How Much Life Insurance Should You Buy?

UPDATED: May 19, 2022

For most of us, purchasing life insurance is a low priority expense. After all, paying the rent or mortgage, car payment and other immediate needs are often forefront in our minds when it’s time to budget. While this may be typical, have you actually thought about what will happen if you die? When you do, the next logical question is, "how much life insurance should I buy?"

If you die, many of those bills won’t go away, but your income will. Many families have been left in financial turmoil while also going through the grieving process when a major source of income disappears through death.

How will your debts be paid? What about funeral expenses? What amount of life insurance will take care of your family’s ongoing needs?

You Probably Need Life Insurance

Admittedly, there are a few people who don’t need life insurance. This includes older people who have no debt, no dependents, and plenty of assets. In this case, cash assets can be used to pay those final expenses, and there’s a good chance that proper estate planning has been carried out.

For these individuals, the high cost of late-in-life coverage might not be worth it. You can even prepay for funeral expenses if that’s a concern.

The other major demographic where life insurance may be unnecessary is single folks with no debt or dependents. Here, the only real value of a life insurance policy is to pay those final bills or funeral expenses. However, your family isn’t likely to end up in financial problems long-term due to your death. A small policy from your job might well be enough, if you feel it’s necessary to worry about it at all.

On the other hand, you do need insurance if you have dependents, debt, or anyone who will be impoverished if you die. For instance, people with car loans and mortgage payments risk leaving their families on the hook if their income is permanently lost.

One exception to the debt rule: publicly-guaranteed student loans can be forgiven if the borrower dies before it’s paid off. 

Generally, the category of “needing life insurance” covers a large percentage of young and middle-age adults. If you fall into this category, let’s take a look at your options.

Common Rules of Thumb

Many financial advisors have taken the position that you should buy 10-12 times your salary in life insurance, assuming you have dependents. The thinking is that by the time this amount of money runs out, the debts will be paid off and any survivors will have found a way to adjust. Money can also be used to fund a college education (so your kids don't have to have large student loans) or hire people to do the things that the deceased parent once did. 

While that rule worked well in the days of single-earner families that stayed together, today’s calculations are a bit more complicated. For one thing, we tend to carry more debt than we once did. Your debt load can change the answer to, "how much insurance should I buy?"

A generation ago, the primary debt was the mortgage, but now we have all sorts of things. Car loans, credit cards, installment loans and other obligations pile up quickly. With the exception of forgivable student loans, your estate is on the hook for whatever debt you’ve failed to pay back.

You can also choose to buy several times your salary plus a sum of money (usually $100,000) per child for college.

A Better Approach: Providing For Your Family

We would argue that the common wisdom is a great starting point, but it doesn’t go far enough. For instance, families that lose their sole breadwinner will have to cope somehow. Being able to pay off the car, mortgage and credit cards is just the beginning. This amount of money will settle your estate, but what about the future? 

Let’s say that one parent has stayed at home with the children. In this situation, it will be necessary for the other parent to return to work. Paying for the services needed for a return to work is one additional amount that can be added to life insurance totals. That can include child care (higher amount for smaller children than older ones), the need to hire a housekeeper, and increased education costs. 

Income and Savings Replacement

Looking for something that’s even more comprehensive? Brokerage firm Edward Jones pushes something called the L.I.F.E approach to insurance coverage, which it applies to term policies.

L stands for Liabilities: all your debts including the mortgage.

I stands for Income: how much income will your family need to replace if you die?

F stands for Final Expenses: such as funeral costs, probate expenses, and that last set of utility bills.

E stands for Education: if you have kids that will go to college.

Unless you have saved up enough money to put the kids through school, you should think about how much it will cost for them to get through college. Of course, there are other options you can add to your calculation, such as extra money for the kids or charity.

DIME Rule

Another name for the same basic principle: the DIME rule. This stands for Debt and final expenses, Income, Mortgage, and Education.

In this case, you’re splitting off the mortgage from other debt and the messy world of funerals. This makes sense as some expenses can be reduced, but the family home is an important thing for your survivors to keep. Nothing is worse than a parent passing away and the rest of the family having to move due to a mortgage they can’t pay. Instead, if you include the amount of your mortgage payment as a separate amount then the house will be paid for. 

With an income replacement component, the idea is to let your family retain the standard of living it had before you died. While there’s no replacing you, they won’t have to worry about money.

Finally, factoring in education makes up for the years of college planning which are interrupted by your death.

Both the LIFE approach and the DIME rule have one thing in common: they assume you are passing your accumulated wealth onto the next generation. That’s because they aren’t subtracting your assets from the total picture. In other words, any money in a brokerage account or other savings instrument is not being used to pay back debt or replace income. They can be used, for example, by your surviving spouse for retirement. Or, the money can be passed on to the kids when they get older to give them a head start.

If all else fails, this inherited money can be used as a hedge against unexpected expenses.

Final Thoughts

When deciding which method is most important to you, there are a few things to think about other than what they cover. For instance, did you know that life insurance payouts are tax free? This has several implications. One of them is that your survivors won’t have the extra income count against their tax bracket.

Beneficiaries can pay off the house and not have to pay taxes besides the local assessments. If you have significant assets then the money can be used to pay estate taxes without needing to pay tax on the life insurance proceeds.

Finally, don’t fall for elaborate insurance policy schemes.  Low-cost term policies are fine for most people. Insurance salespeople are notorious for selling expensive whole life or exotic policies to earn high commissions. You could end up paying high monthly premiums that are unnecessary. Instead, take that money and save it in something that can be used as an emergency fund, retirement, or passed to your heirs. This way, you aren’t putting all your eggs in one basket.