Using life insurance as a tool to protect your future income earning potential is a strategy that has grown in popularity throughout our career of helping people buy this product. There are many equations and endless calculators you can use to determine an approximation of the coverage amount needed. But most calculators seem to be endless, asking about future college costs of your unborn children and how much do you spend on eating dinner each night. Most of these calculators invoke thought but don’t prompt action and cause analysis paralysis.
Life insurance is complicated enough, determining the dollar amount of coverage should be the easiest part. If you are able to view life insurance as a financial tool to protect your family from the worst thing that could happen, the loss of you, you are on the right track. The most catastrophic incident that could happen is to lose a parent of the household, especially with a young family. It is bad enough to lose this beloved leader of the household but also losing the income that this person was supposed to generate for the rest of their life would be like pouring salt in the wound of your family each morning they wake up and easily avoidable.
There are many different methods and forms of logic utilized to figure out how much coverage you should have in place. These concepts can range from simple easy to understand methods to complicated and confusing concepts that will make you wonder how the agent came up with that.
At the end of the day it really depends on what you feel comfortable with but below is a good start.
Here are a few guidelines:
- Income Replacement – 10x your income
- Non-working Spouse – Equal to half the coverage of the working spouse typically
- Key-Person Insurance for Businesses – 1-3x annual revenue the key employee is responsible for
- Buy-Sell Coverage for Business – 1 to 1.5x current value of the business
The Basic 10X Rule:
A good general rule of thumb is at least 10X your annual income. Although everyone’s financially situation is different this a good place to start and based on the price you can adjust up or down on the coverage amount.
For example, if you make $100,000 per year we recommend you carry at least $1,000,000 in coverage. In the event of your death this is usually enough to pay of the debts and provide a nice cushion for your family while they get back on their feet. Most importantly, you don’t want your family or partner to worry about immediate financial issues while they’re going through such a hard time emotionally. This is the main reason why we buy life insurance. Term life insurance is very affordable for most people so although 10X your annual income may sound like a lot of life insurance you might be surprised on how affordable it actually is.
What is the MAXIMUM amount of coverage I can get?
This is the question we need to be asking more often. The insurance companies will allow you to insure yourself for each year you plan on working and allow you to buy coverage for each of the years you are expected to work. For example, being a 30 year old who plans on working to age 65 you would be able to get 35 years of income protection. If this individual makes 100k/year and wants to get the maximum amount possible, 3.5M would represent 35 years of income protected.
1-2% of income to buy the most coverage possible. It is important to know and understand that most people outlive their term life insurance policies. This is a good thing. However you should not pay to much into a policy that you hope to never use. You should never go over 2% of your gross income when paying for a life insurance policy. If you think about it paying 2% of your income and replacing 10 years of your income is a great ratio for risk/reward. It’s a small cost and has the potential to have a significant impact that will last a lifetime.
Buy what you feel comfortable spending…
At the end of the day, some life insurance is better than no life insurance.
If what is being recommended by your agent still feels a little out of your budget then we typically recommend cutting that amount in half. Let’s say $1,000,000 is being recommended to you based on your income but maybe the premium is a little more than what you want to spend than sometimes that can prevent you from making any decision at all. Go with half and call it a day. You can always buy more life insurance later on in life.
Just remember to ask yourself, “If I were to pass away would anyone financially struggle?” If this answer is Yes, then buying a smaller policy is better then buying no policy at all.