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How Much Life Insurance Do You Really Need?

[All information below about life insurance coverage amounts is strictly educational in nature and is not insurance advice, nor a recommendation. View the full website disclosure statement here.]

Featured by: Physician on FIRE in the Sunday Best series on 1/9/22

New Year, new coverage?

The New Year is nigh, which means many resolutions await for those of us fortunate to celebrate it. However, one of those resolutions may happen to be grim: Protecting your dependents from a future where you miss the celebrations. And one of the ways we protect our loved ones is through life insurance, which provides the means for financial stability in our absence.

Life insurance is for them, not you

Life insurance is one of the few tools you never benefit from directly. Instead, life insurance is for those nearest and dearest as a way to protect them against your premature death and the financial strain it could cause. Thus, life insurance is a tool to help achieve your goals if things go awry during your accumulation phase. 

But what type of coverage is right for you? After all, there are many types of life insurance! 

The answer is likely term insurance, which I rationalize in: Why You Probably Need (Term) Insurance.

With term insurance, most people outlive their policy, and thus, their premiums never go to use. However, such thinking is obtuse. 

Instead, premiums provide you and your loved one’s peace of mind, which benefits you if you don’t die young. Thus, steer clear of the permanent life insurance entrapment where your premiums “work for you as an investment” because Permanent Life Insurance Is Not An Investment for the layperson.

Who needs life insurance?

To determine if you need life term insurance, ask yourself: Do I have people in my life that would experience financial hardship if I were to pass away today? If the answer is no, then you likely do not need insurance. Examples of those who may not need coverage include retirees, financially independent individuals, or single folks without kids and debts.

However, if you answered yes, the next question is: How do you determine how much insurance you need and for what term? Well, that is what we will devote the rest of this post towards finding out!

Important Note: If you are single, this conversation is between yourself only, but coverage should be enough for any cosigned debts (such as student loans, which can survive death). On the flip side, if you have a partner, you must include them in the conversation since it directly affects them.

Picking up the DIME

A common way to calculate life insurance needs is through the DIME method, which stands for:

Debt (+funeral expenses)
Income (to replace over a given period)
Mortgage (balance remaining)
Education (expenses for dependents)

Whoever coined this acronym deserves a stellar cup of coffee for creating such a catchy mnemonic device! The sum of the components results in the value of the term life insurance one requires. However, I have reminted it to my liking:

Debt (+funeral expenses)
Income (needed)
Mortgage (balance remaining)
Expenses (needing funding)
Sums (already saved or guaranteed, which are subtracted from DIMES rather than added like the previous four categories)

The result is a new acronym called DIMES. But, what do each of these categories entail exactly? I’m glad you asked! Let’s melt DIMES down to find out.

Update 1/4/2022: I have now included a downloadable Excel Spreadsheet that can be used to aid in the various calculations as you move through the post.

Debt (+funeral expenses)

Debt refers to all outstanding debts owed, excluding your mortgage, plus any costs associated with wrapping up your estate (funeral, etc.). In this category, think of credit card debt, student loans, personal lines of credit, and the likes. Then add in funeral expenses, which on average cost around $7,300 as of writing this post.

Importantly, if your spouse has personal debts, factor these in too. Freeing them of higher interest rate debts will be a huge relief when they are already grieving your loss!

Examples of personal debts:
•Credit card debts
•Student loan debts
•Medical debts
•Automobile debts (when the loan exceeds the vehicle’s value)
•Personal lines of credit debts
•HELOC debts

Once you have tallied these debts, you are ready to move on with the next section.

Important Note: If you do not have a spouse, the Income section is unnecessary, so please skip over the Mortgage section; this applies even if you are a single parent.


Income 

Income refers to how much yearly pre-tax income your spouse will need given your absence. The Income section is calculable in three ways:
•Spousal retirement needs
•Replacement of your forgone contributions
•Replacing your current income for a given period

If you want to calculate income precisely, follow along! However, I have created the quick calculation table below for approximate estimates of Income coverage needed if you are not inclined to do calculations. And do not worry about existing retirement savings and life insurance coverage. Those are accounted for in the Sums section to prevent duplication.

Quick calculation table

For those looking for a quick calculation, I have provided pre-generated values for couples jointly earning $80,000, $100,000, and $250,000 before-tax, assuming five different retirement dates for the surviving spouse.

As noted, these figures are all based on pre-tax income.

Income Section Payout Needed

Years to
Retire
Income
$80,000
Income
$100,000
Income
$250,000
Today$1,057,200$1,287,600$3,015,600
5-years$753,769$918,041$2,150,081
10-years$537,427$654,551$1,532,978
20-years$238,159$297,699$744,247
30-years$121,068$151,335$378,337
For the non-immediate retirement dates, I assume the funds will be invested with a growth rate of 7%

The calculations assume the surviving spouse will live on 80% of joint household gross income (explained in Method 1). Since the national average for individual health insurance is $5,424/year as of 2021, I have factored that into retirement now, 5-years, and 10-years. I have done this since I assume early retirements for these scenarios. Additionally, I have assumed 28% and 20% mortgage expenses and savings rates, respectively, which are deducted from income. These are deducted since they are not needed in retirement.

