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Life insurance is rarely required, but it often becomes a consideration when you begin a family or have loved ones that financially depend on you. How much life insurance you need is directly tied to your reason for purchasing a policy. For example, if you 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 significant upcoming financial obligations, assuming your family also had access to your liquid assets.
How to calculate the amount of life insurance you need
When calculating the amount of life insurance you need to purchase, a general rule is that your death benefit should equal five to 10 times your annual income. While this is a simple formula, it’s unlikely to reflect what your actual needs are. The amount of financial protection your family may need changes over time, as children finish school and debts are paid off or paid down.
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 following categories: current debts, income replacement and future expenses.
Current debts may typically include a mortgage, auto loan, credit card balances and other personal loans. Depending on how your finances are organized, you may not need to have 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 if you have a family who needs to go on living in your home. On the other hand, if the house is paid off, or 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 an income replacement. 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 is:
- $20,770 for a public in-state college
- $40,940 or a public out-of-state college
- $46,950 for a private nonprofit college
By adding your current debts, income replacement needs, and future financial obligations, you should 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 to determine your actual life insurance needs.
When adding 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.
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 years old, 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 recommend term life insurance as it’s the cheapest type of policy and offers coverage for a particular amount of time.
Term policies can range from five years to 35 years in length and can provide over $1 million in death benefits depending on the insurer and policy. 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 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 the unlikely age of 121.
Whether you buy term or permanent coverage, try to ensure that your policy’s 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 not many reasons you would need life insurance, but a large number of reasons why you might want it.
The only situations where life insurance might be required are:
- If you’re taking out a sizable loan and the lender requires coverage as a form of collateral. You’ll want the death benefit to be equal to or greater than the loan in these cases. You can use a collateral assignment so the lender will only be paid back the outstanding debt while your 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, you have key man insurance. This life insurance policy is 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:
Value of Life Insurance
|End-of-Life Costs||Whether you’re buried or cremated, the costs associated with your passing can range from $2,000 to over $10,000.|
|Mortgage||If 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 your payments.|
|Children’s Education||Children are expensive to feed and raise, but one of the most considerable costs associated with them is their education. Depending on the college they go to, prices can easily exceed $20,000 per year.|
|Standard of Living||Families 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 Planning||You may want to pass on an inheritance or simply have enough coverage to reduce the burden of inheritance taxes on your family.|