How much life insurance do I need?

How much life insurance do I need?To answer this question, you must first answer another question; what are you trying to accomplish with the insurance proceeds? While there can be many answers to this question, the one that is generally of most concern to people would be replacing the income of the person who is insured. Let’s look at two examples of the most commonly insured members in each family, the Income Earner and the Homemaker.

Under the Income Earner scenario, the goal of Life Insurance should be to replace the income that would be lost. The first step would be to determine the gross (before taxes) earnings of the Income Earner. The second step is to determine a rate of return to use in calculating the insurance proceeds necessary to replace the lost income. For this calculation, we are assuming that the entire insurance proceeds will be invested in order to generate enough income to preserve the capital in perpetuity. In other words, you don’t want to have to use any of the actual insurance proceeds to pay your bills, only the income generated from investing those proceeds. The rate of return we choose should be conservative because you want to limit the risk of losing some of your principal. For this calculation, we will use a 5% rate of return. With these two numbers, you should be able to easily calculate how much Life Insurance you will need. Let’s look at an example:

$50,000 (Gross yearly salary of Income Earner) ÷ .05 (5%) = $1,000,000 (Life Insurance needed)

You can plug your own numbers into this formula to determine what your Life Insurance target should be.

The second scenario, the Homemaker, can be a little more difficult to calculate. Since the Homemaker isn’t bringing in any money, they are often overlooked when planning life insurance needs. This can be a costly mistake. The Homemaker provides many services to your family and plays many different roles. The absence of these services can be quite disruptful to your daily life. Therefore, the first step in this scenario would be to determine what it would cost to replace these services if you had to. Some items to consider would be, a nanny or some form of daycare for the children, a housekeeper, pet sitter/dog walker and a personal assistant to run household errands. Each family’s scenario will be different, so try to think of all the items that would have to be taken care of in the absence of the Homemaker. Once you have determined the net (after tax) dollar value of these services, you will need to make an additional calculation to determine the gross income needed. Although income tax rates will vary from family to family, a good rule of thumb is to assume a 30% rate. Let’s look at an example:

$20,000 (Net value of services to be replaced) ÷ .70 (30% tax rate) = $28,571 (Gross income needed)

$28,571 (Gross yearly income needed) ÷ .05 (5%) = $571,420 (Life Insurance needed)

Again, you can use your own numbers with this formula to determine your Life Insurance target.

Another common use for Life Insurance is to pay off your house as well as any credit card debt you might have. While I would not always recommend doing this, many people have this goal. If you would like to use the insurance proceeds for this purpose, I would recommend determining the amount you would need to pay off your first mortgage as well as any lines of credit and credit card balances. Then you can add this lump sum to the total Life Insurance needed from the calculation above.

The information I have provided here is intended as a general guideline for people in the initial stages of gathering information about Life Insurance. I always recommend meeting with a professional, in this case a Financial Advisor or Life Insurance Agent, when you are ready to discuss your specific needs.

Most people want to provide financially for their family, but they do not always understand the amount of capital needed to generate the desired results. Sometimes there is a disconnect between what people assume and what reality really is. Hopefully this article has shed some light on how much Life Insurance is actually needed in order to properly plan for the future.