The longstanding myth that many people don’t need life insurance is just that: a myth, and a harmful one at that.
The truth is something closer to the opposite. Most United States residents do need life insurance. Not from birth to death and not necessarily in all cases, but the typical would-be policyholder is likelier than not to need life insurance for much of their working life.
The question of whether to buy life insurance at some point in your life has a straightforward answer: yes, probably. The question of which type of life insurance to buy is nearly as easy to answer: most likely term, as it’s more affordable and simpler to understand than permanent life insurance, which is not often a sound investment anyway.
Other life insurance questions are trickier to answer, though not impossible. The biggest one: how much life insurance you need.
And the reason it’s difficult to answer is that it isn’t constant over an entire lifespan. It changes as you age, mark significant life milestones, and grow your wealth. But because life insurance is cheaper when you’re young and healthy, mapping out your long-term life insurance needs now is essential.
As such, you need to understand common reasons to purchase life insurance, approximate guidelines on how to approach life insurance as your family changes, and how to calculate how much you need.
Pro tip: Purchasing life insurance used to be a long, drawn-out process. That’s no longer the case. Companies like Ladder are making it possible to get coverage in just a few minutes. Ladder even has a useful calculator to help you understand exactly how much life insurance you need.
Why Purchase Life Insurance? Common Reasons to Buy
People buy life insurance for a slew of reasons. The most common include:
- Covering the policyholder’s final expenses, such as funeral and burial costs
- Ensuring jointly held debts and debts not forgivable in death don’t burden survivors
- Seeing to expenses indirectly attributable to the policyholder’s death, such as the need for full-time child care
- Maintaining survivors’ standard of living after the policyholder’s death
- Covering educational expenses for all dependents through college
- Protecting business partners’ financial interests, if applicable
According to data compiled by the National Funeral Directors Association, the average cost of a funeral with viewing and burial exceeded $7,000 in 2017. The average cost of a funeral with viewing and cremation was only slightly lower, clocking in at over $6,000.
It’s certainly possible to pay less than $6,000 for your send-off. But it’s also challenging to put a price on that final goodbye, particularly when it’s done less for your benefit than to provide closure for grieving loved ones.
Despite their low relative cost, don’t forget to include your estimated final expenses in your initial life insurance calculation. Failing that, you could feel compelled to purchase final expenses insurance much later in life. Final expenses insurance, a form of term life insurance with a small death benefit specifically designed to cover final expenses, tends to be much more expensive than standard term life insurance purchased earlier in life.
When calculating your life insurance coverage needs, account for any outstanding joint debts held with your spouse or other relatives. That includes any home loans, auto loans, personal loans, and credit cards held in both your and your spouse’s name. It also includes any debts cosigned with a relative other than your spouse or an unrelated friend.
And don’t forget to account for any outstanding or expected debts that can’t be discharged in death. Although most types of debt don’t fit this description, some common obligations do. For example, unlike public student loans, which don’t survive the borrower’s death, some private student loans become the responsibility of the original borrower’s heirs.
If you’re married and live in a community property state, your life insurance needs could be higher than you realize. Under community property law, spouses are liable for any debts initiated during the marriage, even if they’re not officially a joint account holder. That means you’re responsible for your spouse’s outstanding credit card, car loan, and personal loan balances — among many other types of debt — if they die before you and vice versa. Nine states have mandatory community property laws: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
You need at least enough life insurance coverage to pay off these outstanding debts in full, plus a buffer to cover prepayment penalties and housing expenses that outlive your mortgage payoff, such as property taxes and insurance.
Expenses Indirectly Attributable to the Policyholder’s Death
No one can blame you for the financial strain caused by your premature death. But you can’t ignore it either.
Your life insurance coverage calculation must therefore include expenses that wouldn’t burden your spouse if you were still alive. Such expenses often arise from the loss of the deceased’s labor and the corresponding increase in demand on the surviving partner’s time:
- Child care for younger children so your spouse can continue to work full-time or increase their hours worked
- Part-time child care for school-age children so your spouse can work productively
- Home cleaning and maintenance services (such as landscaping) you or your spouse would previously have done personally
- Health insurance for your spouse and children if they previously had coverage through your employer and your spouse’s employer doesn’t offer adequate coverage
The total amount of life insurance needed to cover indirect expenses resulting from your death depends on what expenses you expect to incur and for how long. For example, if you die when your kids are ages 1 and 3, you need about two years of full-time child care for the older one and four years for the younger one. At $15,000 to $25,000 per child per year, that’s anywhere from $90,000 to $150,000 over four years.
Because your chances of living to see your kids graduate from college are good, you can plan to pay for their education out of your savings. However, your premature death could (and probably will) create unanticipated expenses hefty enough to knock your financial plan off course. If and when that happens, whoever assumes responsibility for your kids’ education needs to be able to pay for it.
The easiest way to ensure that is to carry enough life insurance to cover expected education costs for each of your children through their undergraduate years. Use a college savings calculator like the free one at Saving for College to game out multiple scenarios. Then assume something close to the financial worst case: that all your kids (or expected future kids) attend private, four-year universities with no financial aid.
Survivors’ Standard of Living
Your premature death shouldn’t strain your survivors. Aside from the gaping hole you no longer fill, the hope is that they’re able to continue their lives more or less as before. That means they’re not required or compelled to make significant lifestyle changes, such as selling the family home or living without a car. Ideally, they’ll be able to maintain the same standard of living as before — meaning the ability to take a weeklong vacation every year or dine out once a week or even keep the second home you acquired together.
