Life insurance is a financial product where you, the policyholder, make regular payments to an insurance company, and the insurance company makes a lump-sum tax-free payment to your beneficiaries in the event of your death.
While this trade seems simple enough, there are a number of decisions to make. These decisions can meaningfully impact the financial futures of your surviving loved ones, causing anxiety over whether the insurance payout will be large enough to support them when you’re gone. At the same time, increasing payouts in the possibly distant future will have higher costs today, reducing income for current life expenses.
In this article, we'll help you understand how much life insurance you need, what coverage includes, and whether to get whole or term insurance.
Erika Taught Me
- Life insurance should be sufficient to pay off debts and replace income, at least through the youngest child’s college years
- There are a number of “rules of thumb” to calculate required insurance including based on your income and debts
- There are various types including term and whole. Term life insurance has more affordable payments but only promises payouts within a fixed time window
What is life insurance intended to cover?
Life insurance provides financial protection and support for your family in the event of your death. When the insurer approves your family's claim against your policy, you'll generally receive a lump sum death benefit. This money can be used to cover various expenses, including funeral costs, outstanding debts, and ongoing living expenses.
“The primary purpose of life insurance is to replace your income,” explains Brian Hershaff, executive sales agent for Comparion Insurance Agency, a subsidiary of Liberty Mutual. “So that your family doesn’t experience financial stress while grieving your loss.” To that extent, the insurance payout should be sufficient to cover final expenses, current and expected debts (e.g. education), and annual living expenses.
There are also policies that build cash and may provide living benefits for the insured.
How much life insurance do I need?
Insurance needs can vary meaningfully across families. For example, a double-income no-kids household may require relatively little life insurance coverage for final expenses and to supplement the surviving partner’s income. Alternatively, a household with a stay-at-home parent and multiple young children expected to attend college may require meaningfully more life insurance.
How much insurance you need can also vary over time for the same individual, for example, after getting married or having children, purchasing a home, or becoming an empty nester. “As life events happen, your life insurance needs change too,” explains Hershaff. “You should always review your life insurance plan annually to make sure it is still providing the proper protection for your family.”
While many people think it is just designed to cover the costs of a funeral, it can provide a much wider financial safety net for your family.
According to Hershaff, “Especially for families with young children, you’ll want to consider housing costs, income replacement, any debts (credit card, auto, and student loans), and future educational expenses for your children.”
While it's important to discuss details with a licensed professional before buying one, you can also consider utilizing a life insurance calculator online to get a baseline for what is enough life insurance and to help with initial budgeting. A life insurance calculator can help you get a ballpark for how much insurance you need by asking questions about your state of residence, age, height, and weight, and insurance needs such as duration and coverage.
How to estimate life insurance needs
Given the complexities of long-term family financial commitments, it's hard to provide a simple rule of thumb to determine how much life insurance coverage you need. That said, here are some baseline calculations to help you get started.
First, the most basic is the 10X method, which simply multiplies your annual salary by 10. So if you’re currently earning $100,000 per year, then you would target an insurance policy of $1 million.
Note that this method would not differentiate between the two very different family situations described above: that of a double-income no-kids household versus a single-earner household with multiple young children.
Another common technique for estimating how much life insurance you need is to apply the DIME method. Specifically, this entails adding up:
- (D): Existing debts (e.g. credit card, student loan, auto loans)
- (I): Annual income (multiplied by the number of years required for support)
- (M): Mortgage balance
- (E): Education costs for your children
You could make more refined adjustments by subtracting current financial assets such as bank and stock accounts or insurance provided by your job. You may also want to add back expected expenses such as funeral expenses or costs of supporting surviving parents.
“I always recommend having a life insurance policy last at least through their youngest child’s expected college years,” explains Hershaff.
The number of years you want to provide for your surviving spouse and children is a critical component of the DIME method. For an individual earning $100,000 per year, the choice of providing for the surviving parent for ten years or twenty years would be a difference of $1 million in required insurance.
Here is also where we see the value of regularly updating insurance needs. For example, an individual with a stay-at-home parent and young child may want to replace nearly 20 years of income. However, as that child ages and perhaps the spouse returns to work, that individual may require fewer years of income replacement.
Related: What is term life insurance?
How much life insurance do I need with a single income and two small children?
Meet Jack and Rebecca, a 40-year-old couple with two young children under 5 years old. Jack is earning $100,000 per year, while Rebecca is a stay-at-home mom. They have $200,000 left on their mortgage, $20,000 on a car loan, no credit card debt, and would like to save $125,000 per child for college expenses. They have $20,000 in a bank account and $50,000 in their 401(k) plan.
Using the 10X method, Jack would quickly calculate a need for a $1 million life insurance policy. Let’s try the DIME method.
Jack and Rebecca’s car loan and mortgage combine for $220,000, and they’d like to include a combined $250,000 in college expenses for their two children. Following the advice above, they’d like to replace annual income for 17 years, after which their youngest children would be expected to have completed all their education, for a total of $1,700,000 in replacement income.
Combined, this comes to:
- (D): Existing debts: $20,000
- (I): Annual income: $1,700,000
- (M): Mortgage balance: $200,000
- (E): Education costs: $250,000
We can reduce this by $70,000 in savings, yielding a total life insurance need of $2,100,000. This, of course, is much higher than the 10X method.
Is a $2 million life insurance policy enough?
Perhaps, but it depends on your family's needs. You'll need to balance life insurance needs with your current budget.
Considering our rules of thumb, a $2 million policy would cover individuals with income up to $200,000 via the 10X method.
Using the DIME method, a $2 million policy could also cover an individual with $100,000 income who wants 15 years of coverage and has an additional $500,000 of debt, mortgage balance, and expected education costs for their children.
What is term life insurance vs. whole life insurance?
“Term insurance is like renting an apartment — you would have it for a set time, which I’ve seen range from 10 years up to 40 years,” explains Hershaff “Permanent (whole) policies could be like buying a house where it can build equity, otherwise known as cash value. That cash value can provide living benefits including a possible income stream during retirement. Term insurance generally has lower monthly premiums due to its temporary nature.”
Hershaff noted that many individuals have a combination of both term and whole insurance, which can make sense. For example, an individual may consider choosing whole insurance for the expenses they know will be necessary whenever they pass (e.g. funeral costs or charitable gifts) while utilizing the temporary nature of term insurance to regularly update the desired life insurance payout as they age and life changes occur.
Disclosure: Brian Hershaff is the author’s brother. He has twelve years of experience as an insurance agent and has been an 8-time Comparion presidents club winner.