How much life insurance do I need?

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You buy life insurance to provide for your dependents when you’re no longer around to do so. Since none of us comes with an expiration date and since life by its very nature is all about change, it can be tough to accurately predict your family’s financial needs years from now.

So, how do you answer the question, “how much insurance do I need?” Bankrate’s life insurance calculator can walk you through the basics.

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How much life insurance do I need?

The answer to the question of, “how much term life insurance do I need?” depends on several factors, including:

  • Your age
  • The ages of your spouse and children
  • Your income
  • Your mortgage and other debts
  • College expenses for your children and/or spouse
  • The bill for final expenses

“You want them to get through this traumatic event with some palatable options, but that’s it,” says Glenn Daily, a fee-only insurance adviser based in New York City. “One famous agent once said the goal of life insurance is to let your family ‘stay in their own world.’ It doesn’t necessarily mean they have to maintain their current lifestyle. Maybe your spouse would decide to do something entirely different.”

To address this guessing game when purchasing life insurance, insurance companies and financial planners have devised models to help you zero in on this perpetually moving target. Three approaches are the most common.

1. The DIME Formula

The old rule of thumb was to take your income and multiply it by 10. This was the industry’s standards for many years. However, it failed to account for several things.

Most notably, it didn’t take into account your family’s living expenses. This could vary wildly if you have one child or four. Moreover, it does not offer protection in the case of one parent being a homemaker.

As grim as it sounds, what happens if both parents die and only one has coverage? The 10 Rule left many questions unanswered. In its place came the Dime Formula, which takes into account the following:

  • Debt and final expenses: Come up with a solid number based on all the debts you owe, and include the costs of final expenses for each parent.
  • Income: For income, a good rule of thumb is to think about how many years your family would need income in your absence. Multiply this number by your annual income.
  • Mortgage: Include the total amount owed on your mortgage and the property taxes assessed. Similar to income, think about how many years your family would need the money for property taxes then multiply your annual tax total by those years.
  • Education: Determine the total cost of educating each of your children through high school as well as college.

Once you come up with that number, double that for both parents. That way, if something were to happen to both, your family would have sustainable income well into the future.

2. Shortfall calculation

The shortfall approach works backward from the annual income you would want to leave your spouse and family for X number of years. After you decide on this target number, subtract all other sources of annual income that will be available to them, such as your retirement accounts, pension, savings, your spouse’s salary and Social Security. The resulting number is the shortfall you’ll want to replace with life insurance.

“People overlook that they’ll likely have other assets,” says insurance literacy advocate Tony Steuer, author of “Questions and Answers on Life Insurance.” “Right now, you may be just starting to save for retirement, but by the time you actually retire, you’ll have $500,000 or $1 million in your retirement plan, so you may no longer need that $500,000 life insurance policy.”

3. Income generator

Some prefer to set their sights on building up a large life insurance investment that would generate earnings to provide a beneficiary with annual income. For instance, $1 million invested using a conservative average annual yield of 4 percent could provide $40,000 a year to a spouse or family in perpetuity.

“While the need for life insurance is temporary for most dependents, there are exceptions, such as a special-needs child who will never be self-supporting, where the need lasts the rest of their life,” says Steuer, who also is the director of financial preparedness for the insurance consumer group United Policyholders.

Daily says that while no single model fits all families, everyone can benefit from test-driving one or more.

“The good thing about looking at the future and not just the present is that you’re going to get some idea of whether your insurance need goes up, down or remains about the same,” he says. “That’s going to have some relevance for what type or combination of insurance you should buy.”

Factors to consider when buying life insurance

You may be asking yourself, “how much life insurance should I have?” Consider these factors:

  • Your age: Premium rates generally increase with age. If you’re young, term life (covering a certain number of years) is the cost-effective way to cover your risk and keep your future life insurance options open.
  • Age of spouse and children: This helps you estimate how many years of income replacement they’ll need if you were to die.
  • Mortgage and debts: Wrap your home mortgage, car loans, student loans and other debts into your life insurance planning.
  • College expenses: Factor in future education expenses for the kids and possibly your spouse. Tuition and fees for four-year colleges have been increasing by up to 5.2 percent, on average.
  • Your current income: If you’ve retired your debt and laid aside college funds, you may not need to replace your full income. Some advisers recommend a 50 percent replacement as a starting point.
  • Funeral expenses: The average cost for a funeral, burial and related expenses run more than $7,000, while cremation costs range from $2,000 to $4,000. Don’t stick your loved ones with the final bill.

Sources: Etti Baranoff, Glenn Daily, Tony Steuer

Choosing your life insurance policy

Once you arrive at a ballpark coverage figure, Steuer suggests letting your individual circumstances dictate whether to use a cash-value whole life (permanent) policy, term life or a combination.

“One tactic I recommend is to separate the planning for your spouse from the planning for your children, because the timeline for needing coverage may differ,” he says. “If you have a 15-year-old child, then you really only need a 10-year term policy to see the child through college. But if you’re 45 and plan to work for another 20 years, your nonworking spouse is going to need a 20-year life insurance policy, at least.”

All three experts caution against falling for the siren song of cash-value life insurance products that promise big investment returns that you might tap into while you’re still on this side of the lawn.

“That’s one of the main reasons people overbuy,” says Steuer. “You want to strip out all the distracters and address your actual need. Don’t expect something from your life insurance that you wouldn’t expect from your other insurance policies.”

Baranoff puts it even more succinctly: “Life insurance is for widows and orphans.”

The bottom line

Life insurance gives you peace of mind your family will have sustainable income once you pass. By taking these factors into account, you can determine how much life insurance you need.