One of the biggest questions many have when it comes to financial planning has to do with how much life insurance they need.
There are some rules of thumb, such as getting seven times or 10 times your yearly salary in coverage, but, really, how much life insurance you need comes down to your personal financial situation, and what you hope your life insurance will accomplish.
Why Are You Getting Life Insurance?
The first thing you need to figure out is why you are getting life insurance.
Most people get life insurance to help protect their families in the event that the unthinkable happens. If you are getting life insurance for these reasons, you will need to consider income replacement and debt repayment.
Others choose to get life insurance as an investment, or even as a way to provide an inheritance. Some view life insurance as a way to help their families pay estate taxes and funeral expenses. Since life insurance is not subject to income tax for the beneficiaries (it might be subject to state and federal estate taxes), some like to use it as part of their estate planning.
When determining how much life insurance to get in these cases, you will have to do your best to estimate estate taxes, funeral expenses and other costs, when choosing a policy amount.
For the most “regular” folks, though, figuring out life insurance requirements depends on estimating how much will be needed to pay off debts and provide income.
Deciding How Much Life Insurance to Get
As you decide on how much life insurance you need, it is important to consider likely expenses.
First of all, add up the debt that you have. If you want to ensure that your family has a place to live after your passing, you can include the balance of your mortgage in your calculations.
After you have added all of that up, you can figure out how much money your family will need to replace your income.
You can do this a couple of ways. One way is to figure out how much capital your family would need if the money was put into an income producing portfolio and 4% was withdrawn each year. If you earn $50,000 a year, your family would need $1.25 million in capital. According to different economic theories, this method would ensure that money lasts indefinitely. You might want to add that number to estimated funeral expenses and your debt repayment amount so that your family has the requisite capital after everything is taken care of.
Another way to figure out what your family needs is to add up yearly expenses or income, and figure out how long they would need to be provided until your youngest child is of age.
If you make $50,000 a year — and assume that you spend that much — and your youngest is five years old, you would need to figure $50,000 a year for 13 years (until the youngest turns 18). In our example, that would be $650,000. You can then add other expenses that you have, such as debt pay off, funeral expenses and other things you would like to pay for (such as college costs) to the base income replacement number.
Other things to remember when deciding how much life insurance you need include retirement account contributions, the cost of benefits (like health insurance), and the cost of services that might need to be hired (like child care or housekeeping).
Deciding on insurance amounts is a personal exercise in financial planning. Run the numbers to get an idea of what your family would need if you were gone, and base your insurance policy amount on that.