Running the life insurance numbers: Determining your coverage

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Guidelines and calculators can help you decide.

© Vitalii Vodolazskyi/stock.adobe.com

Determining how much life insurance to purchase can be tricky. You need to figure out how much coverage you need, but you also have to consider how much you can afford to pay in premiums. You can use formulas and calculators to help, but at the end of the day, there’s no precise, “correct” amount of insurance you should buy—no matter what an insurance agent tells you.

Generally speaking, there are two ways to determine how much life insurance you need. One approach is to take a multiple of your current (and expected future) income. The other focuses on your specific debts and your family’s future financial obligations.

The basic question is: If you were to die suddenly, what would it take to replace your income?

There’s a general consensus within the insurance and financial planning community that you should purchase coverage somewhere between 10 and 15 times your annual income. Some advisors may recommend multiplying your income by 20 or even 25. If your family has an annual income of $200,000, a $2 million policy would meet the 10x income threshold. A multiple of 25 would indicate a policy with a $5 million death benefit.

When the death benefit is paid out, it could be invested, and you (or your surviving family) would draw on the nest egg for income. Ideally, you would use a withdrawal rate designed to sustain the portfolio. Although it’s an estimate, 4% is often considered a safe amount to withdraw on an annual basis.

If the portfolio sees solid investment returns of 8% or 9%, and inflation (which erodes your purchasing power over time) runs at its historical rate of 3%, the principal balance of the account should last many decades—even into retirement. But if the portfolio value were to fall during an economic downturn, for example, you might wish to reconsider the 4% withdrawal rate.

In our example, the $5 million benefit could be invested and the beneficiaries could expect to draw $200,000 per year in income without reducing the nest egg. A 4% withdrawal rate on a $2 million policy would be $80,000 per year. Remember, the actual rate of return on your investment portfolio will affect the amount you should withdraw each year (for better or worse).

Keep in mind that household expenses could be at least somewhat lower in the event you or your partner were to pass away. Another consideration is that although the death benefit payout is not taxable, earnings from the portfolio may be taxed as income or capital gains.

Another method for determining how much coverage you need is to use formulas that include debt and future expenses (such as college education for your kids or a future home purchase) combined with a revised income multiple. With this method, the income multiple is lower because the expenses related to debt and long-term savings are already accounted for.

Items to consider might include:

If your family is earning $120,000 a year with a mortgage balance of $240,000, and you expect $200,000 in child-related expenses (in today’s terms), you would consider a policy for $1.4 million (240,000 +200,000 + 960,000).

It’s important to note that education expenses often outpace general inflation. If a policy were to pay out a death benefit 10 years from now, the amount allocated to cover college expenses might no longer be sufficient. That may be offset somewhat by a reduction in a (future) mortgage balance, however.

If this all sounds confusing, don’t worry. The point is to consider life insurance coverage within the context of your overall financial plan. These formulas and methods can help inform that context, but there is no precise, “correct” amount of coverage you should choose.

And after all, a major factor in the amount of coverage you purchase is the amount you can comfortably afford.

Of course you’d like to purchase enough insurance to leave your family comfortable in any scenario. But particularly for families who need insurance in the first place, that amount of coverage may not be affordable.

Life insurance premiums are determined by your age and health status (which is greatly affected by factors such as tobacco use). Rates for women tend to be slightly lower than for men.

A ballpark estimate for a relatively healthy 30-year-old for a $1 million benefit on a 20-year term policy is $40 per month, or $480 per year. Want $2 million of coverage? You might have to shell out $960 per year.

Looking for coverage that would allow a 4% withdrawal rate equal to a $200,000 salary? That would require a multiple resulting in $5 million of coverage, for an estimated annual premium of $2,400.

If you’re considering a term policy, play with the numbers, figure out your desired coverage level, and then get a few quotes. Your actual cost may be higher or lower than the estimates provided here.

Permanent life insurance policies are significantly more expensive. A whole life estimate for a 30-year-old healthy individual is nearly 15 times the price of term insurance. Remember that a permanent policy will also include a cash accumulation savings component.

Some policies, such as universal life, may provide flexibility and premiums that are lower than whole life, but will still cost significantly more than a comparable term policy.

Determining how much life insurance coverage you need requires some art as well as science. Formulas, calculators, and general guidelines from an insurance or financial planner are a great place to start the process, but ultimately you’ll need to determine what you can afford. Consider whether you’re more comfortable with a term policy, or if you’re willing and able to pay more for the benefits of a permanent life insurance policy.