How Much Life Insurance Do You Need?

By Richard A. McGrath, CIC, LIA

Most people recognize the need for life insurance, but they typically don’t know how much or what kind of life insurance to buy.

So how much do you need?  It depends on your financial goals, your lifestyle and other factors.  Life insurance serves many uses, but its most important purpose is to ensure that your family can continue its current lifestyle if it loses your income.

Insurance experts typically estimate that your family will need 60% to 80% of your income on an ongoing basis to continue its current lifestyle.  Because your living expenses will be eliminated, your family will not need 100% of your income.

Your family will also need funds to settle your estate and pay other one-time expenses.  The balance on your mortgage, credit card debt, car loans, home equity loans and any other debt should be considered.  You may also want to include the costs of college for your children, as well as any other final expenses.  The rule of thumb for a funeral and other final expenses is that they will cost about 4% of your total estate or $15,000, whichever is greater.

Once you have calculated all of these expenses to the best of your ability, you’ll need to review all sources of income, as well as all assets.  In addition to your spouse’s earnings, include any survivorship benefits, as well as income from dividends and interest.

Assets listed should include real estate, investments and any existing life insurance policies.  Include funds from 401(k) plans, SEPs, IRAs and other retirement plans.  Also include funds in bank accounts, certificates of deposit, mutual funds, stocks and bonds, and any other investments.  Also include any rental income.

Calculating the Shortfall

Once you calculate the value of all sources of income, all expenses and all assets, you will need to determine if there is a shortfall between income and expenses, and how large it is.  Subtract one-time expenses, such as funeral costs, first.  Next, calculate how much income your surviving spouse or other family members will need to pay ongoing expenses.

At this point, you’ll need to make some decisions.  Do you want the “death benefit” from your life insurance policy to pay off the balance on your mortgage, for example, or do you want your spouse to continue making monthly payments, perhaps using funds from your savings account or some other source of income?  If you and your spouse are not of retirement age, will funds from your 401(k) plan be needed?  What are the tax consequences?  Will your spouse be selling any assets to pay off expenses?

Finally, you’re ready to compare what’s available with what’s needed.  Go back to the percentage of your income that’s needed to sustain your current lifestyle.  Subtract total expenses from total income, then subtract the amount left from the amount of ongoing income you’ll need.

The number you’re left with is the amount of money you’ll want your life insurance to provide on an ongoing basis.  Of course, if you have any existing life insurance policies, subtract the death benefits from your total.

You now have identified the amount of income you need your insurance to replace, but you’re not quite done yet.

To provide income on an ongoing basis, your beneficiaries will need to invest the death benefit – or what’s left of it after paying off expenses – and live off of the returns it produces.

For the sake of simplicity, assume your family needs $50,000 a year.  You would need to produce a 5% return on a $1 million death benefit to produce that level of return.  If your family needs $100,000 a year, you would need to produce a 10% return on the $1 million policy, a 5% return on a $2 million policy or some other variation.

Keep in mind, though, that if your family needs $50,000 today, it will need more as the cost of living rises.  No one knows what the rate of inflation will be in the future, but be certain to include some flexibility in your calculations if you want to make certain your death benefit provides income to your beneficiaries as long as they are alive.

A final point to consider is that your needs will likely change as you age.  When you are young and raising a family, your income needs are greater than when you are old and retired.  As you get older, you may want to adjust the level of insurance you have.

You don’t want to have to pay for less coverage than you need, but you also don’t want to have to pay for more coverage than you need.

Cash Value vs. Term Insurance

In addition to determining how much insurance you need, you’ll have to decide whether to purchase term life or cash-value life insurance.

Some people purchase term insurance when they are young, then switch to cash-value insurance when they are older.  Term insurance is in force only for a certain number of years.  Once the term expires, you will need to purchase another insurance policy.  As you age, the cost of term insurance increases.

Cash-value insurance is more expensive and also increases in price as you age, but it’s the one form of insurance where you’re guaranteed to collect on your claim, assuming you keep up with premium payments and meet the conditions of the policy, and your insurance carrier remains solvent.

Cash-value life insurance provides coverage throughout your life, as long as you do not cancel the policy and continue to pay your premiums.  The younger you are when you purchase your policy, the greater the percentage of your premium that goes toward building cash value.

Depending on the type of policy, the cash value may be invested by the insurance company or by you.  You may borrow against the cash value, although unpaid loans will reduce the death benefit and surrender value.  If you cancel your coverage, you may receive all or part of the cash value if you cancel your coverage.  When you purchase cash-value insurance, you often have to pay sales charges.

Because cash-value life insurance has tax advantages, it is frequently used for transferring financial assets, especially for estate planning and business succession planning.  Transferring ownership of the life insurance to an irrevocable life insurance trust can reduce estate taxes.  If the policy has a Modified

Endowment Contract (MEC) rider, any earnings in the MEC account will not be subject to income taxes until they are distributed.

Calculating the amount of life insurance a person should buy may seem complex, but it’s a figure that can be obtained fairly quickly if the proper financial information is readily available.  Try making the calculation yourself, or visit your insurance agent and ask for assistance.  Insurance agents make such calculations routinely.

Richard A. McGrath, CIC, LIA is President and CEO of McGrath Insurance Group, Inc. of Sturbridge, Mass.  He can be reached at

This article is written for informational purposes only and should not be construed as providing legal advice.