How much life insurance do you REALLY need?

On Friday, I shared a guest response to a reader question about life insurance. Many GRS readers rightly complained that it didn't do a good job of answering the question. One reader — Mike from Four Pillars and ABCs of Investing — took it upon himself to write this response.

One of the most common issues that people with any kind of dependents face is, “How much life insurance do I need?”.

This is a tough question to answer in a simple equation; there are quite a few variables which affect the amount of insurance needed. First off, I'm only going to discuss term insurance. For most people, that's the only type of insurance to consider.

J.D.'s note: I said this over the weekend, and I'll say it again: Permanent life insurance (such as whole or universal) is not a bad idea for everyone. For some folks, it absolutely makes sense. But for the average joe, term insurance is usually the best option.

One of the key factors to consider is what kind of lifestyle you want your family to have if you pass away. How much financial impact will your death cause to your family? Do you want them to be filthy rich if you die? Do you want your partner to continue to work? Do you want them to be debt free? Is it important that they keep the same house? Will they be fine without any insurance?

The amount of insurance you might need/want will vary widely depending on your current financial situation. Let's look at two general situations.

Situation one: You want enough insurance to cover a specific use and don't need any insurance to provide future income for your spouse.

This might be the situation where both spouses are working and making decent money and have no kids. In that case, they might decide to get enough insurance to pay off all debts, at which point the survivor should be fine since they'll keep working.

This calculation is pretty easy. Just add the amounts of debts and whatever other costs you want covered, and that's how much insurance you need. The problem, of course, is that the amount of debt you have now and the amount of debt you have in 10 years will be quite different. (Hopefully, you'll owe less in 10 years!)

There isn't a lot you can do about this other than buy different terms of insurance. For example, you might buy $100,000 for 10 years and $100,000 for 20 years. You can also cancel insurance at any time, so one strategy is to insure for the entire amount necessary and, if you end up debt-free, then just cancel the insurance. Life insurance needs are very inexact so sometimes you just have to pick a reasonable amount and go with it.

Example: Mary and Fred both have good jobs and will continue to work if one spouse dies. They've decided that they'd like to have enough insurance to cover the mortgage. The mortgage is $300,000 so they decide to get $200,000 of insurance for 10 years and $100,000 insurance for 20 years. The idea is that they will have paid down the mortgage enough in 10 years that they don't need the original $300,000 amount anymore.

Situation two: You want insurance which will provide future income for your spouse/kids.

This is a bit more complicated since you're now dealing with a lot of future assumptions. Regardless, for this situation an incorrect amount of insurance is a heck of a lot better than no insurance at all, so let's continue.

In this case I'd suggest that you start with all current debts and assume you need enough insurance to cover that amount. That's the first part of your insurance needs. The second part will provide an investment portfolio large enough to provide the desired annual income. To do this calculation, you can use the 4% withdrawal rule to be conservative.

The amount of insurance you buy will be the sum of these two numbers.

Example: John and Sue are in their 30s, have two kids under five, a mortgage of $300,000, and other debts equaling $40,000. Sue is a stay-at-home mom who might return to work one day. They've decided that if John dies they want to have enough money so that Sue doesn't have to work again if she doesn't want to, but she won't be filthy rich. They're assuming that $40,000 of income per year will accomplish this goal. They have no savings of any type.Step one: Add up the debts = $340,000 insurance needed.
Step two: Calculate the portfolio size necessary to provide $40,000 per year. $40,000/0.04 = $1,000,000.Total insurance needed is $1,340,000.

You can see from this example that future income is expensive! Using the 4% rule is fairly conservative. You might want to consider using a 5% or even 6% rule if the income needs are for a shorter term (i.e., if the insurance is only to cover a 10-year income gap before retirement age).

Other facts to consider when looking at future income:

  • Retirement savings. If a couple is in their 50s and has a good retirement portfolio built up then the survivor might only need income until they reach 65 at which point they can live off the retirement savings.
  • Pensions. This is probably more applicable to older people, but if Social Security and/or other private pensions are in the not-to-distant future then they should be factored in as well.

