Life insurance is part of good family financial planning—it insures a basic level of income for your family to live on if you should die. However, the amount of life insurance you need isn't always cut and dry. There are numerous rules of thumb, including the famous advice that you should carry 10 times your annual income in coverage. The problem with using a rule of thumb is that one size doesn't fit all - especially when finances are concerned. Instead of relying on a rule of thumb, consider your financial situation, and your likely future needs.
Factors that Influence How Much Life Insurance You Need
Your financial situation has a lot to do with how much life insurance you need. For instance, someone with substantial savings may not need as much life insurance as someone without savings. Factors that influence how much life insurance your family would require to get by without you include:
- Whether or not you have a spouse that works.
- How long children will be living at home.
- The size of savings a family has.
- Social Security benefits, pension benefits and retirement account distributions available after death.
- How much debt needs to be paid off.
- Whether or not you have children with special needs and the attendant expenses.
- What other expenses you want paid for (college, funeral, etc.)
Sit down with your life partner and decide what you want your life insurance to be able to accomplish, and use that as a starting point in deciding how much life insurance you will need.
Figuring How Much Life Insurance You Need
One of the most basic ways to figure out how much life insurance you need is to just determine how much you need to replace your income. If your main goal is to provide income replacement, you can use an online calculator to figure out what you will need. If your youngest child is 5, and you want life insurance until he or she is 18, you will need at least 13 years of coverage. It might be wise to get 20 years of term life insurance coverage, though, just in case you have another child.
If you make $50,000 a year, you will need to use that figure as a basis for your income replacement for 20 years. You will need to assume that your survivors will put the money into some sort of investment vehicle that provides interest income. If you think that your family can get a 3% return, after inflation, then you plug the numbers into the calculator. The number that comes out is $743,873.25. You will probably need to get life insurance coverage in increments $100,000, though, so in this example the policy size will likely be $800,000. This will allow your family some leeway to pay for funeral expenses and even pay down some debt.
However, as you might imagine, many families agree that they need a little more than just income replacement. If your family has debt, paying off that debt with a life insurance payout can be quite helpful. In our example above, a family might still owe $160,000 on a mortgage, $8,000 on a car, $15,000 in student loans, and have $6,000 in credit card debt. That comes to $189,000 in debt. If you want to pay off the debt, you can add that $189,000 to the $743,873.25 for a total of $932,873.35 - or $1 million in coverage. As other expenses are added, coverage can go higher. However, few people making $50,000 realistically need much more than $1 million in life insurance coverage.
Reducing Your Life Insurance Needs
Of course, determining how much life insurance you need goes the other way as well. Circumstances might mean that you actually need less coverage. In order to determine whether or not you can get away with less life insurance, once again start with your income replacement amount, which is $743,873.25, if your partner does not work. If you have $100,000 in assets elsewhere that can be liquidated, then that will reduce the total amount of life insurance needed.
If your spouse does have a job, you can refigure the amount of income you will have to make up in the event of your death. If your total household income is $50,000, but $15,000 of it comes from a spouse's part-time job, then the replacement income needed is only $35,000. Using the calculator, we see that replacing that $35,000 a year would require a policy of $520,711.28. You can add debt payoff and other expenses as needed.
It is important to note that there are other considerations as well, depending on your situation. First of all, your money may not get the rate of return you expect (which is why our example uses a rather conservative return), and you could find that the money doesn't go as far as you would like. Another consideration is that you may need to pay more for some services, such as childcare or house cleaning, depending on who does these types of work. Also, note that this article deals mostly with term life insurance; if your goal is investment instead of income replacement, you may need to consider different scenarios involving different types of whole life insurance.
In the end, how much life insurance you need is largely subjective. You will need to consider your family's individual needs. It can help to speak with a financial planner about your options, and different scenarios that can affect how much life insurance