If you want to do a more detailed calculation, which is prudent for proper coverage, proceed to various methods. But, if you do not plan to manually calculate any of the income methods, scroll down to the Mortgage section after selecting your chosen value from the table above, which will represent the Income component of DIMES formula for an insurance payout.


Method 1: Spousal retirement needs

Generally, the savings needed for your spouse to retire alone will be similar to the figure required for you both to withdraw while alive, albeit slightly less. Why? Because the cost of living per person is cheaper as a couple than as a single dweller. And it is only getting more expensive to live alone

Thus, I suggest using 80% of your joint retirement needs as a target to fund your spouse’s widow or widower lifestyle.

Why use 80%? Well, the American Academy of Actuaries said it costs single retirees 70-75% of a couple’s budget to retire upon a decade ago. Thus, I erred on the side of caution and rounded up since your portfolio size is intertwined with how much income you can safely draw. 

(If you can find a more recent figure on single retiree expenses, please share it in the comments below. I searched continuously, and the 2011 figure is the latest I could locate.)

To determine your joint retirement portfolio needs, you first need to assess your retirement income requirements. By doing this, you can ensure a safe withdrawal rate by extrapolating out your portfolio size based on a sustainable yearly withdrawal stream.

But, what if you are unsure how much income is required to retire with your partner? That is okay!

First, take your current (yearly) lifestyle expenses and subtract any debt, mortgage (if you have one), combined health insurance, and saving payments. Then add any lifestyle indulgences and discretionary sending planned, and voila, you have your joint income needed after-taxes.

Next, multiply the above number by 0.80 to account for the reduced expenses of your spouse continuing without you. Then, if early retirement is the goal, add solo health insurance costs for your partner to the net 80% figure. (This assumes early retirement will require health insurance for 30+ years. For those much closer to Medicare age, you can add the expected sum of health insurance costs to the Expenses section, in One-off payments, and skip solo health insurance costs by using $0 for the value.)

To determine the solo health insurance cost, take the current ACA Exchange insurance cost for your spouse, years until medicare age, and net inflation rate (NIR) for health insurance and plug them into the equation below.

Average cost of health insurance equation/Solo yearly health insurance cost

Net inflation rate (NIR) for health insurance equation

Health insurance inflation rate – ordinary inflation rate = Net inflation rate for health insurance

The current health insurance inflation rate (HIR) is 3.44% as of writing this post.


You now have determined the annual after-tax living requirements for your partner alone. Subsequently, you will need to factor in the estimated tax rate your partner will pay.

Your partner will be able to claim widow or widower tax tables for two years after your passing. However, they will spend most of their life in the single or head of household tax bracket unless they remarry. Thus, I encourage using the single or head of household tax bracket effective rate for the following calculation.

Significantly, tax rates can and will change, so make your best-educated guess and know that it may change.

Source: Bankrate.com
Source: Bankrate.com

Important Note On Taxes: While the one-time insurance payout is non-taxable, the growth of the money through investing will be taxable. (After all, the payout can only go into post-tax accounts.) Thus, your spouse will have a mixture of long-term capital gains and ordinary income each year, depending on the selected retirement investment portfolio construction.

Once the estimated effective tax rate is determined, express it as a decimal and use it as the denominator, dividing the income sum from above in the numerator position while subtracting your tax rate by 1.

Retirement income needs / ( 1 – Effective tax rate)

Example: $80,000 / (1 – 0.20) = $100,000

Lastly, divide the final yearly income sum by 0.04, which will give you the dollar figure needed to fund your spouse’s annual retirement needs. 

Why divide by 4%? Because 4% is known universally as the safe withdrawal rate for retirees. Hence, it is formally known as the 4% rule, which I outline in How Much Do You Need to Retire?

The resulting sum represents the dollar amount needed from the Income section to sustain your partner’s successful retirement, starting today, with few chances of running out of funds during their lifetime.

Immediate spousal retirement sum equation

However, if you were to die today and your spouse would continue to work, you must calculate the non-compounded value (assuming your spouse would invest the insurance proceeds).

Non-compounded value equation

Value in the non-compounded equation is the previously calculated sum above.


Method 2: Replacement of your forgone savings

For those that want only to replace their portion of forgone joint retirement savings, multiply your savings portion, expressed as a ratio, by the sum of the prior section (either the immediate retirement sum or the non-compounded sum for a later retirement). The resulting number is the payout needed for your partner to substitute your forgone savings. 

