It’s hard to get a straight answer when it comes to life insurance, as it seems like most people you can ask for guidance are trying to sell you some. However, you can do basic calculations to help determine how much and what kind of insurance you should have. Many financial websites provide easy-to-use calculators that you can try, like this one from Forbes, and there are manual methods you can use as well. None of the methods are hard and true, however, so our advice is to find what makes the most sense for you and tweak it as necessary.
The Gist
For an overall big picture, calculate your life insurance needs with this basic equation:
[financial obligations you want to cover] – [existing assets that can be used toward bills] = your life insurance need.
Common items to consider include whether your family will need replacement income after your death, mortgage payments if they aren’t covered by income replacement, and any other large debts you may have. Existing assets that could be used toward paying these debts include existing life insurance (perhaps through your employer), and any savings that you have (including any 401(k) plans or college 529 accounts).
The DIME Method
If acronyms are your thing, you can calculate an estimate for your needed coverage using DIME: Debt, Income, Mortgage, and Education.
Debt: Try to estimate how much debt you would leave behind, including credit card debt and other loans.
Income: Generally, you should multiply your annual income by the number of years you want to provide income replacement for your family.
Mortgage: Add your mortgage balance.
Education: If you have children headed to college soon, are still paying off student loans, or are currently in school yourself, try to calculate the final amount needed.
Essentially, adding up all of these amounts predicts how much life insurance is potentially necessary. While this is a good method for a general sum, however, it fails to factor in existing financial resources your family might use to cover expenses, such as savings accounts and other investments.
Things to Consider
“Hidden Income”
Hidden income is income you receive through your employment but that isn’t part of your gross wages. This includes items like your employer’s subsidy of your health insurance premium, or any 401(k) contribution matching programs. Be sure to include any work “perks” when calculating how much you would need to replace your income.
Investment Options
Many financial advisors recommend that you invest in life insurance using multiples of your annual salary; for example, that you should get 10 times your salary before taxes. This is a simplistic way of calculating such an important figure, but there is a method to their madness. Buying some set multiple of your salary relies on the assumption that your family knows how to invest wisely. Assuming no inflation, and assuming you could assemble a bond portfolio that pays a certain amount of interest, your family could invest your life insurance payout and be able to live comfortably off the interest without “invading” the principal sum.
In other words: Say you bought a life insurance plan worth 10-12 times your annual salary. When you die, your dependents could invest the payout into good growth stock mutual funds with an average return of 10-12%, and live off the growth of that investment without even touching their initial investment. This sounds wonderful, but the reality doesn’t really take into account that inflation and market fluctuations, and that your family may not be savvy enough to invest wisely.
Term vs. Whole Life
Term insurance is the most affordable plan, because they are only good for a specific amount of time — usually 10 to 30 years. They’re cheaper because the insurance company is assuming less risk: if you die after the term is over, they’re off the hook. Whole life insurance policies will pay out no matter how long you live, and they also build cash value over time that you can borrow against. (This amount also increases over time as you pay your premiums.) Financial experts generally believe whole life insurance is a wise investment, while recognizing it’s not always attainable for everyone. If you’re currently shopping, remember that prices are always lower when you’re young and healthy, so prices will only go up the longer you wait.
Employer Life Insurance Plans
Many people have life insurance through an employer plan, but the common advice is not to rely on that. Although the plans might provide a source of income after your death, it usually isn’t enough. In addition, most employee life insurance plans are contingent upon you currently working there when you die in order to benefit, which renders it useless if you switch jobs or retire.
What If I Don’t Need Any?
If you’re reading through these tips and feeling as if you won’t need life insurance, it’s entirely possible that you’re right. If you don’t have any dependents or massive debt, or if you’re wealthy and can self-insure (as in, set aside money for any final expenses), life insurance can be redundant. Trust your instincts! But when in doubt, experts advise it’s always safer to over-insure.
