How Much Life Insurance Do You Need?

If you die unexpectedly, will your family be able to maintain their current standard of living? It is an uncomfortable question to consider, but crucial for your personal financial plan. That is why life insurance is one of the most important purchases you can make to protect your loved ones. But how much life insurance do you need?

There are a lot of different strategies out there. At the end of the day, your situation, obligations, and priorities are unique and your life insurance needs should reflect that.

But where do you start? Here are 5 starting points to help you determine your life insurance needs:

• Income multiplied by 10-12x
• DIME Formula
• Human Life Value / Future Projected Income
• Percent of Income Spent on Premium
• Future Expected Expenses (DEEM Formula^TM)

How do you calculate each of these methods and which may be right for you?

What Is Life Insurance?

Life insurance is a product that pays out a benefit to your named beneficiary when you die. You pay premiums to the insurance company over the life of the policy for this protection.

Life insurance is a key part of your protection bucket in the 5 pillars of personal finance.

There are many forms of life insurance with the main types being term insurance and permanent insurance. Term insurance has a maturity date and expires with no death benefit paid if you outlive the policy. Permanent insurance will cover you until you die as long as you pay your required premiums. However, permanent insurance does cost 5-15x more than a similar term policy.

The choice on what type of insurance to get is up to you. But most people are well-served with a majority of their coverage being in the form of term insurance. Buying term and investing the difference (BTID) is a popular strategy to optimize insurance coverage at a lower cost.

What Are The 5 Methods To Calculate Life Insurance Needs?

Deciding how much life insurance you need can seem like a daunting task. However, there are some strategies that can help guide you towards an answer. Each of these strategies can serve as a starting point, but everyone’s insurance coverage needs are unique. You should consider making adjustments to any method you choose so that it fits within your personal financial plan.

1) Income Multiplier Method: Life Insurance at 10-12x Annual Income

The income multiplier method is a very simplistic way to calculate your life insurance needs. You take your gross annual income and multiply it by some factor. It is commonly recommended to target 10-12 times your annual income for this purpose. Therefore, if you make $100,000 a year, your life insurance coverage need under this rule is $1.0 to $1.2 million.

There are many variations of this rule. Some recommend a multiplier as low as 5x and some as high as 20x. There are also versions that add a flat amount per child to cover college expenses, usually $100,000.

This guideline is very generalized and ignores anything specific to your needs. The income multiplier and its variations don’t account for expenses, debt, future salary growth, number of dependents, home ownership, or a host of other factors.

The other methods on the list offer a much more robust view of your needs. But if you want a 2-second general estimate, 10-12x your annual income fits the bill.

2) DIME Formula: Debt, Income, Mortgage, & Education

DIME stands for debt, income, mortgage, and education. This method has you add up all 4 amounts and uses this as a proxy for your life insurance needs.

The DIME formula builds on the simple income multiplier method. When calculating your life insurance, you add up:

• Debt: Add up all your outstanding debts. Credit cards, student loans, personal loans, car loans, etc. When you die you don’t want to leave any uncovered debt. If you have a debt that is forgiven when you die, you can choose to ignore it here
• Income: Take your income and multiply it by the number of future years you would want to replace. Do you want 20 years of coverage until your kids are adults? Then take your annual income multiplied by 20. You can also choose to cover all future salary to retirement age.
• Mortgage: Add your mortgage balance or purchase mortgage protection insurance
• Education: Add an amount to cover your children’s expected college tuition and room & board cost.

After you add all the items up, you subtract any insurance you have already, including any amount you want to self-insure. The DIME method will likely result in a higher life insurance need calculation than an income multiplier, generally.

However, it has a large flaw in that it assumes a static number. Overtime your debts and mortgage should decrease. You may wind up being over insured after a few years of aggressive debt paydown and savings using the DIME formula.

3) Human Life Value: Future Projected Income

The younger you are, the more working & earning years you have ahead of you. The human life value method considers your current and future financials based on salary, age, and desired retirement.

For a standard working career, most people are estimated to need:

• 30x annual income when 20-30 years old
• 25x annual income when 31-40 years old
• 20x annual income when 41-50 years old
• 15x annual income when 51-60 years old
• 10x annual income when 61-65 years old
• 1x NET WORTH when 65+

The above numbers are generally accepted estimates. However, doing a full human life value calculation you would project out your earnings based on your actual occupation, career ambitions, and planned retirement. Doing a real projection with your expected future earnings may result in very different results than the numbers above.

The human life value have the benefit of including inflation and future income growth. But it can result in a very high coverage amount. A 25 year old would save 10x annual income under the income multiplier method in #1, but 30x annual income under human life value estimate.

4) Spend A Percent of Income on Life Insurance Premiums

If you are on a budget and have an allocated amount for insurance premiums, this rule may work for you. This method has you decide on your budget for premium payments and buy enough coverage to hit that expense.

The recommended percent of income to use can be from 1% to 6% which is quite a large range. If you use a 1% rule and make $100k a year, that would give your $1,000 to spend on life insurance.

The downside of this method is that insurance premiums can vary significantly depending on your health and the type of product you choose. This means your actual coverage amount can also vary significantly. You could have $100,000 of permanent coverage or $1.5 million of 10-year term coverage under this rule. That is very different results.

Permanent insurance cost 5-15x more than term insurance. The rule doesn’t specify type or length of insurance, meaning this rule can leave you grossly underinsured.

Additionally you can pay twice as much or more if you are very unhealthy as opposed to being in the best health rating. If you are unhealthy, you likely need more insurance as there is a greater chance you will die. This rule would result in the opposite conclusion since for the same premium you would have less insurance coverage.

5) Future Expected Expenses: DEEM Formula^TM

The last method takes a look at your future expected expenses and sets a coverage amount based on that. Under this calculation, you would look for the expenses you want to cover for all your dependents.

You can take the DIME formula above and replace income with future living expenses. This DEEM formula can make sense for those who are earning more than they spend. Life insurance is there to provide for your loved ones when you die. You save money to pay for future expenses. Your income isn’t what you need to replace, it is the living expenses.

[Professor B.T. Effer Note – As far as we are aware, there is no references to a DEEM formula of life insurance needs. We are claiming a trademark on the method with this post. We view this as the optimal way to view life insurance though.

Your insurance is to cover your dependents needs if you die. You only need your entire income if you are spending almost all your income. If you make $100,000 a year, but you save a significant amount and your family lives on $60,000 a year, your insurance needs to cover that $60k living cost, adjusted for inflation.

An easy way to estimate your cost of living is take your income, strip out how much you save in retirement & investment accounts, and remove payments on debts & mortgages. You are adding the balances of both debt & mortgage separate in the DEEM calculation. The leftover number is roughly what you are spending on lifestyle. But, if you have a budget, which you should, you will have a more accurate number to use.]

The Final Word – Your Insurance Needs

Life insurance is an extremely important part of your financial plans. However, knowing how much coverage to get can be confusing. If you use one of the 5 methods above, you will have a very useful starting point for your coverage amount.

But remember, these are guidelines and depending on your unique situation you may want more, less, or a different mix of life insurance products. You can work with an insurance advisor or visit the site of a major insurance company to see what is available.

Frequently Asked Questions (FAQs)