(Your savings portion or ratio is your annual retirement savings divided by the sum of your annual joint retirement savings. For example, Your $20,000 / Joint $40,000 = 0.50 ratio)

Forgone savings portion replacement equation


Method 3: Current income replacement for a period

For those who want to replace their income for a set period, multiply the years desired by your current income. That will be your sum to use for the Income section.

Set period income replacement equation


You now have your Income section number from one of the three methods, and you may add it to the figure generated during the Debt section.


Mortgage

Relatively self-explanatory, the Mortgage section of the DIMES equation refers to how much debt remains on your home loan. You will use the current balance remaining on your mortgage for this section. 

Why? As alluded to previously, housing as a single adult is more expensive. Thus, paying off the mortgage after your passing gives your spouse an advantage.

(If you do not have a mortgage and rent with your partner, you will need to provide your spouse with a more significant income grant by factoring rent in the Income section above.)

You may now add your mortgage balance to the sum of your Debt and Income sections.


Expenses

The Expenses category includes any temporary future expenses, such as education, childcare, or one-off expenditures that you need to plan for in the insurance payout sum. Let’s discuss these individually:

Education

Education refers to future higher education costs for your dependents, which on average, is a little under $10,000/year per dependent as of writing this post. However, this figure only includes in-state public tuition. If you plan to help fund your dependent’s entire college education, this figure rises to nearly $26,000 after factoring in housing, food, and school supplies.

Thus, for a 4-year college degree that you and your spouse subsidize completely, expect to pay ~$103,500/dependent in today’s dollars. 

If you don’t plan to pay for your dependent’s education or have dependent’s, you can skip this subsection. Furthermore, for those planning to pay a flat dollar amount of higher education expenses, use that as a sum for the Education subsection. However, if none of these caveats exist, let’s determine the future cost of education for your yet-to-be high school graduate.

Cost of 4-year degree with various costs considered

Years Away4-Year Tuition4-Year AdditionalTotal Cost
0$38,320$65,220$103,540
4$44,451$75,655$120,106
8$50,582$86,090$136,673
12$56,714$96,526$153,239
16$62,845$106,961$169,806
20$68,976$117,396$186,372
Years Away represents the years until a dependent starts college

My table assumes a higher education inflation rate of 4%, which I calculated using the rolling 10-year average increase across all states, with the help of the dataset provided by 529-planning.com. For additional costs, I assumed a 2% inflation rate (which is presently less than current inflation). Lastly, the future start date moves in 4-year increments, beginning with 2021 as year 0.

If you want to calculate the expected cost of a 4-year degree with higher certainty in your state, use these equations below by factoring in your state’s college inflation rate, using this link, and the ordinary inflation rate, which the Federal Reserve targets at 2%. Once you calculate future tuition and additional costs, combine them to find your dependent’s total projected education costs.

Tuition cost equation

Additional costs equation

Total costs equation

Future tuition cost + future additional costs = Total future costs

EIR stands for education inflation rate expressed as a decimal, and FIR stands for Federal Reserve targeted inflation rate expressed as a decimal of 0.02. Notably, you can use whatever inflation number you are comfortable with instead of the FIR.

Childcare

If your spouse plans to retire in the event of your premature passing, childcare costs will likely be minimal. However, if they plan to work and your insurance payout covers only retirement funding, you will need to factor in child care costs in your state. After all, your spouse likely will need outside help as a single parent. Furthermore, if you have a dependent with special needs that will require assistance beyond both of your lifetimes, now is the time to consider those costs.

For those needing childcare assistance, the average cost of childcare in the United States was $10,501/year as of 2021 using the dataset found here and averaging the 40 states listed together. Significantly, this data biases childcare costs for dependents aged four and below. Furthermore, childcare services may not be necessary once dependents are ten years old. 

Using the average above, I have extrapolated the dataset into a table and assumed a 2% inflation rate for your convenience. The result provides an easy ballpark estimate of childcare costs a single parent may incur if relying on professional daycare services.

Childcare Costs Incurred

Years of CareTotal Costs Incurred
2$21,212
4$43,281
6$66,242
8$90,130
10$114,983
Cost is per dependent

For those desiring a more accurate calculation of childcare costs, use this link to determine childcare costs in your state. Then use the following equation to determine the total cost of childcare for the desired period at a given inflation rate.

Total childcare costs for a given period formula 

This equation assumes inflation compounds once yearly

One-off payments

If you or your spouse project any one-off, substantial payments in the future, add them into the Expenses section here. Examples include relocating, building a retirement home, etc.

For those closer to Medicare that have decided to factor in health insurance costs here, you can use the following equation to determine the total value needed for spousal health insurance.

Closer to Medicare spousal health insurance sum equation

HIR = Health insurance inflation rate, which is 3.44% as of writing this post.



