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How Much Life Insurance Do I Need?

How Much Life Insurance Do I Need?
Cynthia Paez Bowman
Updated October 12, 2021
4 Min Read

As you reach major milestones such as getting married, having kids and/or buying a home, you take on more financial responsibility for yourself — and your loved ones. Life insurance is an important part of financial planning. It ensures you don’t leave your family burdened with all the financial responsibility you helped carry while living.

Even if you don’t have kids or a spouse, you can buy life insurance and designate a favorite charity or church as the beneficiary. Most people who buy life insurance intend for the money to cover:

  • Burial costs
  • Outstanding debts
  • Estate taxes
  • Their lost wages
  • Medical or special care expenses for a dependent or loved one
  • College for kids or grandkids
  • Living expenses for a spouse
  • Mortgage payoff

Life insurance is popular because the death benefit or payout you leave behind is typically a tax-free lump sum that can be used for the ideas mentioned above and more. There are no rules on what your beneficiaries can use the money for. A million-dollar policy with your spouse as the beneficiary isn’t considered taxable income. Therefore, he or she will receive the full $1 million, tax-free, to spend as desired.

Calculating How Much Life Insurance You Need

There are four ways to calculate how much life insurance you need. Each method has its benefits and drawbacks.

1. Work backward

One way to calculate how much life insurance to buy is to look at how much premium you can afford to pay each month instead of the policy total. For example, you may have $150 per month available for a term life policy. After getting a few life insurance quotes, you find that the amount would buy you $500,000 in coverage.

Pros:

  • The simplest way to buy life insurance
  • You’ll stick to an amount you can afford.
  • You can work on supplementing the death benefit in other ways, such as paying down debt or contributing more towards your retirement income.

Cons:

  • The payout may not be enough for your survivors’ expenses.
  • You may miss out on special policy features just above your set budget.

2. List out your financial obligations

On the other side of the spectrum, you can list out all the financial obligations you’d like to fund. It will take some time to create a thorough list of expenses.

Add up existing debts and bills, plus other costs or expenditures. Subtract savings, investments and retirement funds from the amount and you’ll arrive at the target number.

Pros:

  • The most detailed way to answer “how much life insurance do I need?”
  • The research process will give you a financial snapshot of your debts and overall net worth.
  • Non-essential expenses that may be important to your family members can be included in your detailed list.

Cons:

  • The most time-consuming way to figure out how much life insurance to buy.
  • Your survivors may not use the money as you intended.
  • The amount may not cover changing or unforeseen costs.

3. Multiply your income

Give your family time to adjust to the loss by replacing your income for a set amount of years. Multiply your annual income by five, seven, ten or your number of choice. Fewer years of income replacement works best if you have savings in addition to life insurance and/or older kids close to becoming independent.

Pros:

  • A quick way to calculate the death benefit without underestimating the amount
  • Replaces your income for the number of years you choose

Cons:

  • May not cover larger expenses such as college tuition
  • Lacks the deep analysis of your family’s financial situation

4. Use the DIME method

Lastly, the DIME method is the most comprehensive way to figure out the best life insurance amount. It breaks down as follows:

  • Debt: Set an amount aside for taxes and debts you may owe, such as student or personal loans.
  • Income: Multiply your annual income by the number of years you’d like to guarantee earnings.
  • Mortgage: Add the balance of your home loan.
  • Education: Estimate the costs of private school and college.

Compared to the other ways to calculate life insurance, going with the DIME approach ensures you cover all the bases.

Pros:

  • The most thorough
  • It’s easy to remember DIME
  • Accounts for all the life stages and milestones

Cons:

  • It’s likely the highest (and most expensive) amount of life insurance.
  • May be more than your loved ones need, overinsuring your family.

Life insurance for employees and non-employed

Many employers offer life insurance as part of an employee benefits package. Group life insurance through an employer is typically cheaper than an individual policy, but it may have limitations:

  • You’ll have to stick with the insurance company the employer selected.
  • Your workplace may set limits on the death benefit amount.
  • You risk losing coverage if you leave the company or the employer downsizes and eliminates life insurance.

Life insurance for employees is best as supplemental coverage. As with the non-employed or freelancers, shop around for life insurance that gives you full control of the decision-making.

How much life insurance can I afford?

Leaving loved ones $1 million sounds like a no-brainer, except that the policy’s monthly premiums may be more than you can afford to pay. Finding the balance between how much is enough life insurance — and what you can afford — is the challenge. The amount you can afford may be more (or less).

What is the next step?

Now that you have a better idea of how to calculate life insurance, get a few life insurance quotes to compare. When shopping for coverage, remember five important things:

  1. The death benefit is not necessarily guaranteed: If you choose a lower-cost term life insurance policy, you’re only insured for a certain number of years (typically 10, 20 or 30 years). Survive the term and the death benefit (plus the premiums you paid) are gone. To avoid this, choose a permanent life insurance policy with no expiration date, such as Whole Life, or buy a rider that refunds the premiums you paid over the years.
  2. Over-insuring is expensive: Buying more than your family needs sounds great, but the higher premiums could hurt your budget or affect other parts of your financial plan, such as retirement contributions or investments.
  3. Communication is vital: Talk to your spouse or family about your life insurance plan. Their input could provide insight into how much coverage they’ll actually need.
  4. The funds can be used however the beneficiary wants: You may calculate the amount based on what you envision the money for, but the beneficiary may decide to spend the death benefit differently.
  5. Life insurance should be part of a financial plan: For life insurance to work well, get your financial life in order by having an emergency savings fund, paying down debt and regularly contributing to your retirement fund.
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