How Much Life Insurance Do I Need? More Than You Think - Let Me Explain
How Much Life Insurance Do I Need? Well if you are asking this question you are far ahead of most people. In fact, the majority of clients who come to see me already have a figure in mind.
Let’s face it ANY figure over $100k sounds like a LOT of money. I mean seriously how many of us see a chunk of change like this in one check? I’d say not many.
So these figures can be deceiving.
The thing most clients forget is that this cash is going to have to replace an income PERMANENTLY.
Hmm, this means years down the road your family is going to rely on this payout to keep the train on the tracks UNLESS you replace it with some other source.
To clarify, how much life insurance is ENOUGH let’s take a look at the process now.
My Name is James Heidebrecht & I'm An Independent Life Insurance Agent
…and the founder of Policy Architects. So life insurance is my jam. Yep. I spend hours every day researching life insurance products and companies to bring my clients the best rates around for the most comprehensive policy.
But that’s not all. I maintain this blog to help people just like you do their homework BEFORE they sign on the dotted line.
Anyone can plug their deets into an automated system and deal with the call centre agent that receives your info. This is a hit or miss approach. Maybe you will get a kick-butt agent who really knows insurance OR maybe you will get a newbie who doesn’t really know what they’re doing.
Nothing against newbies, we all have to start somewhere…The thing is unless you know something about life insurance you are in their hands.
So let’s get on with the show!
How Much Life Insurance Do I Need?
A Needs Analysis Will Help You Determine What Your Coverage Should Be
Being underinsured leaves your loved ones vulnerable. Remember, a life insurance policy covers your family for decades so it’s a good idea for you to do a certain amount of planning ahead.
Most people request less coverage than they need. That’s because they fail to look at all their debts and the reality of the cash needed to keep their family afloat long term.
It’s so easy to underestimate needs.
To begin the process, you’ve got to ask yourself two questions:
Question #1: If I'm not here tomorrow...how much cash does my family need to stay in the same home, to continue paying the same bills (including mortgage), to cover my kids' college in the future?
The answer to this is different for everyone. Perhaps you don’t have children but you’re worried about your surviving spouse. Maybe you’re thinking about a business partner. Could be your kids are older and on the cusp of going to university. Or, perhaps you’re a superhero taking care of an adult child with a disability… the list goes on.
Question #2: How long do my loved ones need the cash? 10 years, 15 years, 20 years, or even longer?
If you’ve just started a family, 25 or 30 years is a good place to start. Or maybe your kids are in their late teens and going to college in the next couple of years. In that case, your window of financial vulnerability may be more like10 years.
Perhaps you don’t have kids but your spouse depends on your income to help pay the mortgage and other living expenses. How long do they need that help for?
Are you getting the idea?
So now that I’ve got you thinking about how much and for how long, there are two basic methods you can use to figure out how much life insurance to buy.
How Much Life Insurance Do I need - Rule of Thumb Method
I get it, you know life insurance is important but you’re a busy person, you’ve got a lot on your plate.
One quick way to calculate how much life insurance you need is to multiply your GROSS salary by 10. For example, if you make $50k you probably need at least $500k in coverage. If you have young kids at home, I’d say you need closer to fifteen times your salary to be on the safe side.
Rule of Thumb Example
Bilal is 35 years old, married and has 5 year old son and an 8 year old daughter at home. He’s an engineer earning roughly $100,000 per year. In addition to his $480,000 mortgage amortized over 25 years, he has $50,000 in his RRSP but no other significant debt to speak of.
If we apply the Rule of Thumb method, Bilal will require fifteen times his gross salary, $1,500,000 (15 X $100,000) in coverage because he has a young family.
How long does he need the protection?
Option #1 – 20 Years
He figures a minimum of 20 years at which point his kids will be 25 and 28 years old respectively. A $1.5 million, 20 year term policy with RBC life insurance at standard, non-smoker rates, will cost him $84.20 per month. That sounds affordable but what if wants a longer term? After all his mortgage is amortized over 25 years. A longer period will provide him with a little more peace of mind.
Option #2 – 25 Years
An RBC $1.5 million 25-year term policy will set Bilal back $119.97 per month. Hmmm, that’s a little more than he wants to spend. Is there another option? His insurance agent suggests he consider layering term coverage to save money. What does that look like?