In summary, ignore all rules of thumb and insurance salespeople, and sit down to figure out how much insurance you need/want. Think about what it would be like financially if you or your spouse died and there was no insurance. Think about what you would like things to be like financially, and calculate how much insurance is necessary to fill the gap. Another approach is to pick specific insurance amounts and then apply those amounts to your situation. For instance, if you had $500,000 of insurance and you died tomorrow, what would your spouse do with the money and what would their financial life be like?

Don't get hung up on details. It doesn't matter how accurate your estimate is because things will change and then you'll be over- or under-insured. I did a case study on myself only a couple of years ago where I went through the process for determining how much life insurance I needed. Things have changed so much in the last two years for me (I can't believe how much) that I'll have revisit this calculation: We have two kids now, our debt is less than half of what it used to be, my business is doing extremely well, and I don't think I'll keep my day job as long as I'd originally thought. (I get a lot of my insurance through work.)

Too much insurance is expensive. It's easy to just get a large amount of insurance (just to be safe), but the reality is that if you are over-insured, then you're paying a lot of extra money over 20 years. Plus, you don't want to give your beneficiaries any extra incentive to bump you off! 🙂

J.D.'s note: Another way to come up with a coverage amount is to use this handy online calculator from the nonprofit LIFE Foundation.

More about...Insurance

Become A Money Boss And Join 15,000 Others

Subscribe to the GRS Insider (FREE) and we’ll give you a copy of the Money Boss Manifesto (also FREE)

Yes! Sign up and get your free gift
Become A Money Boss And Join 15,000 Others
guest
48 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
chacha1
chacha1
10 years ago

Thanks Mike! I was confident that follow-up would be swift and substantive. This is exactly the method I used to calculate our term life policies. 2 spouses, both working and content to continue so, each of whose incomes would cover current expenses once debt payments are out of the picture … $40k in debt … (it’s less now!!) $30k in annual rent/utilities … $30k to replace 3 old vehicles with one primo new one … = $100k to get the surviving spouse financially free and clear and in a position to move forward with life; after, of course, a year… Read more »

Ted @broketofree
Ted @broketofree
10 years ago

Great look at life insurance. I was talked into life insurance by my agent (whom no longer is my agent) and I felt like I bought way to much. The stress my agent put on me was to get my wife and kids enough money so they would not have to worry for a number of years. Somehow I was a bad father for not having a lot of life insurance. Which was way too much for our budget and needs. Thanks for making it clear that we can have different ideas about life insurance, and it is okay.

Jim
Jim
10 years ago

Thanks for the posts on the insurance topic. We’re running through this now, so it is nice to read a bit of different view point than what the Insurance Salesmen want to sell. (Of course, selling is their job!) We’ve come up with our own numbers and durations, less than the sales team’s numbers. We tried to take in to account mortgage, child care, college funding, living expenses, etc. Of course we _want_ the seven figure payoff if one of us dies, but is that really right? Do we want to pay the monthly now for that eventuality? If I… Read more »

Nicole
Nicole
10 years ago

Don’t forget to insure a SAHP– the services provided will have to be replaced at market value. Though, to be honest, we just used a heuristic from some online thing… enough insurance to replace 10 years of income for a term of 25 years or something like that. The future is so uncertain that getting anything more fine than that didn’t seem worth the time. We satisficed when our son was born so that we would actually have insurance… if we had tried to optimize, our life insurance probably would still be in the same situation as our wills, that… Read more »

sashie
sashie
10 years ago

I think the other issue to perhaps consider for a future post topic is disability insurance. The likelihood is so much greater that one of us will be disabled than the likelihood that one of us will die. So, we looked into disability insurance. This is something to look into especially if you have a highly specialized (and highly paid) job that you would not be able to do if you become disabled. Just another thing to think about that goes along with this topic. Again, as with all insurance, something that you need to really investigate before you start… Read more »

ami | 40daystochange
ami | 40daystochange
10 years ago

Great follow-up post, like having specific guidelines. (and the calculator provides some great starting points for discussion).

