Life insurance is one of the biggest purchases of your life. You need it to make sure your family is protected in the event that the unexpected happens. The insurance payout should allow your family to maintain its lifestyle without worrying about money.
But you might be wondering: how much life insurance is the right amount?
Buying too little, and you leave your family exposed to financial strain upon your death. Buying too much, and your family may wish for your death! All kidding aside, you’re paying for something you don’t need if you buy too much insurance.
In this post, I will explain exactly how to find that magic number manually. You can also use a good online life insurance calculator to do the work for you if you find it too tedious to do by hand.
But it’s actually quite easy to calculate manually. All you have to do is follow this formula:
Cash needs + Income replacement – Existing assets = Life insurance needed
Let’s begin by breaking down each component.
Cash needs
Because life insurance pays out a lump sum amount, you can use a portion of it to pay off your liabilities. This is referred to as the immediate cash need. What liabilities do you want to be paid off? You can include the following:
- Mortgage
- Credit card debt
- Other debt
- Children’s education fund
- Emergency fund
- Funeral expenses
For example, if you have a mortgage of $400,000, want to build up education and emergency funds of $25,000 and $5,000 respectively, and anticipate $10,000 for funeral expenses, you can simply add these numbers up to get your cash needs. In this case, you’ll have a cash need of $440,000.
Income replacement
The second major component is calculating the amount needed to replace your income.
When you die, the biggest financial strain on your family is the loss of your income. If you’re just starting your career, you will likely earn well over a million dollars until age 65. And a high-income earner will make multiples of millions of dollars. If you die prematurely, you need life insurance to replace this lost income.
But how much do you need to replace your income? The 2 key factors that affect this amount is:
- The percentage of your income to replace
- The number of years you want to replace your income
Because the death benefit is tax-free and you’ll have the mortgage and other liabilities paid off, you don’t need to replace 100% of your income. Plus, you won’t be around anymore so your family’s expenses should drop too. That’s why your family should be able to maintain its lifestyle if you replace 50-70% of your pre-tax income. If you’re using your after-tax income, you can be more conservative and replace 70-80% of your income.
You also need to determine how many years you want to replace your income. Common terms are for 5 to 10 years, or the number of years until your youngest child reaches age 18 or 25.
Once you know the percentage and the number of years, you can calculate how much insurance is needed to replace your income.
For example, say you made $50,000 before tax. You want to replace 70% of it for 10 years. The first method to calculate the insurance needed is to simply multiply $50,000 x 70% x 10 years = $350,000.
But since your family will take the income annually, you can invest the lump sum insurance payout. With the second method, your family takes $35,000 of the death benefit to support its lifestyle and the remaining balance is invested. Your family withdraws this amount every year until the balance is depleted after 10 years. In this scenario, if you use a 6% rate of return, you’ll only need $273,000 of life insurance.
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Existing assets
Lastly, you deduct your existing assets from the cash and income replacement needs.
Your existing assets are things that you’re comfortable with selling to support your family in the event of your premature death.
That means if you want your family to keep the asset after your death, do NOT include it here.
For example, if you have a rental property and don’t want to sell it after your death, don’t include it in the calculation. Likewise for RRSP accounts that are reserved for retirement.
However, you can include money in your savings and non-registered accounts. The other major item you can include is existing life insurance.
For example, if you have group life insurance coverage through work, you can use it to reduce your life insurance needs. Keep in mind that if you quit your job, you’ll lose the group coverage. So don’t use it if you don’t plan on working there for a long time.
Let’s say you have $100,000 of life insurance through your employer and you plan on staying there for a long time. You can then reduce your life insurance needs by $100,000.
Putting it all together
Remember the formula at the beginning?
Cash needs + Income replacement – Existing assets = Life insurance needed
Using our examples throughout this post, the cash needed at death was $440,000, the money needed to replace your income was $273,000 and you have existing life insurance of $100,000 as part of your benefits at work.
Plugging these numbers into the formula gives you an additional life insurance need of $613,000.
The next step is to decide whether you want to use term or permanent life insurance to fulfill that need.
Remember, this is just a snapshot of your life insurance needs. It’s a moving target that changes over time. You’ll need to review it around every 5 years to make sure the amount you bought is still appropriate. Major life events like having a child or getting a raise should also trigger a review.
Author Bio: Brian So is a life insurance agent based in beautiful Vancouver, British Columbia. He runs Brian So Insurance and is committed to helping his clients find the best coverage for their needs. He takes a holistic approach to insurance, implementing life, disability, critical illness, healthcare, and long-term care insurance into his clients’ risk management plan to provide comprehensive coverage for their families.
