Once you’ve decided you need life insurance, the next question is often how much coverage you should buy. There isn’t an easy answer to this question because every person and every situation is different.
A basic goal for many purchasing life insurance is to make sure your dependents are taken care of if you’re no longer around to do so. Whether it’s your spouse, your children, or an aging relative, you want to make sure your loved ones don’t experience undue financial hardship on top of dealing with your loss.
But purchasing just the right amount of coverage to ensure this outcome is a bit of a guessing game. You could die suddenly next week or live to the ripe old age of 100. Additionally, it may be difficult to know what the future holds for your career growth, your spouse’s career, and your children’s future as well. Planning financially for such a set of circumstances isn’t easy.
Financial Planning Models
With so many factors influencing your decision, it can be hard to know where to start. But over time, financial planners and insurers have come up with three coverage models to help life-insurance customers get a ballpark figure of the amount of coverage they may need.
One method is to simply multiply your current income by 7 to 10 years. This 7 to 10-year timeframe is a kind of industry standard. In this case, you goal would be to replace your earning capacity long enough that your children could become independent or your spouse could adjust to new life changes.
If you currently draw a $100,000 salary, this would mean multiplying that number 7 to 10 times. You’ll end up with a figure of $700,000 to $1,000,000. This may be a good amount to help your family as they transition to a life without you, under certain circumstances. One downside to this calculation is that it doesn’t take into account other factors — do you have one child or four, do you have significant real estate holdings, does your spouse work, etc.
A more complex method is to come up with an annual income goal for your dependents and how many years you want them to be able to depend on this income. Once you have this target figure, you have to work backward, subtracting state pensions, 401ks, savings, investments, social security, your spouse’s salary, and so on.
What you’re left with is the shortfall, the difference between what you want to leave your family and dependents and what other non-insurance means can provide. In this scenario you insure for that shortfall amount.
Many people forget about their savings or pension when they start considering life insurance, so this method can help you avoid buying too much coverage when your family has other safety nets in place.
Another approach to this coverage question is to plan for a large investment amount that will generate a sizeable annual interest. The principal amount invested is left untouched while the beneficiary is provided with income through interest. A million-dollar policy could provide your beneficiary with a $40,000 income indefinitely at a conservative interest rate of 4%.
Generally, a life insurance payout is a temporary fix. You may want to help your family through a difficult time, but eventually their life circumstances will change. Children grow up, aging dependents pass on, your spouse will retire, etc.
Most dependents won’t need lifelong income in your absence, but some might, such as a special-needs child. There may be circumstances where you will want or need to provide this financial care indefinitely.
Your Unique Circumstances
The ballpark figure these three models can give you is a good start for determining how much life insurance coverage you need. The next step is to dig in to your personal situation for a better estimate.
Your Age: Your age can help you decide whether you need a term life policy for the next 10–20 years or if you’re ready for a permanent policy, whichcould be bought at a savings when you’re younger.
The Ages of Your Spouse and Children: How many years of income replacement do you need? Young children could mean more than 10 years of income dependency while grown children and a spouse near retirement age could mean something much different.
Mortgage and Debt Amounts: Don’t forget to factor in your debt amounts, including your home mortgage, car payments, and student loans. Some debts may die with you while other debt obligations may fall to your spouse.
Educational Expenses: Beyond income replacement, you may hope to ensure your children can further their education without accruing their own student loan debts. Keep in mind that college tuition costs have been rising at more than 5% annually, with the price doubling in the last 20 years.
Current Income: Do you still carry significant debts or obligations? If not, you may not need a full replacement income. Some financial planners suggest 50% may be enough to suit your family’s needs.
Funeral Expenses: An important initial draw on a life insurance payout is often the deceased’s funeral expenses. Average funeral costs are currently around $7,000 while cremation could be as much as $4,000.
Considering The Future
These are the factors that can help you address what specific coverage you anticipate now and over the course of your life insurance policy. But keep in mind that our lives are continually changing. Many times these changes can be a great joy — a new baby, a promotion, a new home, an early retirement.
When you encounter life changes such as these, don’t forget to revisit the question of how much coverage you need. You may find you need more coverage or less coverage as you move through life. Let your insurance broker or financial planner know about changes to your life circumstances as well. They may be able to save you money on coverage levels and premiums as your needs change.