I second Sashie’s (#5) comment that disability insurance would be a great topic. Seems like most people don’t think of getting disability coverage, which can be surprisingly expensive – yet more people and families are likely to benefit from disability insurance than life insurance.

Brent
Brent
10 years ago

A welcome, well reasoned approach to coming up with a number. For me its still $0, but I have some through work regardless. When you are single, without debts or children the question is much simpler.

miki
miki
7 years ago
Reply to  Brent

If you haven’t set aside money for your funeral, you need insurance for that. Don’t leave your family scrambling to pay for your burial.

Poultry in Motion
Poultry in Motion
10 years ago

Nice article, and a good follow-up. I’m with Sashie in that I *think* I understand the term insurance thing, but I honestly don’t have my arms around disability insurance. I’d like to find out more specifics (is there a term policy, what does it cover vs. what’s not covered, etc).

JD, I’m glad you’re back and I’m glad you’re done w/ the book. The comments on some of the past few posts seemed a bit off-base while you were gone. I look forward to reading your new book, but I look forward to your daily GRS posts more 🙂

Chris
Chris
10 years ago

I first started looking at term-life insurance when I was 25. I actually found out the rates for 10 to 30 yr terms don’t change much from age 25-35. Therefore, to have life insurance until age 65, getting a 10 yr followed by a 30 yr term is MUCH cheaper than a 30 followed by a 10.

That’s what I observed, at least.

Jacque
Jacque
10 years ago

Mike, thanks for the post.

JD, I’d also vote for another disability post!

Sierra Black
Sierra Black
10 years ago

Thanks for posting this. It’s a topic I really know next to nothing about, and this was a good primer for understanding why my family needs life insurance and how much we should have. I’m confused about how this relates to the life insurance policy my husband has through his work. Is that a term policy?

lhamo
lhamo
10 years ago

Big improvement over the last guest post, but this one (and the calculator) STILL ignore the issue of SSI survivor benefits. Come on people! This is potentially a major source of income for families with minor children who suffer the death of a wage-earning spouse. Why is everyone ignoring it? Am I missing something here?

I can’t get on the social security site at the moment, but it looks like there is a whole publication devoted to the topic. If this is not required reading for insurance agents, it should be:

http://www.ssa.gov/pubs/10084.html

Greg C
Greg C
10 years ago

As far as Social Security survivor benefits go, I know someone on the last post made a comment about getting a lot if you have many kids. HOWEVER, on my social security statement it clearly says the maximum family benefit is only 2x the individual survivor benefit. In other words my family would get the same for a wife and 2 kids as a wife and 1 kid. It reads spouse $XXX, child $XXX, maximum family $X,XXX ( which is wife+1 child). I agree that it can be a significant source of income, though. At least temporarily. Keep in mind… Read more »

Greg C
Greg C
10 years ago

My preference would be enough money so that my spouse would never have to work again and children would make it through college,etc. I understand people who don’t consider these things necessary. However, it really depends on individual circumstances. For example, my spouse does not work now. She hasn’t earned income in a few years and has never earned significant income in her life. Despite being intelligent and capable and doing all the traditional “right” things ( graduated from college with high honors), she has never had much opportunity. I don’t see it getting any easier as she gets older… Read more »

Megan
Megan
10 years ago

I think too often people also forget to add funeral expenses which can be upwards of $5000-10000 or more. This is yet another important reason to have life insurance. Also our situation closely resembles the 2nd scenario except we dint have a mortgage. So it’s also important for the stay at home parent to at least have a small policy to cover funeral expenses and daycare that the existing parent would need after the partner’s death.