Once you have calculated the costs of the three Expense subsections, add them together to the sum of the prior Debt, Income, and Mortgage sections.


Sums

Sums is the final category and refers to all current savings towards retirement and education, plus any existing life insurance coverage you have. The sum of this section is then subtracted, not added, from the prior four sections.

For example, if you have saved $30,000 for higher education expenses, this figure is deducted from your DIMES calculation. Additionally, suppose you have existing life insurance coverage that you previously purchased or that your employer provides. In that case, you can subtract it out, too, since it becomes cash in the event of your premature death. 


Calculating your life insurance coverage number (i.e., amount)

You have made it to the final section, which calculates the coverage needed using arithmetic: D+I+M+E-S 

Debts (+funeral expenses) + Income + Mortgage + Expenses – Sums = Coverage needs

Voila! The number calculated is a reasonable ballpark estimate of the term life insurance coverage you should consider purchasing. 

For those interested in doing the calculations themselves, I have included a link below to download an Excel spreadsheet. The downloadable spreadsheet will allow you to enter the various details of your situation, which will then automatically generate the ideal coverage numbers for life insurance.

Final life insurance coverage consideration: Term length

While the calculation above considers time to determine the total dollar value needed in an insurance policy payout, it does not tell us what length of coverage is necessary. For this, we must do self-reflection and consider life insurance laddering.

Definition of life insurance laddering: The process of buying multiple life insurance policies of different amounts and expiration dates so that coverage decreases over time as your savings naturally grow. Implementing such a strategy ensures higher coverage when you are younger and decreases over time as your coverage needs wane, saving you money and providing flexibility.

While everyone’s situation is different, to determine the term length you need, weigh where you could be 10, 20, and 30 years from now. At each interval, how much savings do you project having? Will you still have debts? Using a compound interest calculator, like the one located at Investor.gov, and looking at your debt payoff schedule for various loans you have is critical during this exercise.

Once you estimate your financial situation in the future at various stages, you can ladder your life insurance needs. While more complex, laddering is an excellent strategy for those willing to afford the extra time to run through the various calculations. However, if you would prefer to take the simple route, you would select the coverage level that covers everything needed today and lasts until retirement (or whenever your last Debt, Mortgage, or Expense section expenditure is paid for, whichever is greater).

Example of term insurance laddering: Blair is 30 years old and has a spouse and a newborn. Together, they plan to retire at 60 and pay for their child’s education expenses. Blair buys a 20-year term policy with $150,000 in coverage to provide for their newborn. Additionally, Blair purchases three-term policies for $300,000 each, with 30, 20, and 10 year coverage periods. By doing this, Blair covers the family with $1,050,000 in coverage against premature passing. Thus, Blair has peace of mind and coverage that doesn’t overinsure themself as they age.

In closing

Life insurance provides peace of mind for those still in the accumulation phase of their life. While easy to overlook, life insurance is a critical tool to ensure (and insure) your family’s future stays on track. Furthermore, by implementing the ladder strategy, you can ensure you only pay for what you need and nothing more.

After finishing this article, I hope you have a better idea of how much life insurance coverage might be appropriate for you and what length of coverage makes sense. However, it is essential to note that if you have additional considerations not mentioned in this post or a more complex lifestyle, weigh them and seek professional help if necessary. 

So, do you have life insurance coverage? If yes, did you use a similar method to the one outlined above to calculate your needs? If not, what strategy did you use? I would love to hear in the comments below, and if you enjoyed this article or have comments, concerns, or critiques, please let me know. Thanks for reading, and as always, have a great day!


FAQs:

How do you determine how much life insurance you need?

By taking the sum of all debts owed, years of income needing replaced, mortgage balances remaining, and expenses needing funding, and then subtracting out savings and insurance policies that you already have. You can use the spreadsheet in this post to do a more detailed calculation.

What is better term or whole life?

Term insurance will generally be the better insurance option for the layperson, as the premiums are more affordable and the opportunity cost of investing in a whole life policy compared to traditional investment accounts is substantial.

Are life insurance payouts taxed?

Generally life insurance payouts are not taxed. However, once they are invested or deposited in a bank, and growth or interest earned will be taxed.


Mile High Finance Guy

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4 thoughts on “How Much Life Insurance Do You Really Need?”

    1. Thanks, Accidentally Retired! The idea started after discussing life insurance coverage with Sam of Financial Samurai in the comments section of one of his most recent posts. After some back and forth, I decided to see if I genuinely needed life insurance coverage or not, given my FI status.

      During my analysis, I failed to find a sufficient resource online to help me determine my coverage needs, so I decided to create my own and share it with others! The results suggested a modest Term 20 policy because we plan to have a child within two years and help pay for their higher education costs. Our FI failed to cover this fully. Thus I will need to start diverting more money to the 529 plan I created already in the future.

      Thanks for commenting!

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