There are a few ways to figure out how much life insurance you need. Some are more complicated than others, and some take more factors into consideration than others. Here we show you the academic way to calculate your need, but also more simple and practical methods. For the simplest method or estimating how much you need, multiply your current after-tax income by 15. For most people, this ends up being a very accurate estimate.
With life insurance, it is very important to consider not only how much coverage you need, but also how long you need the coverage. Depending upon the goal of the life insurance, the time that it is needed will vary. If the life insurance policy is needed for a long time, or for an entire lifetime, you should consider a whole life insurance policy. If the coverage is needed for a shorter amount of time, say 10 years or 20 years, you can probably use term coverage.
Table of Contents:
- What Creates a Need for Life Insurance?
- How Much Life Insurance Do You Need?
- Rules of Thumb
- The “Pay Off Debts and Fund Future Major Expenses” Method
- Needs-Based Calculation for Life Insurance
- Other Methods for Other Needs (Such as Business Life Insurance)
- Do You Need Term Life Insurance or Whole Life Insurance?
- What to do if you need more life insurance coverage?
- What to do if you need less life insurance coverage?
What Creates a Need for Life Insurance?
For life insurance to be necessary, two components need to be true. The first is that there must be lost economic value from the death of someone. Typically, this lost value represents the future earning power of the individual. Future earning power alone is not enough to justify life insurance on their life though. To need life insurance, another person or group of people must depend on that future earning power in some way. It could be a company depending upon that person’s ability to bring in revenue, or it could be a spouse depending on the income from a job to pay for living expenses. Either way, both a future income earning potential and a reliance on that future income by another must be present to create an economic necessity for life insurance.
How Much Life Insurance Do You Need?
Here is a simple life insurance needs calculator.
Figuring out for yourself how much life insurance coverage you need can be complicated. An individual or family’s financial situation is complex, and calculators usually do not do enough to factor in every variable that can change the amount of coverage somebody needs. Consider working with a financial professional such as a CLU designated life insurance agent, or Certified Financial Planner. They can calculate your exact need, and most do not charge anything for this service because they will make a commission on a policy that you buy from them.
How to Calculate Your Need Yourself
As we said, there are different ways to answer this question. For simpler methods and shortcuts, you can skip below. For an advisor, the academic method is best. For many people, this method is probably a bit complicated and it is easy to make a mistake. If you are a professional or wish to use the method that is taught in college, it is as follows:
- Figure out the amount of money that the insured person will make each year of their job. Don’t worry about cost of living raises.
- Take away the amount of money that it costs that individual to live each year (food, insurance, personal expenses) and what they pay in income tax. Note that this is not the cost that it takes his or her family to live, only the amount of money that would be saved by this individual dying.
- Figure out how many years are left until retirement.
- Choose a discount rate to arrive at a present value of each year. This is a fancy way of saying what the rate of return would be if that future money was invested in a conservative way, net of inflation. Usually, something in the 3% to 6% range is best.
- Figure out the net amount of money the person is worth each year (step 1 minus step 2). Now take the present value of $1 each year until retirement (discounted by the rate in step 4), and add the present value of each dollar. Now multiply that total by the annual salary determined in step 1.
This method is a fancy way of figuring out the net present value of the future income stream, of the insured person working. At a most basic level, you can think of it as a person who makes $50,000 per year with 10 years until retirement, being worth $500,000. Because that $500,000 would be invested if it was all received today, you don’t need the full $500,000. You can take slightly less, depending upon how much is made by investing. The percentage amount you are anticipating to make by investing, net of inflation, is the discount rate that you can choose.
If this is confusing or seems to logically overstate the amount of life insurance needed by the “smell test”, don’t worry. There are other shortcuts that you can use that are much simpler, to figure out what the survivors will really need.
Rule of Thumb Methods
Pay Off Debts and Fund Future Major Expenses Method
Another simple way that people determine how much life insurance is needed is by calculating the total amount of debt outstanding, and how much will be needed to pay off large future expenses such as college for a child. Many times a surviving spouse can make enough income to survive, as long as the mortgage, other debts, and college educations of the children are funded.
The most common debts that need to be repaid are mortgages, credit cards, student loans, home equity lines, and business loans. It is important to account for all debts which could be left outstanding. Other debts that may be left outstanding include auto loans, financing on furniture, financing on electronics, short term loans, taxes, and even money borrowed from friends and family.
Major expenses that may happen in the future usually revolve around children’s education, weddings, funeral expenses, or a big home move. As a rule of thumb, you should have $150,000 allocated to a college education for each child. They will not only need tuition, but also books, apartment or dorm living, food, and possibly tutors. For a wedding, $50,000 is a good number.
The idea behind this being an effective method is that if the debts are paid off and future major expenses funded, the remaining family members will be able to earn income at a rate at least sufficient to provide for their lifestyle. This is also effective because it provides enough money for the survival and advancement of the family, even if the insured person does not currently earn enough income to ensure those things. In other words, these debts and expenses can be so high today that many people do not even earn enough money to pay for them, and using a method based upon income will result in a money shortage.