Ric
Ric
10 years ago

I sell life insurance as an agent for the largest P&C insurer in the US. I constantly stress it isn’t about dollars. It is about WHAT DO YOU WANT YOUR LIFE TO LOOK LIKE IF SOMETHING HAPPENED TONIGHT? Would your spouse go back to school? Move in with mom? Sell the house? Want to work part time until the kids are 15? There are NO WRONG ANSWERS!!!! ONLY YOUR ANSWERS!!! You would be amazed at what you learn about your spouse when you sit them down and say “if I was killed in a car wreck TONIGHT what would you… Read more »

almost there
almost there
10 years ago

Great post. My life insurance allows my spouse to keep the principle in effect for 30 years after I pass while living off the crediting rate of 5.14%. It has been that rate for a number of years. (example: on a million bucks, the income would be $51400/year-taxable, with a lump sum payment of the million tax free at the end of the 30 years or to our child if she were to pass before then.) Ask if that is the case with a prospective insurance policy.

Justin
Justin
10 years ago

Great post. My wife and I are still trying to figure out how much we really need (we don’t have kids so really its more to support each other in case something happens).

I definitely think its a tough question to answer because it depends on lots of factors- are both spouses/parents equally able to support the family? How old are your kids? What’s your current income level, and do you want your family to have just enough to scrape by or basically retire?

Brendan
Brendan
10 years ago

While it is important to get value for money I sure no spouse would complain that their deceased partner had too much insurance.

Dave
Dave
10 years ago

What about taxes? When I originally signed up for life insurance several years ago, I thought my spouse would have to pay taxes on anything over $500K, so I had to take that into consideration on how much to get in my policy. Has that changed? Was I wrong before?

Money Reasons
Money Reasons
10 years ago

I bought what I could afford at the time. I was banking on Social Security death benefits kicking in if I died. The SS death benefits would tide my wife over if I were to die back then.

Now since we have 2 kids, and college off in the distance, I up my coverage to 1/2 a million a few years ago.

CB
CB
10 years ago

Thanks Mike for the simple formulas. Of course as you (other commenters) have said, there’s much more than just picking a number.
Is there more in formation concerning when you need insurance vs when you could hold out. Like younger without kids or older and close to retirement or in retirement?

JD, Thanks for keeping your head when all about you were losing theirs.

Stacey
Stacey
10 years ago

Just a thought… it may be less expensive to buy one larger policy than two smaller ones. When we went to get insurance there was a very small difference in premiums for $100,000 vs $200,000 benefits. I haven’t done the math, but I’m going to guess that you’ll pay a lot more to get one 10-year policy and a second 20-year policy. And like the commenter above said, no one’s ever complained about getting “too much” life insurance after a loved one passes. It’s okay to ask for multiple quotes from your insurance agent! We asked for three different scenerios… Read more »

Derek Winters
Derek Winters
10 years ago

JD,

Please mention how you can “double” your life insurance by setting up a living trust instead of a will. This may have some upfront costs but the money can be transferred tax free and will protect anyone from viewing the assets of the estate.

PB
PB
10 years ago

It is not always possible to get term life insurance. If you have an illness, as in our case where my husband has juvenile diabetes, it is impossible. We got him a whole life policy when our children were very small (actually, before the last one was born) and have paid a large premium on it every month. At 62, he is extremely healthy, except for being chronically ill, but it makes no difference. The insurance company is now trying to talk us into letting the policy lapse, for no very good reason that I can see except that since… Read more »

DMB
DMB
10 years ago

There are a few major variables you can’t exclude when calculating the amount of insurance needed; inflation, health care costs, & college/grad school tuition (if you have kids). 20 yrs down the road that $500K will be worth closer to $200 or $300K. Also, based on the rate of tuition increases these days there is no way $500K will even begin to cover a 4 year private college. Lastly, as everyone has experienced care costs are skyrocketing and the survivor may/may not have coverage.

