Think about everything your family would lose financially right now if you died. Your paycheck would be gone, as would all the things you typically buy with it, from groceries and your mortgage to music lessons and sports equipment.
They’d have access to any savings you have — if creditors didn’t take it to collect on your outstanding debts. But even that will only last so long.
And on top of that, they’d need to cough up thousands of dollars for your funeral expenses. Now ask yourself if you have enough life insurance to stop that from happening.
How Much Life Insurance Coverage Do I Need to Buy?
Your life insurance needs won’t remain constant throughout your life. They increase as you accumulate debt, start a family, and enter your peak earning years. Then, they start to decline as you pay off your mortgage, send your kids off to college, and ease closer to retirement.
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At some point, you probably don’t need life insurance at all — your net worth will be enough to support your survivors after your death, and you won’t have any debts or major future financial obligations to speak of.
But life insurance is cheaper and easier to get when you’re younger. Ideally, you’ll purchase all the coverage you’ll ever need when you’re in your 20s or early 30s, before you need maximum protection. That means you have to calculate your future life insurance needs without knowing quite how the future will turn out.
Your actual life insurance need is a moving target. If possible, use a life insurance ladder, a strategy in which you take out multiple policies that add up to the coverage you need so you can step down your life insurance coverage — and premium costs — over time. That way, you can get cheaper life insurance now and offload policies as you no longer need them rather than getting new, more expensive policies later.
There are several ways to calculate your needs. Choose the life insurance calculation method that makes the most sense for your personal situation.
Best for Protecting Survivors From Debts: Debt-Protection Method
This method ensures your debts in life don’t create a burden in death.
Specifically, you want to secure enough life insurance to do two things:
- Pay Off Jointly Held Debt. If you have a spouse or domestic partner, you probably share some debt with them: a mortgage, home equity loan, credit cards, car loan. You need enough life insurance to pay off these debts after you die.
- Cover Significant Future Expenses. Your life insurance policy should also cover predictable big-ticket expenses you haven’t yet incurred yet. A classic example is your kids’ college tuition — that’s tens or hundreds of thousands of dollars per kid that your surviving partner will have to come up with.
You just subtract your assets from your current debts and future expenses. The hardest part is gathering all the information. For example, let’s say your situation looks like this:
- Debts: Let’s say you have a $300,000 balance on your mortgage, $25,000 in credit card debt, and $50,000 in student loans that your spouse co-signed for a total of $375,000 in debt.
- Future Expenses: You also have two kids and expect to spend $200,000 each to put them through college for a total of $400,000 in future expenses.
- Liquid Assets: You currently have $50,000 in savings and $25,000 in a taxable brokerage account. Disregard illiquid assets, such as your home equity. That means you have $75,000 in liquid assets.
Formula:
(Debts + Future Expenses) – Assets = Current Life Insurance Needs
Example:
($375,000 + $400,000) – $75,000 =
$775,000 – $75,000 = $700,000
Best for People Uncertain of the Future: Multiply by 10 Method
The multiply by 10 method is ideal if you know you need a decent amount of life insurance coverage but don’t have a good handle on your future expenses. It’s a “good enough” method for many would-be policyholders.
That said, this method might leave you short if you currently have or expect to have really significant debts and expenses. Or it might be overkill if your debts and expenses are modest compared to your income or you have a relatively high net worth for your age.
The calculation itself is easy. Multiply your current gross annual income by 10. For example, let’s say you make $200,000 per year before taxes.
Formula:
Gross Annual Income x 10 = Current Life Insurance Needs
Example:
$200,000 x 10 = $2 million
Best for Parents of Young Kids: Child Buffer Method
It’s no secret kids are expensive — really expensive. Known costs like food, clothing, child care, and education are bad enough, but it’s the unknown and hidden expenses of raising kids that can really bust your budget.
The child buffer method can help cover the cost of raising your kids to adulthood if something happens to you. It replaces 10 years of your earnings to help get your surviving partner or the children’s guardian over the hump of seeing your children out of the nest.
The U.S. Department of Agriculture estimates that the average cost to raise a child born in 2015 to age 18 is about $233,000. Lots of these costs, such as day care, accrue early in life. But big-ticket expenses loom for teens and young adults too, notably college tuition.
