If you’re stuck on this question, don’t feel like you’re all alone. Figuring the amount of insurance necessary is a common speed bump for many people. Opinions vary on what method should be used to calculate the amount needed but one fact is not contested. If you have people who depend on your income and you don’t have the savings to support their lifestyle until they’re self sufficient you need life insurance.
Without question the most common singular recommendation to determine your face amount is to calculate 10 times your income. Don’t mistake it’s familiarity with some form of universal wisdom. This figure doesn’t account for a lot of things like whether your spouse has an equal income or whether you have a $350k mortgage. It also doesn’t reconcile the difference between someone with 4 children and someone with no children 5 years away from retirement. The biggest reason it’s popular is that it can be determined on the spot without a calculator or writing anything down.
The standard of living approach makes more sense. This method requires you to calculate the standard of living your family will need to live on and then multiply that number by 20. The idea being that the insurance payout can be invested by your beneficiaries and earn 5% per year as an income equal to yours without eating into the principle. An easy way to determine the standard of living is to look at your current budget. This one seems to make a lot more sense but it still doesn’t account for number of children or debt. For someone close to retirement this method is probably overkill and for a young family it’s probably not enough.
The DIME Method
The DIME method is easy to remember and does a great job of considering the major pieces of finance necessary.
Start by adding up all of the debts that are outstanding like a car lien, credit cards, medical bills, or even that pesky school debt. Any debts you hold now will be the responsibility of the executor of your estate to settle. You can read up more on what happens to your debt when you pass but essentially you don’t want this to be an additional stress for your loved ones. If you’re a recent empty nester or if you’re about to be think of the major ticket items you’ll want to ensure there’s money for like some time off for your spouse to grieve or funding for a potential wedding.
Don’t forget to add burial expenses to the amount as well which will depend on what sort of arrangements are made as well as where you live. Costs can range from $5k to $20k so $15,000 on average should be enough.
Income replacement is normally the largest ticket to redeem and is also the most customizable. Your family’s situation is going to determine how you calculate this one. If you have children for example you’ll want to make sure there’s enough money to get them to college so multiply your current income by the number of years until your youngest is 18. Remember that even if your spouse works and has an equal salary to yours once they become a single parent they’re not going to have the same amount of time to dedicate to work anymore. If your spouse is dependent on your income multiply the number of years until retirement by your salary.
- Frugal tip: Divide your salary in half and multiply by number of years until retirement.
For example: Your youngest is 17 and your spouse is 46 but relies on your income alone. You have an annual salary of $80,000 which would be meant to support you and your spouse but in this case it will be for one person. Half of your salary should be enough for the next 20 years until they reach 66 which is full retirement age. $80k/2 = $40k times 20 years = $800,00.
Calculating the mortgage is by far the easiest on of all to figure. It’s worth noting that in some cases your spouse may not even elect to pay off the mortgage if your rate is particularly low. That money can be put to work as an investment at a better rate elsewhere but you’re going to want it to be there all the same to ensure they have to flexibility to pay it off if needed. Also don’t be tempted to skip this step and elect a mortgage insurance policy until you’ve looked at the differences between them.
If you have children and plan to send them to college you’ll probably be surprised to find out how much it will cost you. Over the past 20 years tuition growth has far outpaced inflation and is greater than 5%. Plan on a minimum of $100,000 per child considering tuition, room and board, books, food, and clubs. Even if you’re planning on them to earn scholarships and grants it’s not guaranteed so it’s best to have the funds available just in case.
The biggest thing the DIME method omits is to account for the work you’ve already put in saving for the above circumstances. Once you’ve tallied up all of your debts, income replacement, the mortgage and education costs don’t forget to subtract your savings. Add up all money in your 529, your market investments, or any other assets that could be used and subtract that amount from the total. The only thing I wouldn’t subtract would be retirement accounts no one will be able to access immediately like a 401k or IRA.
There are numerous other methods that can be implemented some of which may be a hybrid of the above methods like adding money for a college fund or multiplying your annual income by the number of years until retirement. Without question the best method would be to meet with a fee only financial advisor who can take a detailed look at your finances and situation and recommend and amount.