We want to be transparent about how we are compensated. Some links in articles are from our sponsors. Learn more about how we make money.
The Role Life Insurance Plays in Your Finances
The purpose of life insurance is to ensure your family and loved ones are financially secure after you die. If you have a family and you don’t have a high net worth, life insurance is an absolute necessity. To start with, dying is not cheap. The average cost for a funeral these days ranges from $10,000-$20,000.
For most people in most circumstances, term life insurance makes more sense than permanent life insurance. This is due to the massive price difference between term and whole life insurance, with term insurance having a significantly lower premium.
How Much Is Enough?
The questions of whether you need insurance and whether to go term or permanent are fairly straight forward and intuitive. What is much less obvious is how much insurance do you need?
According to one industry report, only 59% of Americans have life insurance. More interesting is that nearly half of those people with life insurance are “underinsured”, meaning they do not have as much life insurance as they should.
When you think about how much life insurance you might need it’s important to remember an important fact.
You’re not insuring your life, you’re insuring your paycheck.
The point of any type of insurance is to maintain the status quo for the beneficiaries. Insurance should not make the beneficiaries better off or worst off (from a financial perspective).
The point of life insurance is to maintain your family’s standard of living in the event of your passing.
Unless you have a trust fund or have achieved FIRE, the largest asset you have in life is your paycheck. When you die, your paycheck dies with you. While at the same time, the following items remain with your family when you die.
- Car payments
- Grocery bills
- Property tax
- Childcare costs
How much life insurance you need is determined by how many years of your paycheck you need to leave behind to ensure your family does not financially suffer in the event of your passing.
Breaking Down the Numbers
Life insurance Canada has done a great job of breaking down the numbers of how much of our annual paycheck we might need to insure and for how many years you want that income replaced.
One of the biggest variables is whether you live in a single or dual-income household. If you are the sole income provider or the clear breadwinner, you will need more life insurance than if you and your spouse made a similar amount of income.
One rule of thumb is that for single-income households, at least 80% of income needs to be insured. For dual-income households, at least 60% of income needs to be insured.
Another important factor that will help you determine how much insurance you need is how many years’ worth of income do you want to replace?
- The most number of years of income you would want to insure would be enough to replace your income from today until retirement. Remember, you are insuring your income and your income goes away at retirement so it does not make sense to insure beyond that point.
- The least number of years of income you would want to insure would be the number of years until you expect your children to be financially stable. Anything less than this amount could put a financial strain on your family.
Let’s illustrate with a hypothetical example.
- You live in a dual-income household
- Your current age is 37
- You make $60,000 per year
- Your spouse makes $40,000 per year
- You have one child who is seven years old
- You assume your child would be financially secure by 25 and that you plan on retiring by 60
If you wanted to ensure your income until retirement, you might consider an insurance policy worth $828,000 ($60,000 X 60% X 23 years).
If you wanted to ensure your income until your child is financially secure, you might consider an insurance policy worth $648,000 ($60,000 X 60% X 18 years)
Like with any financial decisions, it’s important to develop a logical framework to make decisions.
It’s helpful to remember why you buy life insurance which is to provide financial security for your family in the event of your passing and your family losing the income you provide.
How much life insurance you need will be dependent upon how many children you have, whether you have a spouse that is working, whether your spouse would want to continue working, and what age your children will become financially secure.
The factors discussed in this article are some but not all of the variables that need to be considered for you to choose the optimal amount of life insurance.
To know the exact amount of insurance you need it’s best to sit down with a financial planner you can trust that will walk through all of your specific details and provide an unbiased assessment of your insurance needs.
Do you have life insurance? What factors did you consider when choosing how much coverage you paid for? Let me know in the comments below.
Ben Le Fort
Hi, my name is Ben. I am the founder of Making of a Millionaire. I have been obsessed with personal finance and learning how to manage money, ever since my parents declared bankruptcy and lost the family home to foreclosure in 2010.
I spent the next 10 years continuing my journey of educating myself about money. This education was both formal and informal.
On formal education, I earned a Bachelor’s and a Master’s degree in Finance & Economics.
On the informal side, I consumed every book, video, blog post, and podcast that discussed personal finance.
Education was nice, but it wasn’t until I began implementing what I learned that I began feeling more hopeful about the future.
Before long, I had paid off my first loan. Then the next. By 2015 I was debt-free. By 2016 my wife and I bought our first house. Then we started investing. We bought another house and began building real wealth.
As our wealth grew, the memories of that family bankruptcy seemed further and further in the rear-view mirror. My stress and anxiety began to melt away and I was able to sleep at night without my mind racing and problem-solving.
By 2018 I knew it was time to start sharing what I learned about managing money and Making of a Millionaire was born.
I hope you find the articles, videos, and courses created by Making of a Millionaire to be of value to you. Please feel free to reach out to me directly if you ever have feedback or questions.
You can read all of my articles on my personal site, or on Medium. If you’re interested in video-based personal finance tutorials and education, you can Subscribe to my YouTube channel or check out my in-depth personal finance course.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.