How Much Life Insurance Do You Actually Need?

Life insurance is rarely required, but it often becomes a consideration when you begin a family or have loved ones that financially depend on you. How much life insurance you need is directly tied to your reason for purchasing a policy. For example, if you are the primary earner for your family, you would need a much larger life insurance policy than if you just wanted to cover your end-of-life costs.

A simple rule of thumb is that you should buy enough life insurance to cover all significant upcoming financial obligations, assuming your family also had access to your liquid assets.

How to calculate the amount of life insurance you need

When calculating the amount of life insurance you need to purchase, a general rule is that your death benefit should equal five to 10 times your annual income. While this is a simple formula, it’s unlikely to reflect what your actual needs are. The amount of financial protection your family may need changes over time, as children finish school and debts are paid off or paid down.

A better rule of thumb is to add together your current and future financial obligations, then subtract all assets that would be liquidated if you pass away.

How to calculate debts & financial obligations

Financial obligations can typically be divided into the following categories: current debts, income replacement and future expenses.

Current debts may typically include a mortgage, auto loan, credit card balances and other personal loans. Depending on how your finances are organized, you may not need to have all of these loans when calculating your life insurance needs. For example, an outstanding mortgage should usually be accounted for in your life insurance death benefit if you have a family who needs to go on living in your home. On the other hand, if the house is paid off, or you don’t live with a partner, your children have their own homes and your house’s current value is greater than your outstanding mortgage balance, you may not need to include it.

It can be challenging to determine how much life insurance you would need as an income replacement. An accurate figure would require you to evaluate your family’s ongoing expenses, future expenses and savings plan. You can do a simple approximation by adding the following figures together:

Since this is an approximation, the figure you come up with is likely higher than your family’s actual needs. However, you still need to account for your family’s upcoming expenses. These may include the cost of sending your children to college, your spouse purchasing a new car, paying for an elderly parent’s long term care or even helping fund a child’s wedding.

Typically, education costs are one of the largest expenses that needs to be accounted for when purchasing life insurance. According to the College Board, the annual all-in cost (including tuition, fees, room and board) of sending a child to college is:

By adding your current debts, income replacement needs, and future financial obligations, you should have a figure that represents the maximum amount of life insurance you might need.

How to calculate your assets

The next step is to add together your assets and other sources of income. This figure will be subtracted from your total financial obligations to determine your actual life insurance needs.

When adding your current assets, you should include brokerage accounts, savings accounts and any existing life insurance policies. However, you should exclude retirement accounts, such as a 401(k) or IRA.

If your family has multiple earners, take their after-tax income and multiply it by the number of years they intend to work. Include this in the sum of your assets.

What kind of life insurance do you need?

Once you’ve calculated how much life insurance you need at the moment, you should calculate how long you’ll need this amount of coverage. This is important because the cost of a life insurance policy is correlated to the number of years it lasts since you’re more likely to pass away during the period of coverage.

For each financial obligation, you should determine whether it’s time-specific or time-independent. A time-specific cost would only impact your family during a particular period of time.

As an example, if your child is 12 years old, you would expect that their college costs were handled within the next 10 years. A funeral is a common time-independent obligation, as it’s a cost that could happen at any point.

For most families, the majority of projected expenses are time-specific. If this is the case, we recommend term life insurance as it’s the cheapest type of policy and offers coverage for a particular amount of time.

Term policies can range from five years to 35 years in length and can provide over $1 million in death benefits depending on the insurer and policy. If you have costs that aren’t limited to a specific period of time, there are two main options:

Whether you buy term or permanent coverage, try to ensure that your policy’s premiums are level for the entire length of the policy. When this isn’t specified, the insurer can raise your rates and you may not be able to afford the coverage later, even though it’s still needed.

When do you need life insurance?

There are not many reasons you would need life insurance, but a large number of reasons why you might want it.

The only situations where life insurance might be required are:

Aside from contractual requirements, many people choose to purchase life insurance because it can provide financial relief to their families and loved ones if they pass away. Some of the most common costs that life insurance is used to cover are: