Do You Need Life Insurance?
Life insurance is an important piece of a financial plan, especially for young families still in their accumulation phase. In this post we dive into common questions like: Do I need life insurance? What type and how much life insurance should I buy? How much will it cost? We also review an example of calculating your life insurance need.
Do I Need Life Insurance?
If people depend on your income or if you are a primary caretaker (or both), you likely have a need for life insurance.
Life insurance is intended to provide for financial needs such as:
- Supporting a spouse
- Raising children
- Paying off debts
- Final expenses
- Education funding
Life insurance is meant to protect and ease the burden of your loved ones in the event of a tragedy, not provide a big windfall. Once you have enough assets to “self-fund” your goals, you may no longer need life insurance.
For this reason, you likely do not need life insurance for your entire life. You only need life insurance until either (1) you no longer have others relying upon your income or (2) you have enough assets to cover your goals.
What type of life insurance should I buy?
Term life (as opposed to “whole life” or “permanent life”) insurance is designed for this protection need. More specifically: Level Term Life Insurance.
Level Term Life Insurance provides a level amount of insurance for a specific term for a level premium. For example, a $1,000,000 10-year term policy will provide $1,000,000 of coverage for 10 years for a level (unchanging) premium (ex: $20/month).
Your term life insurance remains in effect so long as you pay your premium. But if you no longer need the insurance or determine you need a different amount of insurance, you can cancel your policy simply by calling your insurance provider.
How much does life insurance cost?
Average Costs
Several factors influence your cost of life insurance, including age, gender, length of policy, amount insured, health, and family background.
As of July 2022, a healthy 35-year-old male can expect to pay about $30 per month for a $500,000 20-year term life insurance policy; and $26 per month for a healthy 35-year-old female.
By comparison, a $500,000 whole life policy for that healthy 35-year-old male is expected to be over $550 per month.
Why the difference?
One of the reasons term life tends to be cheaper is because the odds of a payout are far less likely.
Consider it from the insurance company’s perspective. If you buy a “whole life” policy and hold it your whole life, the insurance company is eventually going to make a payout.
But if you buy a term life policy to protect your family during your 30s, 40s, and 50s, you are buying this insurance hoping the insurance company will never have to make a payout.
How much life insurance do you need?
Follow these steps to determine how much life insurance you need:
- Calculate Coverage Need: Combine your debts, your unfunded goals (cost of raising your children, education costs), and final expenses (burial costs, funeral).
- Calculate Funding Sources: Life insurance you already have (work-provided coverage, for example) and assets like cash, taxable investments, 529 plans earmarked for education, etc. Note: Illiquid assets like retirement accounts (IRA, 401(k), etc.) and your home are not included in Funding Sources.
- Calculate Coverage Gap: Subtract your Funding Sources from your Coverage Need to determine the amount of additional insurance required.
- Determine Term: Estimate how long you will need this coverage (until kids are out of college, your debts are paid off, your funding sources outweigh your need).
With these data points, you can find the right term life insurance policy for you.
Other Rules of Thumb
You can also follow a few simple rules of thumb to determine how much life insurance you should consider. However, similar to our discussion of rules of thumb for retirement savings, it’s important to acknowledge these are just rules of thumb and your mileage will vary.
1. 10x Your Income
Multiply your income by 10. Pretty simple. However, you can quickly see how this rule of thumb could be way off the mark for your situation.
2. For Parents: 10x your Income + $100,000 per child
Taking the 10x income calculation one step further, this rule of thumb accounts for the added costs of raising children.
3. DIME Calculation
Using the DIME formula, you total the following:
- D – Debts. Credit cards, auto loans, and so on.
- I – Multiply your Income by 10x
- M – Mortgage
- E – Final Expenses
Example of Calculating Life Insurance Need
Let’s review an example of a 40-year-old couple, John and Emily, with two children.
Coverage Need
- Shared debts total $450,000, including John and Emily's mortgage and auto loans. Federal student loans are excluded because they are dischargeable upon a borrower’s death.
- Both spouses earn a satisfactory income and would not need additional support if their partner were to pass.
- John and Emily's children are ages 5 and 7. The couple assumes an average cost of $15,000 per year to raise each child until age 21, totaling $450,000.
- Unfortunately, the average annual cost to raise a child does not include college costs. John and Emily would like to provide in-state college tuition and room & board for their children. The current education cost for their state universities is $28,000 per year. Two kids, four years each = $224,000.
- Final expenses are estimated to be $15,000.
The total coverage needed for each spouse is $1,139,000.
Funding Sources
- John and Emily have saved $120,000 in bank accounts and a taxable investment account.
- 529 plans for college education total $40,000.
- John has employer-provided group term life insurance coverage of $250,000.
- Emily owns her own business and does not have any life insurance coverage.
Funding Sources total: $410,000 for John and $160,000 for Emily.
Coverage Gap
John has a Coverage Gap of $729,000 and Emily has a gap of $979,000.
To fill this gap, John and Emily could each purchase 15-year term insurance policies (at which point their children would be 20 and 22 years old). A 15-year $750,000 policy for John and 15-year $1,000,000 policy for Emily would meet their needs.
Advanced: Laddering Policies
Your life insurance needs should decline as your debts are paid down, your children age, and you build more assets. If you buy a lengthy term life insurance policy based on your needs today, you may find yourself over-insured in 10 to 15 years. This isn't the end of the world as (1) being over-insured is better than under-insured and (2) term life insurance is relatively inexpensive.
However, laddering your life insurance policies can avoid being vastly over-insured and save you some money on premiums.
Laddering your term life insurance policies means purchasing multiple life insurance policies that expire over time to reflect anticipated changes to your coverage needs and funding sources.
Policy Ladder Example
Continuing with our example above, fast forward ten years for John & Emily.
John and Emily's debts have declined by $100,000. Their children are also ten years older; therefore the remaining estimated cost to raise them is $150,000 instead of $450,000. Total Need is now $739,000 instead of $1,139,000.
John and Emily have also been saving and investing in their college savings accounts, which have grown to $140,000.
Given lesser needs and a greater funding source, their coverage gap has declined by $500,000 over this ten-year period.
If John and Emily had purchased 15-year policies to cover their initial gap, they would find themselves over-insured today. (Again, not the end of the world as coverage is relatively inexpensive.)
However, to avoid being over-insured and to save some money on their premiums, John and Emily could ladder two policies. For example:
- John could buy a 15-year $250,000 policy and a 10-year $500,000 policy
- Emily could buy a 15-year $500,000 policy and a 10-year $500,000 policy
The combined policies during the first ten years would cover the initial gap. As their needs decline and funding sources increase, the 10-year policies would expire. But John and Emily would continue to be covered adequately by their 15-year policies.
Reviewing Your Life Insurance Needs
As demonstrated in the example, your life insurance needs will change as all of the variables in your life change. Switching jobs, new additions to your family, a new home, new additions to your family, and so on. It's wise to evaluate your life insurance coverage needs at least annually, but also as life changes occur.