Life insurance is about responsibility. You purchase a policy to provide money for the people who depend on you in the event you’re not around to support them.
So when it comes to how much life insurance you need, ask yourself: How much will those dependents need to cover your obligations if you’re gone?
This is a difficult question to answer. You can’t predict the future. You don’t know when you will pass away. And it’s challenging to determine what your survivors might need in 10, 20, or 30 years.
There are a number of templates, calculators, and rules of thumb available. One thing to keep in mind is that these tools are guidelines only. The amount of life insurance you need will depend on your individual situation, which includes your budget for life insurance premiums.
The disparity in these formulas also reveals how opinions differ. Some of the ways to calculate the amount of life insurance you need include:
- Multiplying your current annual salary by 6 to 10. That means if you earn $60,000 a year, your life insurance death benefit should be $360,000 to $600,000. Some experts suggest bumping that multiplier to 10 to 15 times your income. That means a person making $60,000 would need between $600,000 to $900,000 of coverage.
- Multiplying your current annual salary by the number of years left until your anticipated retirement. That means if you currently earn $60,000 annually and you have 30 years until you reach retirement age, you should have $1.8 million in coverage.
- The standard of living method. With this formula, you take the amount of money required to maintain your current standard of living and multiply it by 20. The standard of living method is based on the concept that survivors can withdraw 5 percent of the total benefit each year while investing the rest. If the survivors can earn at least 5 percent annually on that investment, they can essentially replace the income they withdrew.
Rather than use a one-size-fits-all template, you can get a more personalized assessment of your life insurance needs by undergoing a needs assessment. This is often done with the help of an independent licensed insurance agent.
A good agent will help you understand how much insurance is recommended by doing a comprehensive needs analysis. This is a method (usually done with software) of exploring your current financial situation and future financial needs to get a clear picture of your insurance needs.
When doing a needs assessment, you may be asked to consider some of the following questions:
1. Who depends on you financially or who do you want to provide for?
For many people, this includes a spouse and dependent children. You want to ensure that your surviving family members have enough to maintain their standard of living and pay their bills after your death, for a set number of years. This means you will want to base your life insurance death benefit on how much you would earn over a set number of years.
If you help an aging parent or support a sibling with special needs, you may want to consider their financial needs when determining the amount of your death benefit.
Others, such as young singles or older pre-retirees, may not be concerned with supporting dependents if they die. However, they may want to consider a final expense policy to ensure that surviving family members don’t have to pay for funeral and estate settlement costs out of their own pocket.
2. How long do you need to support dependents?
If you have young children, you will want a larger death benefit to ensure their care at least until they turn 18. Also, consider how long your surviving spouse can go without your income before they’re able to make it on their own.
3. Do you have children who may go to college?
It may be more difficult for your family to save for and cover your children’s college education if you’re no longer alive. As you assess your life insurance needs, consider how many children you have, and estimate how much their combined education may cost.
4. How much debt will you leave?
Some people mistakenly believe that debts are retired or forgiven when a person dies or becomes disabled, but this is rarely the case.
In general, your debt becomes the responsibility of your estate following your death. Whoever is assigned as the executor of your estate will be in charge of settling your debts. The assets you leave, such as bank accounts, real estate, and investments, are used to repay your debts as much as possible.
One thing to keep in mind is that any loan that you have co-signed for, such as a mortgage with your spouse, will remain the responsibility of the surviving borrower.
One way that life insurance helps surviving family members is by paying off outstanding debts. This includes your mortgage, private student loans, auto loans, credit card debt, and any loans not forgiven upon the death of the borrower.
When doing your needs assessment, tally up your total debts and try to purchase enough coverage to completely pay off those obligations. This minimizes the possibility of your surviving family losing a house or having to sell other property to settle those debts.
5. How much do you have saved?
You may be able to get by with less life insurance coverage if you have a significant amount of money saved.
However, you should consider how accessible those funds are. For example, if you have equity in real estate holdings (not your primary residence), that property would need to be sold in order to benefit your survivors. The same is true for stocks, mutual funds, and other investments. Not only that, but if you have capital gains in those investments, selling them will create a tax bill for your survivors.
6. Do you need to help your spouse save for retirement?
Surviving spouses may fall behind on retirement savings. This often happens to women who spent time away from work on maternity leave or to raise children prior to them going to school. Your surviving spouse may be a business owner who didn't have access to a 401(k) and couldn’t put aside much for retirement.
Also, it’s common that one spouse earns less than the other. If the higher-earning spouse dies first, the surviving spouse may need to put aside more to ensure adequate retirement savings.
Also, keep in mind that surviving spouses may take time off from work after your death to grieve and/or to focus on children. This can also cause them to fall behind on retirement savings.
As you conduct your life insurance needs analysis, consider whether you should enable your surviving spouse to set aside more money for retirement saving.
7. Are you part or full owner of a business?
If it’s important for your business to continue following your death, you should consider how life insurance can help with that. In the event you have partners, life insurance is often used to help the surviving partners buy out your share of the business should you die. To help with this scenario, you should work with a licensed insurance agent and an attorney with experience in setting up these arrangements.
A needs analysis provides an educated recommendation
This analysis will help determine the overall cost of what you will need your estate to pay for if you pass away unexpectedly, as well as items you hope to provide for. It will also consider how much your dependents need to live on and for how long once they lose your income.
With this information, your agent can make an educated recommendation on an amount of life insurance that adequately meets the needs of your family and loved ones without overspending on unnecessary insurance coverage.
Consider a GI rider
The life insurance policy you buy today may not be adequate enough to meet your needs tomorrow. Maybe your current budget doesn’t have enough room for a larger policy, or you may need additional coverage later due to an increase in income, purchase of a home, and/or additional dependents.
One way to increase your death benefit amount in later years is to buy a guaranteed purchase option (GPO) rider, sometimes referred to as a guaranteed insurability (GI) rider.
This rider enables you to increase the amount of your coverage without having to go through the underwriting process. There may be limits on how you use this option, such as the amount of death benefit you can add and when you can increase coverage.
At the very least, buy some life insurance.
According to LIMRA’s 2018 Insurance Barometer Study, about 60 percent of all people in the U.S. were covered by some type of life insurance. However, about 20 percent of those with life insurance say they don’t have enough.
Experts say that many of the remaining 80 percent don’t have enough either, they just don’t realize it.
With life insurance, having some is always better than having none. At the same time, it’s better to buy too much than not enough, especially if your beneficiaries must eventually depend on that death benefit.
Learn More: How to Buy Life Insurance
Jack Wolstenholm is the head of content at Breeze.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.