When it comes to securing your dependents’ financial future, a fundamental question to ask yourself is, “How much life insurance do I need?” The answer relies on a number of personal factors, including your income and your family. Here are key things to consider as you calculate your life insurance needs.
In this article, you’ll find:
Is there a rule of thumb for life insurance coverage?
Whether you are choosing whole or term life insurance, some advisors recommend multiplying your annual income by six or 10 to come up with a rule-of-thumb estimate of your life insurance needs. These back-of-the-napkin estimates are a great starting point. But will this be enough?
The two more precise approaches for determining your life insurance benefit are known as income replacement and needs analysis.
How does the income replacement approach work?
The income replacement approach allows you to select a life insurance benefit that will replace the earnings you would otherwise provide for your dependents.
This is the amount of money left from your gross income after you deduct taxes, savings, life insurance premiums and any money you spend on yourself. For most people, this works out to between one-half and two-thirds of your total salary, with higher earners in the lower end of the range.
If you expect your salary to average $75,000 over your career, you can anticipate that about $50,000 a year, or two-thirds of your gross earnings, will support your dependents. If you are 30 years old and plan to retire at age 65, you’d need to replace this income for 30 years.
Basic income replacement
The simplest way to calculate income replacement is to multiply the number of years you plan to continue working by the earnings you anticipate providing for your dependents.
For a person seeking to replace $50,000 of annual income for 30 years, a $1.5 million life insurance policy is one way to accomplish this goal.
Another income replacement option is providing your beneficiaries with enough money to create a revenue stream through investments.
Unless you make alternative arrangements, your beneficiary receives your policy’s death benefit as a tax-free lump sum. He, she or they can use all or a portion of these funds as principal in an income-producing investment, such as an index or mutual fund.
Since this approach comes with inherent investment risks, it’s best to discuss it with a qualified financial professional.
However, as an oversimplified example, before taxes, a $1 million investment in an account generating 5% annual growth would produce $50,000 a year. In this scenario, the principal remains in place as long as the investment’s growth exceeds withdrawals.
If you spend down the premium, you can earn $50,000 a year from a $768,000 investment with 5% annual growth. In this scenario, the principal is gone at the end of the 30-year-period.
This latter calculation is based on factors found in a compound discount table, which financial professionals use to analyze returns on various investment sums.
Three ways to replace a $50,000 annual salary for 30 years:
- Option 1: Withdraw $50,000 a year from an account established with an initial $1.5 million balance. The interest offered by the depository institution could stretch these funds out over a few more months or years.
- Option 2: Invest $1 million in a fund generating 5% annual growth. As long as withdrawals don’t exceed growth, the balance will remain in place.
- Option 3: Invest $768,000 in a fund producing 5% annual growth. Under this scenario, the principal is gone at the end of 30 years.
Risks to consider
Unfortunately, it’s tough to find a stable investment that consistently produces a 5% return each year for Options 2 and 3. A few down years, particularly in the early years of the investment, could severely diminish the principal and its ability to produce income. These are among the reasons why it’s so important to discuss investment risks with a financial advisor.
It’s also important to remember that the income-replacement approach, in general, fails to account for all the unique needs you may have.
What is the advantage of a life insurance needs analysis?
Many experts prefer using a needs analysis to calculate your life insurance benefit because it accounts for your dependents’ immediate, ongoing and future needs. These are items you can list and tally up on a sheet of paper or in a spreadsheet.
In the event of the unthinkable, your dependents would need funds to cover bills and household expenses for at least a month or two after your death. They may also need funds to cover:
- The cost of your funeral.
- Professional services to settle your estate.
- Any outstanding debts you have, such as credit card balances, student loans and business loans.
The most common ongoing financial needs for most families are the costs of housing and living expenses.
When your life insurance benefit includes funds to cover the mortgage balance or at least 10 years of rent, your family can remain in your home for as long as they choose.
Your dependents’ living expenses will include the costs of food, clothing, health care, entertainment and transportation, until they become self-sufficient. If your children are young, you should plan to include more for these purposes than if they are nearing adulthood due to the length of the time they’ll need the support.
You can consider funding your dependents’ living expenses with funds for them to create a revenue stream, similar to those described above for income replacement.
For most families, the most common future needs are college tuition or other higher education costs. For some families, this can also include the costs of job training or retraining for the surviving spouse.
Depending on your family’s situation, here are a few more examples of future needs you could support through life insurance.
- If you are single or have no dependents, your needs might be limited to covering your final expenses, such as funeral costs and outstanding debts.
- If you are a stay-at-home parent, your spouse might need to hire someone to help look after your children.
- If you are the primary caregiver for an aging parent or another family member, your survivors would need to pay someone else to provide such care.
How do I calculate my life insurance needs?
Determining the total amount of money your dependents will need is half the equation in calculating your life insurance needs. Once you’ve identified your dependents’ total needs, you can deduct the value of other assets you intend to pass on. These include your savings, investments and any other life insurance coverage you may already have, such as a policy from work. The difference between the amount your dependents will need and the sum you already have is the amount you’ll need in life insurance.
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