Life insurance, at its core, is designed to provide your financial dependents with a stream of income if you were to pass away. If you have someone that is dependent on your income, there’s a good chance that you are in need of life insurance.
Determining how much life insurance you need can be a complicated process, taking into account a number of variables such as current and future earnings, investment earnings assumptions and other goals. Below is a “back of the envelope” way to estimate how much life insurance you need to be fully insured. (For related reading, see: 5 Ways to Make Sure You're Not Over-Insured.)
Start With Your Family’s Expenses in the Event of Your Death
This would include final expenses and outstanding debts that your family would need to pay in the event of your death. Make sure you know if some debts (i.e., some federal student loans) will be retired at your death.
Add Amount Owed on Mortgage
Even if your family may not pay off the mortgage in the event of your death, having enough life insurance to pay off your mortgage will provide your family with the option to either pay down the mortgage or invest the proceeds.
Add Any Unfunded Goals
The most common example of this would be college funding. If one of your goals is to fully fund your children’s college expenses, take the expected amount of college cost minus the amount you have already saved for this goal.
Determine the Amount Needed to Fill the Cash Flow Gap
This is the most difficult part of life insurance planning. It’s morbid and hard to predict. Take your crystal ball out, and try to project your family’s income and expenses in a world without you. There will be a few major changes to your family’s spending once you are gone:
The family’s income will change: Ask yourself, "Will my spouse continue to work in the event of my death? If my spouse is not currently working, will they have to start working?"
The family’s expenses will change: Because we’ve already included the mortgage in our target number, we can assume that the mortgage payment goes away. Will there be any other expenses that will go away in the event of your death? Is there any utility you provide to your family that would need to be paid for such as house cleaning, child care, landscaping? This also needs to be accounted for.
Once you’ve taken into account the future changes in income and expenses, determine the cash flow gap, or annual shortfall, that your family would incur in the event of your death. (For related reading, see: Insuring Against the Loss of a Homemaker.)
Calculate the Present Value of the Cash Flow Gap
Using an online calculator, determine the lump sum needed to fill your cash flow gap for X number of years. Because life insurance is intended to replace a decedent’s income, I recommend using the number of years the insured intends to work as the X number of years. If you would like to take a more conservative approach, you can use the beneficiary’s life expectancy. Because the proceeds would likely be invested in more conservative income-producing assets, I recommend using a conservative interest rate assumption for the present value calculation.
Subtract the Value of Your Non-Retirement Investments
If you have non-retirement investments, these can help supplement your cash flow gap. For this reason, subtract the post-tax value of your investments. This will get you to your total life insurance need.
As with any “back of the envelope” calculation, this is designed to provide you with a ballpark estimate for life insurance need. There are many factors that could change your need including:
No desire to replace 100% of spouse’s earnings until retirement: I think my wife is a catch, and it wouldn’t take her more than five years to replace me. In this case, I may want to provide her with enough life insurance to provide her with enough financial flexibility to be able to provide for herself for the next five years (not the remainder of her life). This would decrease my life insurance need.
Assuming that spouse will be saving enough to fund retirement expenses: The above process assumes that the spouse will be saving enough to fund their own retirement expenses. If the spouse is not currently saving for retirement, or not saving enough, this will increase your life insurance need.
I recommend using this calculation as a starting point, and determining the type of life insurance you need (term, whole, universal, etc.) with a financial professional. (For related reading, see: What You Need to Know About an Emergency Fund.)