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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.
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.
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.
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?
Let’s illustrate with a hypothetical example.
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.
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.