If you died today, what would happen to your family?
Not just financially, but emotionally and physically.
Would money help through the difficult transition?
For many people, the answer is yes. Unfortunately, people don’t like thinking about their death, and often fail to plan for how much life insurance they need.
There are a few different types of life insurance, but I am primarily going to talk about term life insurance. Although whole life insurance and universal life insurance exist, there are very few situations where those make more sense than term life insurance.
Let’s define term life insurance to set the stage for how much life insurance you need.
Term life insurance is where the owner pays a premium on a regular schedule to a life insurance company. In return, the life insurance company contractually states that they will pay a lump sum benefit to named beneficiaries if the insured dies within the term period.
Now that you know what term life insurance is, let’s explore other types of life insurance, how to decide the term length, and how to calculate how much you need.
As with anything in financial planning, how much life insurance you need is part art and part science. Please keep that in mind as you decide for yourself.
Other Types of Life Insurance – Whole Life and Universal Life
I want to spend most of my time talking about term life insurance because it’s the type of life insurance most people need; however, the incentives in the insurance industry make it so that many life insurance agents push whole life and universal life more.
Life insurance agents can earn larger commissions on whole life and universal life policies upfront and over time compared to term life insurance. You will likely be pitched whole life or a universal life insurance policy in your life.
For someone who is young, in good health, and only needs life insurance for a certain amount of time, term life insurance is usually the way to go.
Other types of life insurance can be good for estate planning purposes (i.e. if you are in your 60s or 70s and are doing generational wealth planning), business planning (i.e. you own a successful business and have illiquid assets), or wasting money. I’m making sure you are still paying attention on that last one.
Other types of life insurance rarely make a good investment. Using them for loans and “acting as the bank” (as it is often pitched) carries risk. I mentioned these because these are common ways people are sold whole life insurance.
If you need further proof that whole life insurance rarely makes sense, consider that approximately 30% of whole life policies are surrendered within the first three years and approximately 45% are surrendered within the first 10 years.
Said another way, if you and two other friends buy a whole life insurance policy, there is a good chance one of you stops paying the premiums within the first three years and gets very little value out of the policy.
There are times whole life and universal life insurance can make sense, but in most cases, term life insurance is more appropriate.
What is the Life Insurance Protecting?
Before deciding how much life insurance you need, you need to identify what you are protecting.
Is it your income?
College education costs for your kids?
Costs of care for an aging parent?
Allowing your spouse to retire if you die?
Something else?
I know most people want a simple answer, like, “You should buy $1 million of term life insurance that lasts 20 years”, but we are talking about death. It’s not simple.
People have different priorities.
Some people I have met want to cover the cost of college education for their kids at the most expensive private university. Others want to fund 25% of college at a public university.
Some people want their significant other to have the option to no longer work. Others want to provide transition money, but don’t want them to have the option to retire.
Some people have aging parents they are caring for and if they died, there would not be enough funds to provide for their continued care.
Think about your own life.
If you died and your income along with it, what would life look like – not only now, but in the future?
What gets funded? Who is hurt financially? How might life change in the future that you are not considering now?
Common things people want to protect include:
- College education costs (private school, college, gap year, etc.)
- Mortgage
- Retirement
- Charitable gifts
- Funeral expenses
- Debts (business, personal, etc.)
This list is not all-encompassing. You should consider your life and how it may change over time to decide what you want to protect.
How Long Should Your Life Insurance Coverage Last?
In general, most term policies are sold in increments of five years’ worth of protection. For example, 5, 10, 15, 20, 25, and 30-year term policies.
Once you have identified what you want to protect, you can decide how long the coverage should last before deciding the amount.
For example, if your kid is age 10, you want to cover the cost of college, and don’t have any other college savings, you may want to consider a 15-year term policy.
A 15-year term policy would provide life insurance protection for the next 15 years, or until your kid is age 25. By that point, they are hopefully out of college!
If you have a 30-year fixed mortgage and are 10 years into the loan, you have 20 years left to pay. In that case, you may want a 20-year term policy. After 20 years, you won’t have a need to protect the mortgage balance anymore.
Something to keep in mind if you are getting a term life insurance policy to have the option to pay off your mortgage balance is that you might move and have a larger mortgage balance in the future.
For instance, if you are 10 years into a loan, but plan to buy a new house in two years, you probably don’t want a 20-year term policy. You likely want a 30-year term policy because once you have the new loan, you will have 30 years to protect again, assuming it’s a 30-year fixed mortgage. Although you won’t have protection for the last two years of the loan, this is usually not too big of an issue if you have other savings by that point that could cover the cost. Plus, it’s harder and typically more expensive to find a 35 or 40-year term policy.
When you think about how long your life insurance coverage should last, you generally want to align the term policy with the length of time you need to protect something.
Since term life insurance tends to be affordable, I also personally err on the side of caution and get coverage for a slightly longer amount of time.
For example, if your mortgage will be paid off in 11 years, you might be fine with a 10-year term policy, but I would also look at the cost of a 15-year term policy. A few extra years of protection may not hurt.
As you think about the coverage you need, don’t forget to consider how life may change in the future.
How to Calculate the Amount of Life Insurance You Need
Since many people like rules of thumb, the general rule of thumb is that you need 7-10 times your annual income.
For example, if you make $50,000 per year, the general rule of thumb says you should have $350,000 to $500,000 of life insurance coverage.
I don’t like rules of thumb when it comes to life insurance coverage because it doesn’t take into account your values or your life.