ABCs of Investing
ABCs of Investing
10 years ago

Thanks for all the kind comments! Is there more information concerning when you need insurance vs when you could hold out. Like younger without kids or older and close to retirement or in retirement? @CB – I think in those two scenarios you might want to play “what if?” and visualize what it would be like if one partner died tomorrow with your existing insurance coverage (which might be zero). Will the funeral costs be a burden? Will there be help from relatives? Can the survivor maintain their standard of living without their partner? (assuming that is what you want).… Read more »

Kelly
Kelly
10 years ago

Ric mentioned Return on Premium Term Life Insurance in in #16, but I haven’t seen any other info on it. Return on Premium means that if you outlive your policy term you are refunded all of the premiums you paid. I took out a 30 year ROP term policy at age 26. At age 56 if I outlive the policy I get a check for the 30 years of premiums I paid. It is more expensive than regular term, but it is a great option if you are younger and fully expect to outlive your term life insurance. The normal… Read more »

JenK
JenK
10 years ago

It’s also a good idea to discuss this with your spouse. My spouse doesn’t think he could afford the mortgage without me, but he ALSO doesn’t want to stay in our house without me. This reframes the question from “need enough money to pay off the house” or “need enough money to replace income” to “need enough money to pay the mortgage for a year or two while he’s getting himself together enough to sell.” That much? We already have in savings/easy-to-access investments. (We have no children.) Oh — and funerals? Another good thing to discuss beforehand, too. My mother… Read more »

largebill
largebill
10 years ago

Good post on a difficult subject. The problem for most folks is the person who should be most knowledgeable and helpful on the subject has a financial stake in getting us to buy the product. So, as customers we are naturally distrustful. Most important thing for folks to do is to periodically review their coverage and life situation.

Kevin Khachatryan
Kevin Khachatryan
10 years ago

I feel like this is a touchy with most people and I know many that don’t even want to discuss their insurance with their spouses.

However, one thing is for certain:
“Ignore all rules of thumb and insurance salespeople, and sit down to figure out how much insurance you need/want.”

They make their money selling you more insurance than you really need.

chacha1
chacha1
10 years ago

Re: funerals, I don’t really know – no personal experience – but isn’t there sometimes a significant delay in receiving a life insurance benefit? So you might want to have funeral expenses saved up in actual liquid cash, and not include that in calculating your life-insurance needs.

Or just go the way I plan to – whole body donation to the local teaching hospital. No muss, no fuss.

Single Person
Single Person
10 years ago

My job gives me life insurance, but I don’t need it, as I am single and childless, and since I am now in by 50’s expect this to be permanently true. (My parents have passed, and my siblings are financially independent.) I wish I could take the money they spend on life insurance and use it, say, to buy additional vacation days. My previous employer set up “flexible benefits.” You got a benefits allowance and decided how to spend it. For example, those with families could opt for more life insurance, single people for less. You could also buy up… Read more »

Lloyd
Lloyd
10 years ago

@Dave @ Accidental FIRE #20: Death benefits are received income tax free. Currently, there is no estate tax although that will almost positively change once Congress enacts legislation or simply does nothing. But even then, life insurance will pass tax free to your spouse. @Stacey #23: Every term policy has a policy fee associated with it usually between $50 and $75. Other than that, the rates for insurance will usually be proportional. So two policies for $100k each will cost the same as one policy for $200k plus the additional policy fee. Insurance companies usually have “bands’ where the cost… Read more »

Ouida Vincent
Ouida Vincent
10 years ago

Thank you, JD for acknowledging that Permanent Insurance is appropriate for some people. I have both term and permanent. I will die, for death is certain, just not during the term of my term insurance. For me, the permanent policies are to make sure that my estate is unencumbered by debt or the expenses of my death and my heirs can continue to derive cash flow from the investment properties I am leaving to them. This has been an awesome discussion. I do have disability insurance. What I can tell the folks asking about it. DI is twice as expensive… Read more »