The child buffer method is therefore appropriate if you already have kids, share kid-related expenses equally with the other parent, and aren’t otherwise overwhelmed by debt and expenses. If $100,000 seems low given the average cost of child-rearing these days, remember that it represents just your portion in a two-parent family unit.
And it’s only a little more complicated than the multiply by 10 method. Let’s say you earn $200,000 per year before taxes and have three children.
Formula:
(Gross Annual Income x 10) + 100,000 x Number of Kids = Current Life Insurance Needs
Example:
($200,000 x 10) + (100,000 x 3) =
$2 million + $300,000 =
$2.3 million
Best for Older Applicants: Income Replacement Method
This method aims to replace most of the income you expect to earn over the remainder of your career. It doesn’t directly address debt or expenses. And the younger you are, the less precise it is because of the cumulative impact of salary raises — or more drastically, career changes — on your lifetime earnings.
As such, this method is best if you’re an older life insurance applicant with a good sense of your likely earning power through the remainder of your career. “Older” is relative here, but by the time you’re 50, you definitely qualify.
Let’s say you’re 50 years old and your current income is $150,000 per year. You plan to retire at 65, so you have 15 years left in your working life. Your calculation looks like this:
Formula:
Gross Annual Income x Number of Years Until Retirement = Current Life Insurance Needs
Example:
$150,000 x 15 = $2.25 million
Best for Minimizing Survivors’ Financial Sacrifice: Standard of Living Method
This method ensures your survivors don’t have to scrimp after your death. The goal is to get enough life insurance that your surviving partner and dependents can maintain their current standard of living at a safe withdrawal rate.
The actual amount of coverage required to maintain your survivors’ standard of living depends on your household’s current spending rate and the number of years you need to provide for. Generally, this method provides income only until the surviving partner retires, at which point Social Security and other sources of retirement income kick in.
To find your standard-of-living coverage amount, first calculate your household’s current annual spending. You can simply multiply your most recent month’s spending by 12, but it’s best to manually tally up each month’s spending over a full year to smooth out irregularities.
Once you have your annual spending amount, multiply it by the number of years you want to provide for. If you don’t have a specific time frame in mind, you can use the number of years until your partner plans to retire.
Let’s say your household spends $60,000 per year (that’s an average of $5,000 per month) and your partner plans to retire in 20 years. Your calculation looks like this:
Formula:
Annual Spending x Years to Cover = Current Life Insurance Needs
Example:
$60,000 x 20 = $2.4 million
Best for Accurate Replacement of Major Expenses & Income: DIME Method
DIME stands for “debt, income, mortgage, and education.” The DIME method for calculating life insurance coverage accounts for each of these expenses to generate an accurate picture of how much life insurance your family needs. First, add up all these expenses individually:
- Debt: Includes all currently outstanding joint debt, such as credit cards, home equity loans and lines of credit, student loans, personal loans, and auto loans
- Income: Your annual gross income before taxes and other deductions
- Mortgage: Your current outstanding mortgage balance if you have one, but not the market value of your home
- Education: Your total known or expected future education expense for all of your kids combined, including early childhood education, private K-12 tuition and expenses, and higher education tuition and expenses
You also need to know how many years you want to provide financial security for. It’s usually the number of years your dependents will need to live on it.
To calculate your family’s future financial needs using the DIME method, do the following:
- Add up all known items within the debt, education, and mortgage categories
- Add each category’s total together
- Multiply your gross annual income by the number of years you want to provide for
- Add that number to your combined total for the other three categories
For simplicity’s sake, let’s say you have $100,000 in non-mortgage debt, $300,000 in mortgage debt, and $250,000 in future expected education expenses. You earn $80,000 per year and want to provide 20 years of financial security. Your DIME method calculation looks like this:
Formula:
(Debt + Mortgage + Education) + (Gross Annual Income x Number of Years) = Current Life Insurance Needs
Example:
($100,000 + $300,000 + $250,000) + ($80,000 x 20) =
$650,000 + $1.6 million =
$2.25 million
Final Word
Circumstances change. Life happens. We can’t predict the future.
You know all this. That means you also know you need to calculate how much life insurance you need without knowing how things will turn out.
The good news is any of these life insurance calculation methods can get you there. You just need to make some educated guesses about the course your life will take and conservative projections around your income and asset growth in the years to come. Then decide which is the best term life insurance company for you.
But what if your assumptions don’t pan out and it turns out you need more life insurance than you thought? You can always buy more — but the sooner, the better.