How much Life Insurance do you really need?

Life insurance is a painful topic. No one likes to ponder their own death and how their family will live without them. That said, if you have a spouse and kids, you need to protect them from the possibility that you might not always be there.

So how much insurance do you really need? Let’s first decide what it is we’re trying to cover here. For starters, I’m not talking about insurance for your business partners or to cover things like taxes on your estate. Today, we’re going to talk about replacing your income for your family if something happens to you.

As I’ve gone through the process for my family, there are two approaches that set both a minimum and maximum to the amount of insurance you could want. From there, you can choose somewhere in between according to your particular situation and preferences.

Bare Minimum VS Deluxe Method

The first method, let’s call it the Bare Minimum method, assumes your spouse will work after your passing and scale down the family lifestyle. It assumes that your spouse is able to earn an income that can support the family through the remaining childhood and adolescent years. Under these assumptions, insurance is there to give a little time and breathing room to figure out how to adjust the family lifestyle after your passing.

So, under my Bare Minimum method, you should buy enough insurance to cover the following amounts:

1. The sum total of all the family debts. Mortgage, lines of credit, cars, and credit cards (which you should always pay off, but in case you’re carrying some…) This will ease the ongoing burden of carrying the family for your spouse.
2. Two years worth of your income. This will give your spouse two years to decide whether to sell the house or not, to reorganize the family lifestyle in a sustainable way and to set the stage for the new future.
3. $50,000 per child. If you already have an RESP, you could reduce this amount by the value of the RESP for each child. This will provide a minimum amount to support each child through their college or university degree.

I used to follow the bare minimum method myself. With the birth of my third child though, I’ve reconsidered my situation. With three children, it will be more difficult for my wife to take care of the kids and have a full-blown career if I weren’t there.

So, my thinking changed to consider a new method of calculating an amount that would allow my wife to live exactly how we currently do, without having to change anything. Let’s call this method the Deluxe method.

In the Deluxe method, you can think of life insurance this way: It is an amount that will replace your after-tax income from now until you retire. After all, it’s your after-tax income going forward that will determine your family’s lifestyle in the future.

I am making one big assumption in doing this. I’m assuming that you are insuring your current lifestyle and savings rate. If you’re overspending relative to your income or if you’re not saving enough for retirement, those are problems that insurance can’t fix for you. Also, if your income goes up or down substantially, you should be reviewing your insurance anyway.

Let’s do a bit of math

There are two variables that matter here: Your current income and your age. Knowing your pre-tax income, we can make some estimates about how much tax you pay. We can then push that forward, increasing by inflation every year (about 2%), until you reach age 65. Knowing your age obviously tells us how many years to push that forward. We then discount that inflated after-tax income every year back to today, at a reasonable investment rate of return (say 5%). The present value of those future after-tax incomes is equal to the amount of insurance you need.

So, from that math, what kinds of rules of thumb can we derive? If you’re around 30 years old, making $100,000 per year, you’ll need about 17 times your income, or $1. 7 Million to cover your future earning potential. At 40, 50 and 60 years old, starting at an income of $100,000 still, the rs are 17, 14, and 7 respectively.

For simpler reference, I’ve created this table to figure out how many times your income you need in insurance to provide for your loved ones as if you were still there.

Do you have enough insurance? Do you have too much?I hope these two frameworks have given you some food for thought on how much insurance you might need, depending on what lifestyle you want to leave for your family if the unthinkable happened to you.