I am a big fan of the popular KISS acronym which if you don’t already know stands for “Keep it simple, stupid”. I try to follow this advice in every aspect of my life. When it comes to figuring out how much life insurance is needed to protect your family, I think we should all KISS.
If you were to go meet with a financial advisor or life insurance agent they will most likely throw fancy terms out at you like “Human Life Value” and “Capital Needs Approach” when trying to figure out how much life insurance you need. These approaches do work and will get you to a number that should be sufficient to protect your family. Keep in mind that there is no exact amount and each individual situation is different. I do believe that it is better to error on the side of having a little too much life insurance instead of having too little, but please make sure it is only term insurance that you are purchasing.
Trying once again to keep things as simple as possible, here are the steps I use to calculate how much life insurance everyone should have:
Multiply your income by 10 - if you are a stay at home parent use the cost of daycare or the cost to hire someone full time to watch the children in lieu of an income.
Multiply the number of other members in your family (not including you) by $200,000 and add that to #1
Add the total amount of all of your existing debts like mortgage, student loans, car loans, personal loans, credit card debt. Everything you owe.
Subtract any big savings you have like retirement accounts, college savings, existing life insurance policies or cash in the bank.
That's it! Pretty simple. Now let’s look at an example using actual numbers:
Michael is 34 years old, makes $100,000 a year and is married with 3 children.
$100,000 x 10 = $1,000,000
$200,000 x 4 (his wife and 3 children) = $800,000
$200,000 mortgage + $40,000 student loan + $20,000 car loan = $260,000
$60,000 in his 401k + $20,000 College Savings + $20,000 savings account = $100,000
Amount of life insurance needed = $1,000,000 + $800,000 + $260,000 - $100,000 = $1,960,000
If I was giving Michael advice in this situation, depending on the age of his children, I would most likely tell him to purchase two separate policies. One being a 30 year level term policy for $1,000,000 and the other a 20 year level term policy for the remaining $960,000.
This approach would be less expensive than getting a 30 year term for the entire amount and it would also better match his long term insurance needs. The two policies together would cost Michael about $100 per month for the first 20 years and then it would drop down to about $65 a month for the final 10 years.
If Michael were to die during the first 20 years his beneficiaries would receive a check for $1,960,000 tax free. If Michael died during years 21-30 then his beneficiaries would receive a check for $1,000,000 tax free. The most likely and best scenario for everyone involved is that Michael will outlive the 30 years of insurance coverage and his family will never receive a payout from the insurance company.
Even though odds are that there will never be a payout, this is still money well spent. Michael has peace of mind knowing that if the worst were to happen to him at least his family will be left with financial security instead of absolute financial devastation on top of the emotional devastation.
At the end of 30 years, the goal is that Michael’s kids will all be self sufficient and that Michael will have worked long enough and accumulated enough assets that he no longer needs the insurance coverage. At that point Michael would be what we call “self insured”.
Hopefully, you found this easy to follow along and it will remove this obstacle if it is delaying you from getting life insurance. I can not stress enough how important it is to have solid life insurance in place for your family. If your situation is anything similar to the example above then you really owe it to your family to have life insurance. Do not dismiss this as an unnecessary expense. The consequences could put your family in worst possible situation imaginable.