How Much Life Insurance Do You Really Need?

How much debt will you be leaving behind for your loved ones? Life insurance is one of those things that people don’t really like to think too hard about. When we’re young–death feels impossible. And as we age–we begin to understand our mortality and the brevity of our lives. Determining the appropriate amount of life insurance is nothing short of a careful calculation. It’s a number that is unique to each individual and each financial portfolio. And, unfortunately, it’s a number that is most often underestimated. According to LIMRA, up to 44% of households would face financial hardship due to insufficient life insurance coverage. Let’s take a look at how you can get that number right.

Do You Have Enough Life Insurance?

It’s a valid question for anybody–at any age. As of January 2021, only 52% of consumers currently owned life insurance. There are significant gaps in coverage between men and women, as well as between different races. Less than one-third of Americans have the information that they need to make an informed decision about their financial futures. Misconceptions about what it is, what it covers, and how much it costs are the biggest obstacles in coverage gaps.

Here are some numbers to think about:

• Depending on your age, you may need 10 to 30 times your annual income in coverage.

• According to LIMRA, more than 40% of Americans regret not buying their life insurance policies at a younger age, when premiums were lower.

• It pays to buy life insurance while you’re young. Premiums typically increase between 8-10% for every year of age.

First, Start with an Understanding of How Life Insurance Benefits are Commonly Used

What exactly is the point of life insurance? Is it to pay for your end-of-life expenses? Or, to settle your financial obligations? Or, maybe it’s to ease the financial or emotional burden of your death on your immediate family. The truth is, there is no one right or wrong answer for how life insurance can help. Here are some of the most common ways that these benefits help:

• Final Expenses: Did you know that the average cost to bury someone in the US is between $7,000 and $12,000? At the very least, you should plan to cover these expenses that would otherwise be a hardship for your family.

• Financial Security: When the primary earner passes away, life insurance can provide continuity with the current lifestyle. Aside from covering final expenses, this is the second most common reason to purchase life insurance. Life insurance benefits can pay off a mortgage, cover common home expenses, or cover the cost of college for any children left behind.

• Investment: For some, life insurance can make a lot of sense as a tax-advantaged investment during life or as a charitable gift after death.

Next, Take Stock of Your Personal Finances

To come up with a number that will fit your needs, consider how much debt you currently have and what your spending habits typically are. Then, make a list of the things that you would like to cover with your life insurance benefit.

Here’s an example breakdown:

• Burial & End of Life Costs = $15,000

• Personal Debt = $15,000

• College Tuition for 2 Kids = $160,000

• Balance on Mortgage = $150,000

So far, we’ve racked up $340,000. Considering the number of individuals who purchase a safe of $250k or less, it’s easy to see where that may not be enough. More than half (54%) of Americans simply do not carry enough life insurance.

Common Formulas for Calculating Life Insurance Needs

If the common ‘balance sheet’ method feels too overwhelming or you just need a simple formula to check your numbers, here are a few of the most common ways that the industry calculates coverage needs.

Rule of Tens

For starters, you could simply multiply your annual salary by 10. This would ensure that enough funds would be provided to cover a decade of typical expenses at your current earning rate–which is plenty of time for your family to adjust. For example, if you currently make $80,000 per year, you need at least 800,000 in life insurance coverage.

Cover the Difference

If you already have excellent retirement planning in place, you may not feel that 10 years of financial provisions are necessary to keep your family afloat. Another way to approach the calculation is to simply cover the difference between now (when you’re buying the policy) and your target retirement date. If you’re within five years, that already cuts the coverage amount in half. For someone who earns $80,000 per year, the recommended coverage goes from 800,000 to 400,000.

Use the DIME Formula

Simplify the “balance sheet” approach with the DIME formula–covering the essential big-spending categories. DIME is an acronym that stands for:

• Debt

• Income

• Mortgage

• Education

Simply add the numbers up and tack on a little extra for good measure. Keep in mind that tuition rates and inflation will continue to cause costs to rise. An $80,000 education today, might be $100,000 or $120,000 by the time your children enroll.

Use the 1% Rule

Do you anticipate big changes in the line items on your annual spending? For some, like entrepreneurs, coming up with solid figures can be very abstract. Here’s where the one-percent rule can simplify your calculations. Instead of worrying about what you’re going to pay for, simply look for premiums that match one percent of your current income.

The Takeaway on Calculating Your Life Insurance Coverage Needs

Buying enough life insurance is an individual decision. Some frugal-minded individuals can comfortably cover themselves on a $250,000 policy while the average American would leave their families in dire straits with that policy. There are a variety of ways to calculate life insurance coverage needs ranging from a percentage of your income to considering how far away you are from retirement. Your personal finances, earning level, family situation, and age all factor into determining what is appropriate.