By Nino Pavan, J.D., CFP®
Life insurance is one of those financial decisions that’s easy to put off, especially when you’re not sure how much coverage you need or which type makes sense. You may know you want to protect the people who depend on you, but figuring out how much income would need to be replaced, which expenses should be covered, and how your existing savings factor in… it can get complicated quickly.
That’s why incorporating life insurance into financial planning can help. Rather than choosing a policy based on a general rule of thumb, you can look at your family, finances, and future needs to determine what coverage makes sense for your situation. Here are a few questions to help you get started.
Do I Even Need It?
Not everyone needs life insurance. If you have enough money saved and invested so that your death would not create a financial hardship for your loved ones, a life insurance policy might be unnecessary. If you are a single young adult with no dependents, you may only need a small policy to cover the expenses of a funeral and burial—or more likely no coverage at all if you have at least some amount saved and invested to cover your final expenses. Take a good hard look at your financial situation and decide if life insurance is the right fit for you.
Two Options for Life Insurance
Before you start thinking about how much coverage to get, you’ll need to choose the kind of life insurance that is most appropriate for your situation. Here’s a breakdown of the two primary types of life insurance.
Term Insurance
Term insurance offers coverage for a specified length of time, which can be anywhere from 5 to 40 years or longer. The downside to term insurance is that it only covers you for your specified length of time, so if you pass away after the term is over, no death benefit is paid to your beneficiaries. But depending on your situation, you may only need insurance for a certain time period—for example, until your kids are grown or you have enough money saved to avoid financial hardship. One of the major benefits of term insurance, as opposed to permanent insurance, is that it is usually the least expensive out-of-pocket option. Since life insurance in most cases is meant to replace lost income or to pay debts or final expenses (and not to serve as an investment vehicle or income source, although life insurance is sometimes marketed and sold for those purposes), term insurance makes sense for most people in most situations.
Permanent Insurance
Permanent insurance is coverage that is not limited to a specific duration of time, meaning it can potentially last your entire life. There are several types of permanent insurance, including Universal Life, Indexed Universal Life, and Whole Life. The benefit of permanent insurance is that it can last longer than a term policy so that a death benefit will be paid to your beneficiary no matter when you die (assuming you keep up with your premium payments). This type of insurance is typically much more expensive than term insurance, and for most people in most situations a permanent life insurance policy may not be necessary. Rather than paying additional premiums for a permanent policy, it often makes sense to just buy term and invest the difference in premiums.
How Much Do I Need?
Finally, the question at the forefront of your mind. Accurately calculating your life insurance need requires the development of a financial plan that looks at your finances holistically. Without knowing where you’re going, how can you buy the right amount of life insurance to protect your loved ones in case life doesn’t go according to plan? Using a rule-of-thumb method to calculate your life insurance need can be a helpful first step, but because everyone’s situation is unique, a rough calculation can only provide a rough output, at best. If you wish to get an initial idea of life insurance needs, the method below can serve as a starting point.
The DIME Method
Conduct a needs analysis by separating your finances into different areas. Couples should do their calculations separately.
- Debt and final expenses
- Income
- Mortgage
- Education costs for children
In addition to these areas, two of the biggest factors that affect how much insurance you need are your marital status and your financial dependents. The more people that depend on you, the more coverage you may need.
Multiply It
After calculating and totaling each of those dollar amounts, apply an income replacement multiplier to determine your needed coverage amount. The multiplier varies based on your age and the status of your home mortgage. For example, if you’re under 50 years old, you can likely use a multiplier of 20. Older couples may be able to use a multiplier of 10 or 15, depending on the number of years left on their mortgage.
Keep in mind that these are just guidelines designed to give you a general idea of the amount of insurance coverage you need. There may be adjustments for your particular situation and what makes the most sense for your family.
Put It All Together
You now have a sheet of paper with a lot of different numbers on it. Here’s how to put it all together.
- Combine your annual income (multiplied by the multiplier), your mortgage balance, your debt load, estimated future financial needs, and death expenses.
- Then subtract your liquid assets (think savings, life insurance policies you already hold, any college funds, etc.).
- The number you end up with should give you a general idea of how much insurance you should buy.
Where Life Insurance Fits Into Financial Planning
For life insurance in financial planning, the goal is to choose coverage that fits with the rest of your finances rather than making the decision in isolation. Your income, family responsibilities, existing assets, debts, and long-term goals can all influence the type and amount of coverage that makes sense for you.
Are you interested in assistance evaluating your life insurance needs or reviewing coverage you already have? Financial Designs can help.
Schedule a no-fee, no-obligation virtual appointment or contact us at (909) 626 1642 or email fdc@fdcadvisors.com today. Our team can look at how your coverage fits into your broader financial plan and discuss the options available to you.
About Nino
Nino Pavan is the President and a CERTIFIED FINANCIAL PLANNER® at Financial Designs in Claremont, CA, specializing in goal-centered retirement planning. With over 30 years of experience, Nino helps individuals and families navigate the retirement process with confidence, making it stress-free. He holds a law degree, a BS in Telecommunications Management, and is a contributing advisor to Kiplinger.
