It’s relatively straightforward to know how much insurance you might need for certain valuables, like a car or your home. But many people don’t know the answer to this question: “How much life insurance do I really need?”
If you find yourself in these shoes, you aren’t alone. According to a study by Life Happens and LIMRA, 40% of people haven’t bought life insurance, or more of it, because they are unsure of how much or what type to buy.
Whether you are retired or still working, life insurance can help solve for many issues. For young to middle-aged couples with dependents, it may be a source of financial protection, income replacement, or supplemental liquidity.
And for households of retirement age? Life insurance can let you enjoy tax-advantaged income, pass a legacy to heirs in a tax-efficient manner, mitigate tax burdens upon death, and even provide much-needed liquidity for post-death expenses.
Here are some helpful basics to consider as you research how much life insurance may be right for you.
How Much Life Insurance Do I Need?
Ultimately, it depends on a few factors:
- Your age
- Whether you have a partner, and their age
- Your human capital and earning potential at that time
- Your partner’s ability to earn income
- Your partner’s human capital and earning potential at that point
- Your specific goals for any potential life policy
- How much you have in other assets
- How much you have in savings
- The particular role that life insurance may play in your plan
- Whether other assets or instruments can already fulfill that purpose
How much coverage you may need can vary greatly. For example, policyholders needing life insurance for dependents will need to evaluate: how much annual income they should protect, how long those year-to-year income needs will be covered, and a total lump sum to meet those numbers.
On the other hand, people with legacy goals may have interest in certain coverage amounts, depending on how much they wish to leave. Many post-retirement age policyholders buy life insurance for legacy wealth transfers, according to retirement speaker Tom Hegna.
All that being said, here’s a general rule of thumb when shopping for life insurance for dependents.
General Rule for Life Insurance Needs for Dependents
A good back-of-envelope calculation strategy is to purchase at least $1 million of life insurance for every $50,000 worth of annual income you must protect.
Why this, you may ask?
Currently we are in a low interest-rate environment. Interest rates have been compressed for more than a decade. And while they have been on the rise, interest rates may continue to remain low for some time. Even though the Fed is indicating plans for rate hikes, they have to be careful not to be too aggressive in trying to “normalize” interest rates.
In a 1% interest rate environment, you would need $5 million to generate $50,000 each year. The “payback,” after all, would be 1%, and when considering the question of income replacement, it’s prudent to look at a 20-year window for how the proceeds will be invested and tapped as income.
Many households would be out of the running for that. So, thinking of the coverage need for $50,000 with a 5% rate on proceeds (and that’s reasonable), we would be looking at $1 million of insurance coverage. Again, that is to generate $50,000 of income from that bucket of money each year.
When it comes to life insurance coverage, the biggest mistake is underestimating needs. Be sure to carefully consider your needs and financial picture before committing to a life policy purchase — if you can, with guidance from a financial professional.
Life Insurance for Post-Retirement Goals
In post-retirement life, life insurance often isn’t needed anymore for the financial protection of dependents. That being said, life insurance coverage may have its place in a survivorship plan — the timing of how the surviving member of a couple may need the income when their spouse passes on.
As you consider these things for your post-retirement life, here are some questions to ask:
- Do you have any outstanding debts that it would be good to have covered for your loved ones?
- Do you have a mortgage that still needs to be paid off?
- What financial resources do you have for health and long-term care expenses?
- How much might funeral costs and other post-death expenses be?
- How much will burial expenses be?
- Will you be giving financial support to loved ones, like college tuition assistance or big-ticket purchases?
- Do you have aging parents who will need your financial support? How does that affect the rest of your financial plan?
- Will you have any potential tax burdens to offset?
Answering these questions is a good starting point for coming up with a lump-sum figure for what your life insurance coverage may be. If you don’t have financial resources in place for healthcare and long-term care expenses, many life insurance policies come bundled with “living benefit riders” that can provide cost relief for those needs.
Apart from these questions, some retirees may use permanent life insurance for supplemental, tax-advantaged income in retirement. If you are considering this in your retirement plan, your life policy will need to be coordinated with your other assets, savings, and investments.
It’s prudent to take a look at your existing financial plan, and see where potential income as well as insurance gaps may be. Of course, any consideration of a life policy, in a retirement strategy, should be only after a careful evaluation of your financial picture has been done and whether a life policy makes sense for you.
Working with a financial professional can help you answer these questions proactively.
Some Final Thoughts to Consider
An estimated one in three households would have immediate trouble paying living expenses if the primary wage earner died, according to the same LIMRA study. And if you consider those online pleas to help people pay for funeral expenses — not to mention other forms of request — you begin to see very real examples of families that were financially unprepared for the loss of their breadwinner.
There are other reasons Americans say they are not purchasing life insurance, according to LIMRA:
- They think it is too expensive
- They have other financial priorities: paying living expenses, building savings, managing debt, and/or saving for retirement
- 25% of Americans believe they would not qualify for insurance
Studies have shown that Americans may overestimate the cost of life insurance by as much as 300%. This leads to many households being underinsured, despite the fact that having good coverage would help them solve for many issues in their financial plan.
Need Help with Determining How Life Insurance May Fit Into Your Plan?
As you make decisions about life insurance and other parts of your financial plan, it’s helpful to seek professional guidance. A knowledgeable financial professional can help you evaluate how things have been in the past, where you are at now, and where you could be. If you are ready for one-on-one expert assistance, financial professionals stand ready to help you at SafeMoney.com.
To get started with a no-obligation consultation, use our “Find a Financial Professional” section to connect with someone directly. Should you need a personal referral, call us at 877.476.9723.