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How Much Life Insurance Do I need?
If you have already determined that you need to get life insurance, then the next step to consider is how much life insurance you need. There is no set rule to determine how much life insurance you need but we provide some great starting points to consider. And don’t forget to check out our charts that will help answer the follow-up question: how much is life insurance?
Note: it is important to understand from the outset that typically life insurance is not taxable. That means you do not have to add in additional life insurance coverage on top of your need to cover tax, because Uncle Sam normally does not touch any of the proceeds. However, be aware that is not always the case and you need to understand how to properly name your life insurance beneficiary to avoid any needless taxes to your estate.
10 Times your Annual Income Approach
Consider this. Suppose I told you I would give you your entire death benefit today in return for all of your paychecks for the rest of your life. Would you take the offer? If not, then you probably need more life insurance.
Most people are under-insured or not insured. To figure out if you have enough life insurance you might want to take your current salary excluding taxes and multiply that by 10. For example, if you make $75,000 a year but $20,000 is taxed, your net income is $55,000. For you to have enough life insurance under the 10 times your salary rule, you would need $550,000 of coverage.
DIME Formula or Method
Under this approach, known as the DIME formula or method, you consider four key areas: Debt, Income, Mortgage, and Education.
Debt: Add up all your current debt obligations, including student loans, credit cards, car loans, etc. You should also throw in the cost of your funeral for good measure. The number you come up with when adding all these categories is your total debt.
Income: Similar to the 10 times your annual income formula above, take your annual income and multiply it by the number of years until your youngest child reaches a predetermined age, such as 18, 21, or 25. Therefore, if your income is $50,000 a year after taxes and your youngest child is 6 and you want income protection until he or she is 21, then the income formula would be $50,000 x 15 years = $750,000.
Mortgage: Add in your current home mortgage balance.
Education: Determine the cost of sending your kids to college. You should probably budget around $50,000 per child for private college and $25,000 for in-state public college, per year. Source. However, with inflation that number is probably going to be much higher in 10 years.
One thing the DIME method does not take into account is your investments and savings. If you are setting money aside then you are “self-insuring” and you can lower the total amount of life insurance you need in contrast to how much money you are currently saving.
Human Life Value Approach
One is the “Human Life Value”(“ HLV”). Here is the best definition I could find, Human Life Value (HLV) is defined as the present value of all future income that you could expect to earn for your family’s benefit, plus other value you expect to contribute, less taxes and personal consumption through your planned retirement date. Source
The Human Life Value can be broken down into an easy formula which basically states that to correctly asses you HLV you need a life insurance amount equal to 15-20 times your salary. That seems a bit high so let's try and break it down into more usable numbers.
Under the Human Life Value Approach, you take your current income earning power and attempt to figure out future income earning power. To put it another way, if you died today, how much income would your family miss out on over your entire life?
If you are like most, peak income years occur in your late 40s and early 50s. From there, your income will move sideways until retirement. This information is important to know for someone who is 30 trying to determine how much life insurance to get. That same 30 year old making $40,000 now may make $60,000, $80,000, $120,000 or more down the road.
You don’t need to use the total income. Instead, subtract taxes and personal living expenses or use 70% of the total income. For example, if you projected income is $100,000, then 100 times 70% equals $70,000.
Once you decide on what your projected income will be, decide how long your income needs to be replaced for, i.e. 5, 10, 20 years, etc. A good rule of thumb is to replace your income until retirement, or age 67 currently.
Then, figure in a small (2-5%) rate of return on the capital, which will lower the total life insurance need.
Next, multiply your net income by how long income needs to be replaced for, (i.e. 5, 10, 20 years.)
Finally, calculate the present value of your future earning power using your small rate of return.
One thing the Human Life Value approach does not take into account is your investments and savings. If you are setting money aside then you are “self-insuring” and you can lower the total amount of life insurance you need in contrast to how much money you are currently saving.
Business owners fall into two categories: sole proprietors and all other types of business structures, such as Corporations, LLCs, LLPs, Partnerships, etc.
Sole Proprietor: Sole proprietors need to be concerned with a few things. Probably the highest priority is taking care of his or her family. A sole proprietor should have enough life insurance coverage to provide income replacement. This is particularly true for the business owner who has no interested heir to take over the business upon the owner’s death.
A less important but serious concern should be on the family owned business succession plan. Consider how much life insurance is needed if a parent dies and the kids are forced to take the reins. Additional life insurance beyond income replacement will be needed if there are debt obligations to creditors or if cash flow is tight or non-existent.