Protecting your survivors’ standard of living means replacing most of the income lost to your premature death in addition to covering major debts, future educational expenses, indirect expenses, and other obligations that could burden your survivors. That’s an expensive proposition. It’s your current annual income multiplied by a flat percentage to account for inflation multiplied by the number of years before your expected retirement date.
In reality, your overall life insurance needs decrease as you pay off debts, accumulate wealth, and realize more of your expected lifetime earnings, so you don’t need to replace every dollar of income forgone if you died tomorrow. To keep your monthly premiums manageable and ensure you’re not continuing to pay for coverage you no longer need, use a life insurance ladder — a way to step down coverage over time using multiple policies with different term lengths and death benefits.
If you own interest in a corporate entity with a business partner or partners, you need to entertain the scenario that your death could threaten your company’s continued existence.
That isn’t only because your expertise is irreplaceable in the short term. It’s also because, as a partner, you bore a significant portion of the company’s operational costs. And most people’s spouses probably aren’t qualified to assume their duties. Even if your spouse is your business partner and fully qualified to do your job, they can’t singlehandedly do the work two people previously did.
For these reasons, your business partner needs you to have what’s commonly known as a key person insurance policy — an insurance policy on your life with your business partner as the named beneficiary. You need a similar policy on your partner’s life, with you as the designated beneficiary. These policies’ death benefits must be high enough to cover operational expenses in the near term and provide adequate liquidity for the surviving partner to buy out the deceased partner’s heirs.
How to Calculate Your Life Insurance Needs
Accurately calculating your life insurance needs involves a fair bit of math, unfortunately. The quick and dirty alternative is to use a multiple of your current income (usually 10) as a very rough rule of thumb.
If you go the latter route, simply multiply your annual income by 10 to figure your total coverage requirement — for example, $500,000 for a $50,000 annual income and $1 million for a $100,000 annual income.
A more accurate calculation involves multiple steps and more math. Run two separate calculations: a maximalist and minimalist calculation. The former is the maximum amount of coverage needed under something approximating a worst-case scenario: early death, low or negative net worth, high expenses, poor investment returns. The latter is a less conservative projection that assumes relatively low coverage needs. The likeliest outcome — and the coverage amount most people choose — lies somewhere between the two poles.
1. Calculate Your Family’s Income Replacement Needs
Start by multiplying your annual after-tax income by the number of years you expect to need life insurance coverage. That could be the number of years you plan to work before retiring, before your youngest child graduates from college, or before you pay off your mortgage.
In any case, the calculation is straightforward. If your after-tax income is $75,000 and you expect to need life insurance for 30 years, your income replacement need would be:
$75,000 x 30 = $2.25 million
That’s the amount your family needs to maintain its lifestyle and cover household expenses throughout the working years you would have spent together.
2. Use the Scenarios Above to Calculate Additional Coverage Requirements
Add in any debts or obligations produced by the life scenarios you expect to encounter, such as higher education, major debts, and child care expenses. Include only debt principal, not the total expected principal plus interest payment.
For example, say the current balance due on your mortgage is $300,000, and you expect to spend $400,000 on higher education. Assuming the same income and term as the example above, your calculation would be:
$300,000 + $400,000 + $2.25 million = $2.95 million
3. Calculate & Back Out Your Net Assets
Subtract your net assets, such as the equity in your home and the value of any liquid savings or taxable investment accounts. Think of this sum as a head start on your debts — money your heirs (or estate) can immediately put to work settling your affairs.
Let’s assume you have $50,000 in liquid savings, $150,000 in a taxable brokerage account, and $100,000 in home equity. Using the numbers above, your net life insurance need would be:
$2.95 million – $50,000 – $150,000 – $100,000 = $2.65 million
4. Calculate Your Actual Coverage Needs (Present Value)
Finally, use a present value calculator like the one at Calculator.net to determine the actual value of the coverage you need to purchase today. Enter:
- The number of years you expect to need coverage
- The rate at which you expect your assets to appreciate, usually known as the “interest rate”
- The future value of the sum of your life insurance benefits, which is the total of the first three steps
When calculating present value, use a conservative (even unrealistic) interest rate like 2%. Over the 20- to 30-year span during which you’re likely to need coverage, a diversified equities portfolio will probably grow by more than 2% per year. But no one knows what the future will hold, and seemingly small changes in the growth rate can make a huge difference. For example:
- The present value of $2.65 million in 30 years at 2% interest is $1,462,987.86.
- The present value of $2.65 million in 30 years at 4% interest is $817,044.47.
Maybe $815,000, give or take, is all that’s needed to secure your family’s financial future if you die prematurely. But assuming you can afford the premium, you’d probably prefer to leave them just short of $1.5 million.
Shop Around & Adjust According to Your Budget
After shopping around for life insurance coverage from multiple providers, some people realize their household budget can’t support a maximalist scenario because the monthly premium is unaffordable. Laddering multiple policies provides some benefits, but the cost of coverage under your presumed worst-case scenario is still too high.
It happens. If your financial circumstances change, you can always add coverage in the future (the sooner, the better). For now, adjust your total coverage down toward your minimalist scenario until you reach a premium you’re comfortable paying.
It’s not quite right to say that calculating one’s life insurance needs is an inexact science. You’ve seen how much math goes into a calculation that incorporates all the information available when the would-be policyholder begins the application process.
Unfortunately for any would-be policyholder seeking an absolute answer to the question of how much life insurance they need, the available information is subject to change. Circumstances are subject to change.
All we can do is make educated guesses as to how our lives will unfold, make conservative projections around asset growth and income, and do our best to adjust if and when our assumptions fail to pan out.
Are you in the market for life insurance? Or are you looking to add more coverage? What questions do you have about the process?