rest of the payout.
  • If you’re taking out a business loan or receiving funding and a requirement of the investment is that you have key man insurance. This is a life insurance policy taken out on a founder or person that the business would have trouble functioning without. Key man insurance pays the business if you pass away, providing capital to hire a new employee or repay business loans.

Aside from contractual requirements, many people choose to purchase life insurance because it can provide financial relief to their families and loved ones if they pass away. Some of the most common costs that life insurance is used to cover are:

ExpenseValue of Life Insurance
End-of-Life CostsWhether you’re buried or cremated, the costs associated with your passing can range from $2,000 to over $10,000.
MortgageIf you want your family to have the option of remaining in your home after you pass away, you need to either pay off the mortgage or confirm they would be able to take over payments.
Children’s EducationChildren are expensive to feed and raise, but one of the largest costs associated with them is their education. Depending on the college they go to, costs can easily exceed $20,000 per year.
Standard of LivingFamilies have a variety of ongoing expenses. Your spouse and kids may not be able to maintain their current standard of living without your income.
Estate PlanningYou may want to pass on an inheritance or simply have enough coverage to reduce the burden of inheritance taxes on your family.
Maxime Croll

Maxime is a Director at ValuePenguin focusing on the insurance industry. Previously she was the Director of Product Marketing at CoverWallet, a commercial insurance startup, and helped launch NerdWallet's personal insurance business. Maxime has contributed insurance insights and analysis to Forbes, USA Today, The Hill, and many other publications.

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.