Simple Multiple of Income Method
A very simple but effective method of estimating how much life insurance you need is to multiply your after-tax take-home income by 15. You can also multiply your pre-tax gross income by 10. This is intuitive because they typically will give you about the same amount of coverage needed.
Gross Income = $100,000 x 10 = $1,000,000
After-Tax Income= $68,000 x 15= $1,020,000
The reason that this works is that 15 years of earning power is typically enough runway for surviving members of a family to pay off any existing debts and provide money to live. Peoples lifestyle generally adjusts over time, so a surviving family member may adapt by either making more money themselves or simplifying their life to lower expenses.
Most Precise Method- Needs-Based Approach
A needs-based approach attempts to calculate exactly what a beneficiary will require to maintain their lifestyle. It uses their projected income, projected expenses, and the growth and drawdown of any investments. It attempts to quantify the total need, and then assign a present value to that need.
How It’s Performed in Practice
From an academic perspective, the goal is to calculate a net present value of an amount that would fully fund the shortfall for all future needs. A discount rate equal to a conservative estimation of the expected rate of return net of inflation of all future liquid capital can be applied to find a “net present value” or in other words the amount of life insurance coverage that you need.
The first and easiest step is to assume that all outstanding debts should be paid off immediately. This is a dollar for dollar need. Take into account the fact that current liquid assets can be used to reduce debts as well.
The next step is to calculate the amount of money the beneficiaries (usually a family) need to survive comfortably. Take the current amount of spending above all current outstanding debt service (i.e. mortgage payments) that the family needs to maintain their current lifestyle. In simpler terms, if there was no debt, how much does the family need to survive and pay bills each year.
Inflate this lifestyle cost number at the expected rate of inflation, and take the sum of every year for the rest of the beneficiaries expected life. Please note that children likely do not need to be supported beyond age 18 or 22, so any spending needs for the children should end at this age. Take into account any lifestyle changes likely to occur as well, such as an increase in spending during retirement for vacation purposes. When calculating the needs for a spouse of the insured, consider the spouse’s need for financial capital to last for the rest of their life. Take into account that many middle-aged people today will live beyond 90 years of age as the average length of life continues to increase in developed countries.
The goal of the above calculation is to find the amount of money that would need to be put into an investment account, earning some conservative estimated rate of return, which will fund all future spending needs. This is the net present value of the amount of money the surviving members of the family will need for the rest of their life to maintain their current lifestyle.
Add in any needs for college education funding. It is recommended by financial planners that you build in inflation of costs at a greater rate than current inflation expectations for the economy as a whole, as the increase in the price of higher education has historically outpaced general inflation in the economy. After figuring out the total amount of money that will need to be spent on education(s) (depending upon the number of children likely to attend college) in the future, figure out the amount of money that will need to be put into a conservative investment account today to fully fund this need.
Steps Simply Put
- Figure out the total amount to pay off all debts that is needed beyond current liquid assets.
- Figure out the total amount of money it will take to fund all future spending needs beyond and current assets available to satisfy this need.
- Calculate the amount of money that you need, invested at a conservative rate, which will satisfy the above points.
- Add any additional money that you would like to leave future generations as a legacy or to pay inheritance taxes (if applicable).
This will give you an exact calculation of the amount of life insurance coverage that you will need to hold in order to completely provide for your beneficiaries. Using this method both reduces the amount of wasted coverage and increases the odds that you will be leaving enough for your beneficiaries so they never want financially if you were to pass away.
Problems With This Method
This method can be difficult to calculate for people unless they have special training or a special software program to help. While the method attempts to assign the most precise amount of money needed for life insurance coverage, it can fall short because the projections used do not always end up being accurate. Investment rates of return can fall short for instance, or large life-altering expenses such as medical expenses can arise. Time is also a major factor in investment growth, and the timing of a death can severely alter projections for the growth of an account. In other words, if you invest $100,000 for 30 years at a growth rate of 6%, it will result in a value of about $575,000. If the same $100,000 is only invested for 5 years, it will only grow to about $134,000. If you are projecting an investment account to grow until retirement, for instance, the timing of the death can alter the dollar amount needed. In this case, a later death actually results in too little life insurance being purchased.
The goal of using a needs-based methodology would be to avoid purchasing too much life insurance since a method using income replacement can overstate the amount of life insurance actually required. The danger is that it ends up not being enough money if the projects are not accurate.
Other Purposes of Life Insurance Use Other Methods to Calculate Your Need
Life insurance is a product that can serve many purposes. While it is typically used to replace the lost income of a family member, it can also be used to replace the value of a key business member, it can be an investment product, or it could be used to avoid estate taxes.
As a key member of a business, the goal would be to attempt to quantify the value of the insured person to the business. Whether they are an employee or an owner, they undoubtedly would cost the business money if they were to die. In some cases, a business may not even survive without them.
As an investment product, the goal would be to fit the life insurance contract into the portfolio of the owner. The amount that they purchase depends upon how much money they are looking to invest in this relatively conservative, but predictable, investment vehicle.
