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October 21, 2021 | 6 Minute Read
Figuring out the amount of life insurance you need is a task that relies on a number of factors. At its core, your life insurance policy can replace the income that you would otherwise provide for your dependents, in the event of your untimely death. But you also want to make sure this will be enough to support the lifestyle you work hard for them to enjoy. Here are a few approaches to achieving your life insurance goals.
The simplest strategy for setting your life insurance benefit is to multiply your annual income by six, eight or some other factor. This is the type of “back-of-the-napkin” estimate that will give you a ballpark estimate you can feel good about. But after you make the calculation, you’re going to have to ask yourself, “Is this really going to be enough?”
There’s a more precise way to calculate the amount of income your family would lose in the event of your untimely death. For this multistep process, start out by estimating your average annual salary for the remainder of your career. Then figure out the portion of your income that supports your dependents. It’s usually between one-half to two-thirds of your gross income, with higher earners on the lower end of the range.
Now that you know the annual amount of income you’d need to replace, there are a few ways to figure out how much to leave to your dependents. The simplest is to multiply this annual amount by the number of years left until you retire.
For a 35-year old expecting to earn an average salary of $50,000 a year until age 65, this sum works out to $1 million. That’s two-thirds of $50,000, or $33,333, multiplied by 30.
A different approach to replacing your income is to contribute to what’s sometimes called an income stream for your dependents. Remember, your beneficiary usually receives your death benefit in the form of a tax free lump sum. You can consider leaving them with funds to use as principal in an income producing investment.
Granted, in a low interest rate environment, your beneficiaries might have to rely on market-based funds to generate income, and these always come with risk. A few bad years could greatly deplete, or even eliminate the principal. Since investment comes with risks and tax implications, it’s best to discuss your specific strategy with a qualified financial professional.
However, as an oversimplified example, investing $666,660 in a fund producing 5% annual growth would also generate $33,333 a year. Under this scenario, the principle would remain in place for as long as funds pulled out of the investment do not exceed the investment’s growth.
Potential ways to create a $33,333 revenue stream for 30 years. (Options 2 and 3 assume that market downturns don’t wipe out the principal in less than 30 years.)
If you could live with spending down the principle, you could also generate $33,333 a year by investing $512,328 in a fund also producing 5% annual growth. The difference is that, in this scenario, the principal dwindles down to $0 at the end of 30 years.
The latter calculation is based on factors found in a compound discount table, which helps calculate the principal needed to achieve specific goals. If you’re into these things, you can easily find a compound discount table online. But again, it’s best to discuss investment strategies with a qualified financial professional.
Now that you’ve seen a few different ways to calculate how to replace your income, you still have to ask yourself the fundamental question, “Will this be enough?”
The best way to answer this is to list out the immediate, ongoing and future expenses your spouse and dependents would have, in the event of the unthinkable.
(Pro tip: When it comes to listing out your dependents’ potential financial needs, paper or a spreadsheet work better than keeping these things in your head.)
Whether you are the primary breadwinner or a stay-at-home parent, your family’s immediate needs will include the costs of your funeral. Your survivors might also need to pay for professional services to settle your estate.
You should also consider funds to cover the initial rounds of bills and household expenses that could arise during your survivors’ time of most intense grief. And if you have any outstanding personal debts, such as credit card balances or student loans, you’ll want to include funds to cover these, too, so they don’t pass down on to your survivors.
Immediate expenses
Ongoing expenses
Future expenses
When it comes to your family’s ongoing needs, mortgage payments and living expenses are usually the first things that come to mind, for good reason. By including funds to cover the mortgage balance, or your share of it, you give your family the choice of remaining in your home for as long as they choose.
In this approach, living expenses will include day-to-day expenses, but not housing costs, which you’ve covered in the mortgage, or future needs, which you can also calculate separately (more on these below).
Consider including a lump sum for your survivors to live on or to use as principal in an income producing account, similar to the earlier approaches to replacing your income. As also previously mentioned, make sure to consult with a qualified financial professional before choosing a specific strategy.
For many families, the most common future expenses include the costs of higher education for children, if not the surviving spouse, as well as contributions to the surviving spouse’s retirement account. However, your family is likely to have specific needs that are unique to you. In general, you should consider including funds to cover anything else that could result in a financial loss to your family, if you were to die.
As you list out all these costs, you’ll start to gain clarity on the total sum your survivors would need. From this, you can deduct the value of your savings, investments and other assets that you plan to pass on, to come up with your total life insurance need. If you already have a life insurance policy from work or elsewhere, you can also deduct the face value of this policy (or policies) from your total need.