Dwight Kellams
Dwight Kellams
10 years ago

We made the right decision for the wrong reason. As a dual income couple planning to have children, permanent life insurance was affordable. In the late 1980’s, permanent life insurance dividend scales were at a historical high and projections showed that dividends would pay the entire premium in 10 years. From 1987 on, except for a handful of years, the dividend scale went down every year. As a result the 10-year projection has taken 23 years to achieve. Talk about not being able to predict the future! However, our first and only child has a seizure disorder and is autistic.… Read more »

Rick McLeod
Rick McLeod
10 years ago

This is certainly a fantastic discussion on a difficult subject! I am an insurance agent for one of the larger property and casualty insurers, and we of course offer life insurance policies as well. The first thing I would ask the general public is to not necessarily knock the advice of your local agent. Many are well versed in the various aspects of the multitude of policies available, plus they have an interest in making sure you are properly covered. This interest is more than financial, by the way! Most agents make their living not by one policy, but by… Read more »

Andrea > Self Employed Rates Blog
Andrea > Self Employed Rates Blog
10 years ago

I went with the option of insuring for the mortgage plus a little more. While this isn’t the same as replacing an income, paying off your mortgage entirely opens up a huge amount of cash flow and removes the pressure of working for that amount of money.

Don
Don
9 years ago

You said: “Think about what it would be like financially if you or your spouse died and there was no insurance. Think about what you would like things to be like financially, and calculate how much insurance is necessary to fill the gap”. Life insurance is income tax-free cash that is placed in the hands of someone you love at exactly the time when they need it the most. When a beneficiary receives a lump-sum payment from the life insurance company… I seriously doubt that they ask if it came from term, whole life, universal, or any of a number… Read more »

sriniwas
sriniwas
8 years ago

My concern is what is the eligibility of a person for taking life cover for eg. if a person earns $84000 per year how much maximum life cover can he take. and also is this limit applicable on the total life cover taken from different insurance companies??

Ritz
Ritz
7 years ago

Roth

A very nice and informative article but why we have not considered the effect of inflation in the article. That will definitely effect our insurance cover amount.

ivan
ivan
7 years ago

Thanks for your article, very helpful

Derek - MoneyAhoy.com
Derek - MoneyAhoy.com
7 years ago

found this post from google. Very informative! I’ll have to research more what the differences are between term, whole, and universal.

Insurance Policy
Insurance Policy
7 years ago

One important point. Don’t pay too much for insurance. It shouldnt be costing more than 5% of your take home. Most of the so called analysts, experts talk about “more the merrier” but end of the day its up to that person/family. Check how much money you’d be ‘wasting’ for agent fee, insurance company fees. So go for term insurance and buy some ETF or some other funds with the remaining money.

TermLife2Go
TermLife2Go
7 years ago

Many young clients think they need a 30 year term. However, with term life insurance, the best bang for your buck is around a 15 year term for someone in their 20’s or 30’s. So much will change for a 20 year old or 30 year old in just 5 years, let alone 30 years. Ultimately, it comes down to the need. If you have young kids in the house, then a 15 year term for 1,000,000 compared to a 30 year term for 500,000, makes a lot more sense. In 15 years your youngest child will be able to… Read more »

Richard Gere
Richard Gere
6 years ago

Whole Life Insurance is designed to provide permanent life insurance protection. Along with the coverage, this policy is accompanied by a Tax Advantage investment. It provides insurance coverage for the entire life time, provided premiums are paid when due. Get a Whole Life Insurance Quote today.

Maria
Maria
5 years ago

I am a 60 yr old widow with three sons,ages 27, 25 & 22. I have a term life policy with my job that is paid by them and supplemental term life with my job that I pay for. I also read that at age 62 my policy will be reduced by 10% and will continue to be reduced. I have already paid over $3000 toward this policy, only because I did not want my boys to be without if I should die before they were no longer my dependents. Should I close out this supplemental policy now that they… Read more »

shares