Corporations, LLCs, LLPs, Partnerships, etc.: For owners of larger businesses, there are different considerations. Three different business owner insurance should be considered.
How much life insurance do I need if I am wealthy?
First, let’s define wealthy. If your total estate is valued at 10 million or more, you are wealthy, even if you don’t feel rich.
Ok, so if you fit into that elite category, how much life insurance do you need? The answer comes down to two primary factors: your state inheritance tax and the federal estate tax exclusion. Some states have an inheritance tax, while most don’t. However, everyone falls under the federal estate tax if their estate is valued above $5.45 million or $10.90 million for a married couple.
So how much life insurance do you need? That depends on several factors but you should consider getting enough life insurance coverage to cover how much your estate will be taxed when you die. If your estate is over the federal exemption limit, you will be taxed 40% on the amount that exceeds the exemption. That is a hefty price to pay.
For example, if your estate is valued at 7.5 million, your estate tax will be on 2.1 million. At a 40% clip, your estate would owe Uncle Sam $840,000. Therefore, you should get a $840,000 life insurance policy to cover the loss.
What type of life insurance should I choose?
Life insurance comes down to the classic argument of permanent life vs term life. It is important to know the difference between the two. Equally important is understanding that life insurance is not an investment. Which type of life insurance policy is best for you is based on several factors. The primary factor you should consider is: PRICE.
The best life insurance is the one you can afford. If you cannot afford it, what good does it do you? Obviously, the best policy would be one that lasts your entire life. However, not everyone can afford $1,000,000 whole life insurance. Nor does everyone need that much coverage for his or her entire life. This is why layering life insurance policies can be so valuable.
Consider Layering Policies
The reality is, the amount of life insurance you need today will probably be less than the amount you need in 20 or 30 years. The one exception would be for the very wealthy, who need life insurance for estate planning purposes. But for those of us who are not the uber rich, our life insurance need goes down as are dependents move closer and closer towards independence.
One method to use to have the necessary coverage today but with a smaller price tag is to layer your life insurance policies. This is accomplished by buying multiple policies, such as
For example, suppose you need $1,000,000 of coverage for 20 years because you have a newborn baby and a couple other children in the home. It may be wise to purchase a smaller whole life policy that build cash value so that your family can use it for paying final expenses and burial costs.
However, you also want to make sure your income is protected into retirement. At 35 years old, that means you need a 30 year term policy. However, your kids will be out of the house in approximately 20 years, so you don’t need to keep the full $1,000,000 of protection in place for 30 years.
Instead, you can buy a 10, 15, or 20 year term life policy in addition to the 30 year policy and the whole life policy.
So in the end, this scenario would look something like this: You have a $50,000 whole life policy (building cash value that you can borrow against), you also have a 15 year term policy for $500,000, as well as a 30 year policy for $500,000.
Overtime, the whole life policy will build enough cash value that you can simply turn it into a paid up policy and stop making payments. Additionally, the 15 year term will end, so payments stop as well. And the 30 year term is cheap, since you bought it at age 35.
And another thing, the 15 year and 30 year policies are convertible to permanent coverage. Therefore, if you ever become diagnosed with a health issue you can always convert all or a portion of your coverage to permanent life insurance and keep it until you die.
But don’t forget the most important point, which is this: if you die while your kids are young you leave behind over $1,000,000 for those you love.
Also, don’t forget about your spouse. Factoring in retirement income for your spouse is crucial, since many spouses will only receive social security benefits in retirement. And unfortunately, social security benefits are not enough to live on.
Marriage: Consider more coverage to provide for your spouse.
Birth: When a new child arrives it might be time to add more life insurance.
Buying a home: with the purchase of a home, your debt obligations increase. Upping your life insurance might be just what the doctor ordered.
Starting a Business: Utilizing life insurance in a buy sell agreement or as key person insurance will help make sure your business succession plan is on solid footing.
Retirement: Consider taking no survivor benefits on a pension and supplementing the difference with life insurance. Also, did you have life insurance coverage through an employer that is not portable or is too expensive to keep? You might need to up your coverage amount in retirement to meet the potential shortfall.
In the end, how much life insurance a person needs varies greatly from one person to the next. If you want to talk over your life insurance needs, give the professionals at TermLife2Go a call. We will gladly spend the needed time with you in order to help you come to a number that you feel comfortable with, with a policy that you are glad to have.