Though it’s a fact that you can’t take your wealth with you, the right life insurance policy helps you leave a meaningful legacy behind. Life insurance serves as a safety net for your loved ones, providing financial support in the unfortunate event of your passing. However, the question of how much life insurance is necessary can be a confusing one. Sifting through the many calculation techniques and formulas and discerning the right approach for your family’s well-being can be a challenge.
In this article, we offer insights on how to tackle the task of deciding your ideal life insurance coverage, shedding light on important factors to consider when making this calculation.
Assess Your Current Life Situation
The amount of life insurance coverage you need depends on your current life situation, including your income level, expenses, debts, and the number of dependents relying on you. In general, life insurance is necessary if there will be a financial burden left by your passing, or if you would like to use it as an inheritance vehicle. For those with limited assets and debts and no dependents or heirs, life insurance is less important.
Determine Your Coverage Level
Life insurance is meant to replace the earning potential lost when you pass away, which means the higher your income level, the higher insurance coverage you’ll need. Similarly, if you have higher expenses or large outstanding debts (like a mortgage), you’ll want to purchase at least enough insurance to cover these liabilities.
Next, consider any dependents who may be relying on you. Do you have a spouse or children? Does your spouse work? How long will they need financial support in your absence? Do you plan to pay for your children’s college education? These are all questions to consider when determining how much life insurance you need.
Let’s take a look at the most common rules of thumb for calculating your coverage level, keeping in mind that each person’s situation is unique and it’s always best to work with a financial professional before purchasing an insurance product.
10x Income Rule
This rule suggests you should have life insurance coverage equal to 10 times your annual income. For example, if your annual income is $75,000, you should have $750,000 in life insurance coverage. This rule of thumb jumps to 20 times your annual income if you have young children or a dependent spouse.
DIME Method
This rule suggests you should consider four factors when determining the appropriate amount of life insurance coverage: debt, income, mortgage, and education. Add up your debts (like credit cards, auto loans, and personal loans), multiply your annual income by the number of years you want to replace it, add the amount of your outstanding mortgage, and add the cost of your children’s education. This will give you a rough estimate of how much coverage you need.
Needs Analysis Method
This method involves a more comprehensive evaluation of your financial needs. It takes into account factors such as your current and future income, your debts, your children’s education, and your retirement savings. A financial advisor can help you with this analysis and determine the appropriate amount of coverage for your situation.
Understand the Types of Coverage Available
After you have a general sense of the coverage level you need, it’s important to understand the types of life insurance available.
Term Life Insurance
Term life insurance is typically less expensive than other types of insurance. It provides coverage for a specified period of time, usually 10, 20, or 30 years. But the use-it-or-lose-it nature of a term policy is a big drawback. If you pass away during the specified term, your beneficiaries will receive a death benefit; but if you don’t die during the term, the policy expires and you get nothing. All the money you spent on premiums will be gone too.
Because term life insurance is one of the least expensive and simplest types available, it’s typically recommended for those who only want coverage for a specified period of time, like until your kids reach a certain age or your mortgage is paid off.
Permanent Life Insurance
Permanent life insurance is more expensive than term life insurance because it covers you for your entire life. As long as you pay the premiums, your beneficiaries will receive a death benefit when you die.
Permanent life insurance also has an investment component known as cash value. This cash value grows over time and can be used to help pay premiums or it can be borrowed against in case of an emergency. There are two main types of permanent life insurance: whole and universal.
- Whole Life Insurance has a guaranteed death benefit and coverage that applies as long as your premiums are paid. Coverage will not decrease or be revoked, and premiums will not increase or decrease over the life of the policy. Coverage can increase based on increases in cash value or reinvestment of dividends, but it will never decrease below the guaranteed value. The growth of the cash value can be based on a fixed rate of interest or it can be variable. The cash value will grow on a tax-deferred basis, but once money is withdrawn from the policy, any earnings will be taxable as ordinary income.
- Universal Life Insurance has a flexible premium and death benefit. The premium is usually lower than whole life, but the policy usually comes with fewer guarantees. With this type of insurance, policyholders can choose how their premium payments are invested, which can provide significant growth potential for the cash value of the policy. It is also riskier than whole life because major investment declines could cause your premium payment to go up next month in order to keep the policy in force. Generally, universal life policies are recommended for those who have a higher risk tolerance and want a greater degree of control over their insurance investments.
We Are Here to Help
If you find yourself wondering if the level of life insurance coverage you have meets your needs, it’s wise to collaborate with a financial advisor or an insurance professional who can help you identify the ideal policy for your situation. Having the appropriate life insurance coverage is essential to provide both present and future stability to your loved ones.
Bear in mind that life insurance is not a one-time decision; it’s a continuous, ever-evolving commitment. Regularly evaluating your coverage helps you maintain confidence that it aligns with your changing circumstances.
At GLH&C Financial Services, we help guide high-net-worth individuals, families, and business owners toward a financially successful future. If you have any questions regarding your life insurance or wish to explore a comprehensive analysis of your overall financial situation, please reach out to us at jim@glhcfinancial.com or give me a call at 916-967-3208 to see if I am the right fit for you.
About Jim
James Callens is a financial advisor at GLH&C Financial Services, a full-service, comprehensive wealth management firm. Jim has over 30 years of experience in the financial industry and uses his extensive resources and knowledge to help his clients experience simplicity and clarity in their financial lives. Jim spent more than 20 years working for GE Financial Advisors, both in its insurance services department and as a regional manager and financial advisor. He took part in GE’s Six Sigma Quality Training program and completed the National Association of Life Underwriter’s four-year LUTCF course. Jim also earned his certificate in financial planning from the University of California at Davis. In 2011, Jim combined his own firm, Callens Financial Group, with GLH Financial Services, creating GLH&C Financial Services, so he could provide even more value to his clients.
Jim lives in Folsom, California, with his wife, Melissa, and his four children, Jacob, Kristen, Grant, and Andrew. Together, they enjoy outdoor activities like kayaking, bicycling, and vacationing at Lake Tahoe. To learn more about Jim, connect with him on LinkedIn.