Life insurance used for estate planning purposes is a very complex field, and some people specialize solely in this area. Typically these are very high net worth individuals and buying the right product with the right death benefit is extremely important.
You Can Buy Both Term and Whole Life
Term life insurance and whole life insurance have very different purposes. Sometimes a person may need term coverage only, sometimes a person may only really need whole life insurance, and sometimes a mix of both types of coverage is appropriate. Some things to keep in mind when designing your mix of coverage.
Term Has Multiple Coverage Lengths Available
Term life insurance is an incredibly flexible product. You can purchase level term life insurance for as little as 5 years, and as many as 35 years, generally with 5-year increments available in between. The longer the length of the term coverage, the higher the level premium will be. This is because the longer the life insurance company covers you, the higher the odds are for them that you will pass away while you hold the coverage. If you are likely to be in a very different financial situation in 5 years than you are today, it may be appropriate to purchase a lower length term policy. If you anticipate needing coverage until retirement, but you believe that you will have saved plenty of assets by the time you retire to negate the need for continued life insurance coverage, you may want to purchase a policy with a term length which corresponds with your likely retirement age.
Term Can Be Convertible
Also important to keep in mind is the fact that term life insurance is usually convertible into whole life insurance for some period of time after it is purchased. If you are unsure if you will need whole life insurance in the future, but want to keep your options open to purchase a whole life policy, don’t forget that most term life insurance policies allow for future conversion. Always check with your life insurance provider on their exact rules regarding term conversions, because every company does vary slightly regarding what point the conversion option is available.
Whole Life is the Only Product for Estate Planning Purposes
If you have an estate planning need to fill, such as the need to pay estate taxes, or you would like to leave a legacy to the next generation, whole life insurance is the only appropriate product. This is because only whole life insurance is guaranteed to be in force your entire life with level premium payments.
A Mix of Different Length Term Policies or Whole Life and Term May be Best
You may know that your house will be paid off in 5 years, and you can drop a significant amount of insurance coverage at that point, but you want to lock in a policy now while you are healthy that will also last for a long time, you may want to get one short term policy to cover the mortgage payment, and one longer-term policy that will last until retirement or beyond to provide for living expenses (don’t forget that reducing face “mortgage life insurance” policies also can be purchased from most insurers). You may need extra coverage while you are young, but also have an estate planning need, and a mix of whole life and term life may be appropriate. An integrated approach to life insurance can sometimes be the most cost-efficient solution.
What to Do if You Need More Life Insurance
You will first need to figure out which type of life insurance best suits your needs. If you need temporary coverage, a term policy will be for you. If you need permanent coverage, you probably need whole life insurance. We rarely recommend a universal life policy or a variable policy due to the higher risks and costs associated with these.
You can buy more life insurance a couple of ways. The most common way is to contact a local life insurance agent, who will help you shop for a policy. Usually, they work for a particular company and they prefer to only sell policies from that company. An agent who is not tied to a particular company can help you get the best deal.
You can also shop for yourself using an online service like Life Ant. We can help you compare quotes from multiple providers and work to get you the best deal, all while working remotely over the phone.
When you assess a policy, you need to take into account a couple of factors. The most important one for most people is price. Often overlooked but arguably more important is the financial strength and history of the company. Will they be around for decades longer to pay your claim? What is their dividend-paying history? You do not want your money to be wasted. Choose a strong company that will be around for the long term. You also want to make sure that they provide good customer service. You may need to make changes to your policy or have questions as the years go by. Make sure that you work with a responsive company that has your best interests at heart.
What to do if You Need Less Life Insurance
You may also find out that you have too much life insurance! If so, you have a decision to make. If you choose to give up some of your coverage, you can do this by surrendering one or two of the policies that you own, if you own multiple policies. If you do not own multiple policies but want to reduce your coverage, you can also submit a face amount reduction to the life insurance company. This will reduce the future premium payments that you will owe on the policy. There are a couple of considerations here though before you give up coverage:
- Could you need more life insurance coverage in the future? If so you may want to consider keeping what you have. If you have a change in your health, you may have trouble obtaining additional coverage in the future. A new policy in the future could also be more expensive than holding the ones that you have.
- Do you own term or whole life? A whole life policy can become less expensive over time if dividend payments are used to offset premiums. Consider which dividend option you are choosing before you surrender the policy.
- Why are you reducing your coverage? Do you need to do it to save money? If not you may want to consider the added financial protection that it provides your beneficiaries. If they do not need the money, you could always make a charity the beneficiary and donate a lot of money to them, or start a fund or scholarship fund to benefit future generations.
If you do decide to lower your coverage, a surrender or a face reduction are both simple. Most companies have specific forms that can be requested through the agent or the home office to accomplish these goals. You may also submit a signed note giving your permission to perform the surrender or face reduction. If you have a term life policy expiring in the near future, consider letting it expire naturally.
Calculating How Much Life Insurance You Need
Remember, the minimum amount that you should carry is enough to pay off all debts, but ultimately an official methodology to determine needs should be used. If you still have questions, you should speak with a financial advisor. You can always get quotes for different amounts of insurance, and compare the prices across companies, which may help you decide what is affordable for you.