What if you make $50,000 today, but your career trajectory is such that you will make $200,000 in three years?
Now, instead of needing $350,000 to $500,000, you would need $1,400,0000 to $2,000,000 of life insurance coverage.
That’s a huge difference using the rule of thumb.
What if you want to cover an expensive private university for two kids? You can probably add an extra $500,000. It doubles the amount of life insurance you need.
Or, what if your mortgage is paid off, your spouse has a full-time job, and you have enough in college savings?
Maybe then, you don’t even need life insurance.
Rules of thumb are fine, but use them as a gut check – not to decide how much you need.
Online Life Insurance Calculators
I like using online calculators to determine how much life insurance is needed. Life Happens has a good calculator.
It takes into account how much income you want to protect, how long you want the income to last, how much debt you want to pay off, how much you want to provide for childcare, how many children you have that you want to fund college for, how much for an emergency fund, and considers how much insurance you already have.
Below are a few photos to give you an idea of how easy it is to work through. There are only seven questions.
The one downside to this calculator is that it does not take into account current savings and investments. For example, if you already have money saved for retirement, it does not take it into account. If you have a larger balance, keep that in mind. You may be able to reduce the total life insurance need.
Bankrate has a different calculator that takes into account the amount you have in savings and investment accounts.
It’s important to take into account your current savings and investments because if you are close to being financially independent, perhaps you don’t need life insurance anymore. For me, being financially independent means having about 30 times your annual desired spending in investments. For example, if you want to spend $50,000 per year, you would need about $1,500,000 in investments.
Having 30 times your annual desired spending in investments works out to being able to spend about 3.3% of your portfolio per year. There is solid research that there is a good chance of not needing to change your level of spending if you spend about 3.3% of your portfolio annually and you have a balanced portfolio of about 50% stocks and 50% bonds. I’m not going to get into the weeds, but if you are curious, you can read Morningstar’s research by clicking the link above.
Although the calculators are helpful, think critically about what you want life to look like if you were gone. I’ve met some people who want their spouse to have the option to never work again. Others don’t want to pay for that much life insurance.
Many people assume if another spouse is working and they only spend one of their incomes that they may not need life insurance. They may be right, but I also find many people don’t consider the emotional impact of a death.
One spouse may need to take time away from work or an extended break. What if that spouse had a year or two of spending available through life insurance to give them the time to grieve and take time away from work?
Even if you have a spouse who doesn’t earn income, they may still need life insurance. Although a calculator or the general rule of thumb may say they don’t need it, there is a significant cost to raising kids and running a household.
For example, if your spouse earns no income, but watches the children, what happens if they die?
You may need to enroll them in daycare. If daycare costs $1,200 per month and you have two children, that is $2,400 in monthly expenses you’ll need to cover. Can you cover that from your paycheck?
If not, you may need life insurance on the life of your spouse.
Laddering Life Insurance Policies
If you are trying to protect income and savings for retirement, you may want to consider laddering your policies.
For example, if you are young and decide you need a 30-year term policy for $1,500,000, you may want to consider three separate policies:
- 10-year term policy for $500,000
- 20-year term policy for $500,000
- 30-year term policy for $500,000
This is just an example. You might need a 20-year term policy for $1,000,000 and a 30-year term policy for $500,000, or any other combination.
The reason for this is that a 30-year term policy for $1,500,000 is likely going to be more expensive than three separate policies. Plus, you likely don’t need $1,500,000 worth of life insurance coverage after 20 years because your savings and investments will hopefully reduce the amount of life insurance coverage you need over time.
For instance, if you had $1,000,000 in investments after 20 years and you still needed $1,500,000 to be considered financially independent, you only need $500,000 of life insurance coverage.
Laddering policies can help reduce costs if you think your investments will grow over time to fill in the gap.
As you can see, deciding how much life insurance you need is not a precise calculation. You need to consider your values, how life may change, and more.
How I Decided How Much Life Insurance to Buy
Now that you have read about how to decide how much life insurance you need, I’ll share what I did.
First, remember I prefer simplicity, and I am usually okay paying a few extra dollars for the benefit of it.
I bought a 30-year term policy that would cover my mortgage and allow my future wife to be financially independent if she wants to live frugally or close to financially independent if she wants to live a more “normal” lifestyle.
Although I wouldn’t recommend she pay off the mortgage because the interest rate is low, the life insurance payout would give her the option if she didn’t want to keep it.
On top of the mortgage payoff, she would have enough to live as she does currently without issues, but she is also early in her career. If she wanted to have lifestyle inflation, the money likely wouldn’t be enough to last her entire life.
I could have laddered a few life insurance policies instead of buying one life insurance policy, but I was okay paying a little more for extra coverage later in life.
Summary – Final Thoughts
How much life insurance you need is not a straightforward answer.
If someone tells you that you simply need 10 times your annual income, run the calculations instead. Use the 10 times your annual income as a gut check against that figure.
Think carefully about how life looks today and how it may change in the future. Do you plan to have kids? Do you plan to buy a larger house? Do you anticipate needing to take care of a parent?
Then, think about the length of time you need coverage. Is it 10 years, 20, years, or longer?
Finally, decide how much life insurance you need for the different lengths of time. You may want a few different policies or decide to lump them together into one policy.
Whether you have existing life insurance you need to review or have thought about buying your first life insurance policy, deciding how much life insurance you need is an important exercise to help protect your loved ones.