How Much Life Insurance Do I Need?

When deciding how much life insurance you need, factors like your age, financial obligations, family situation, and goals play a key role. While not everyone requires life insurance, it can be a valuable financial planning tool for addressing uncovered risks.

Understanding the Purpose of Life Insurance

The primary purpose of life insurance is to provide financial support to the dependents or loved ones of an insured individual after they pass away. When an insured becomes deceased, their beneficiaries are entitled to receive payment from the life insurance provider. This payment is known as a death benefit. Death benefit payments are income-tax-free and typically made in a lump sum fashion. So, when someone says, “How much life insurance do I need?” they are essentially saying, “How much death benefit do I need?” The answer to that depends on what you intend the death benefit to cover.

Common Uses for a Life Insurance Payout

Once a beneficiary receives a death benefit payment, they can spend those funds however they wish. However, there are a few common reasons that folks decide to purchase life insurance in the first place. They include:

• Mortgage payoff: A mortgage is often the biggest liability for the average family. Many families rely on life insurance to pay off the remaining balance of a home loan in the event that one of the homeowners becomes deceased.
• Debt repayment: Life insurance can also be used to eliminate various types of debt, including credit card debt, car loans, and student loans.
• Children’s education or future expenses: Some parents want to ensure they can contribute to their children’s education and/or assist with future expenses like weddings or a first-time home purchase. Unfortunately, many young parents have yet to save the funds to pay for these expenses and plan to use future earnings. However, a premature death would pose a risk to that plan. Life insurance can ensure funds are available for your children’s college tuition, weddings, or even a down payment on their first home.
• Income replacement: In a dual-income household, life insurance can serve the crucial purpose of replacing all or a portion of the income lost from one spouse becoming deceased. Life insurance proceeds can be invested with the sole purpose of providing a steady income stream for the surviving spouse.

Calculating Your Coverage

To estimate how much life insurance you need, start by assessing if any of the aforementioned items apply to you while also considering if you have other needs or goals for a life insurance death benefit. Here’s a step-by-step process:

1. Mortgage and debts: Consider whether you want your life insurance to fully pay off your mortgage and any other outstanding debts. If the answer is yes, add those amounts to your coverage needs.
2. Children’s future expenses: If you intend to cover your children’s college education, weddings, or assist with buying their first home, factor those costs into your life insurance amount.
3. Income replacement: Calculate how much of your income you would like to replace for your spouse/family in the event you passed away unexpectedly. For example, if you want to replace $60,000 per year for 10 years, that’s roughly $600,000 of coverage. If you assume those proceeds will be reinvested, you could reduce that amount to include future expected earnings. Also, be mindful that life insurance proceeds are generally tax-free, so you may not need to replace 100% of your pre-tax income. For example, if your gross income is $80,000, but your net income is $60,000, you would only need to replace $60,000 per year. Some experts also suggest that a surviving spouse’s expenses would be reduced by 25% in the event of the first spouse passing away. You may also want to factor this into your income replacement amount.
4. Additional goals: Some individuals have a specific amount of money they’d like to leave to their children (i.e. $1M). Do you have a specific amount you want to leave for your children or other heirs as part of wealth transfer? If so, this could also be included in your life insurance plan.
5. Estate taxes: If your estate is large enough, you may need to plan for estate taxes. In Illinois, the estate tax exemption amount is only $4 million per person, while the federal estate tax exemption amount is roughly $13.6 million (in 2024). Estates over these amounts may be subject to estate taxes, or inheritance tax. If this applies to you, you may want to secure life insurance as a means to help pay the estimated estate taxes.

Term vs. Permanent Life Insurance

For most of the needs mentioned—such as paying off debts, replacing income, or covering specific future expenses—term life insurance is usually the most appropriate and cost-effective option. Term insurance covers you for a set period (e.g., 20 or 30 years) which is often sufficient to address these temporary financial needs.

However, if your goal is to provide a permanent financial legacy or to cover estate taxes, you may want to consider permanent life insurance (such as whole life or universal life), which does not expire after a set term. Permanent policies are typically more expensive but can be useful for wealth transfer or estate planning.

Final Thoughts

Ultimately, the right amount of life insurance depends on your personal circumstances and financial goals. It’s essential to review your financial situation and plan for the unexpected, ensuring your loved ones are protected. Whether you aim to pay off your mortgage, fund your children’s future, or provide income for your spouse, the right life insurance policy can give you peace of mind that your family will be protected no matter what obstacles arise.

If you’re unsure about how much coverage you need or which type of policy is best for you, a financial advisor or insurance professional can help you make an informed decision.

Consulting with a financial planner who can provide personalized advice can help you navigate these decisions. If you need tailored advice on your retirement strategy, seeking the guidance of a CERTIFIED FINANCIAL PLANNER™ professional can provide clarity and help you make informed decisions.

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