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. Whole life insurance and other types of permanent life insurance are often not sound investments anyway.
How to Calculate Your Life Insurance Needs
Other life insurance questions are trickier to answer, though not impossible. The biggest one: how much term 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 policy needs now is essential.
Once you have a clear understanding of why you’re purchasing life insurance, you can drill down on how much you actually need.
Maximalist and Minimalist: Two Ways to Calculate 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.
Pro tip: Purchasing life insurance used to be a long, drawn-out process. That’s no longer the case. Insurers like Haven Life are making it possible to get coverage in just a few minutes. Ladder even has a useful life insurance calculator to help you understand exactly how much life insurance you need.
1. Calculate Your Family’s Income Replacement Needs (Projected Future Expenses)
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 financial obligations and 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 life insurance companies, 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 financial needs, and do our best to adjust if and when our assumptions fail to pan out.