Option #3 – 20 and 30 Years Combined
A $500,000, 25-year term policy combined with a $1,000,000, 20-year term policy will cost Bilal $96.12 per month. That means he has $1.5 million dollars of coverage from age 35 to 55 and then $500,000 from age 56 to 60. Also, his premiums will decrease to $45.86 per month for the last 5 policy years.
Bilal is happy with this option because he was hoping to keep his life insurance costs under $100 per month.
How Much Life Insurance Do I need - Calculator Method
If you’re a numbers person like me then this is the method for you.
We’re going to look at the following:
- Insured’s age and the age of any dependents
- Annual income and how much of it you want to leave for your loved ones
- Mortgage balance and amortization
- Other debt – credit cards, LOCs, car loans, etc.
- Post-secondary school costs for your kids
- Your assets – real estate, savings, registered and unregistered investments
The calculator method takes a little more time but is it more accurate? Let’s find out.
Let’s use Bilal again. Remember, he’s 35, married and has a son and daughter, 5 years and 8 years old respectively. He earns $100,000 per year as an engineer and has a $480,000 mortgage amortized over 25 years. He has $50,000 in his TSFA and is hoping to contribute more in the coming years.
Before we get into the calculation, we’re going to ask Bilal a few questions.
What percentage of his gross salary does he want to leave behind for his family?
As an engineer, he’s very precise. Bilal wants to make sure that Jennifer and his kids continue to receive the net income he brings in every year. After federal & provincial taxes, CPP contributions and EI premiums are deducted from his $100k salary, he’s left with approximately $72k of net income. That’s what he wants to leave behind for his family.
How many years does he want his family to receive this benefit?
Twenty years he thinks is adequate.
Does he want to leave extra money to pay for post-secondary education for his 2 children?
Yes, he figures $25,000 for 4 years for each child will do it. That’s $200,000 extra.
Applying the Calculator method, Bilal will need $1,590,000 of coverage to make sure his family receives his after-tax income for 20 years and there’s cash left for education as well. We also have to take into account his TSFA will rollover to Jennifer, his wife.
How did I get that number? Let’s break it down…For simplicities sake, we’re going to forget about interest and indexing:
$72,000 (Bilal’s net income) X 20 years (benefit period) + $200,000 (kid’s college fund) – $50,000 (TFSA) = $1,590,000
Option #1 – 20 Year Plan
A $1,590,000, 20 year term policy with Empire Life at standard, non-smoker rates, will cost Bilal $91.79 per month. So with this method, he’s still under the $100 per month cap that he set.
NOTE* Regardless of which method you use, it's important that the coverage amount you choose is affordable. It's better to have a reduced amount of life insurance at the right price than too much at the wrong price!
How Long Does Life Insurance Last?
If something happens to Bilal, how long will his life $1.5 million insurance death benefit last his wife, Jennifer, and their two kids? Let’s take a look at a couple of basic scenarios. Keep in mind, Bilal’s after-tax net income is approximately $72,000 or $6,000 per month.
If Jennifer were to simply put the policy proceeds into an annuity and draw $6000 (Bilal’s net income) monthly, how long will it be before she runs out of money?
ANSWER: 20.83 Years!
For simplicity’s sake, we’re not taking into account inflation or any interest earned.
If you look at the payout calculation chart to the right, you can see the “beginning balance” is $1.5 million, the death benefit of Bilal’s policy. The “ending balance” each year is reduced by $72,000, Bilal’s net annual income.
Moving down the chart, Jennifer draws $72,000 out of her account every year for 20 years. In the 21st year, she will draw $60,000 and then the money is gone.
I don’t know about you but this is a substantial amount of income coming into Billal’s household for a long period of time. There’s no way it can ever make up for his loss but it does mean that his family will avoid financial devastation.
Life Insurance Policy Payout Calculator
Fully Indexed Payout
This time, when Jennifer invests the $1.5 million policy proceeds, it’s subject to the following conditions:
- 4% interest growth
- 2% inflation
- 25% average income tax rate – in reality, it wouldn’t be this high as Jennifer would only be taxed on the interest generated by the proceeds (column 5 in the illustration below)
So how long will it be before she runs out of money while drawing approximately $72,000, after-tax, indexed annually?
ANSWER: 23 Years!
If you check out the illustration below, you can see again the “beginning balance” is $1.5 million (the death benefit of Bilal’s policy). The “remaining capital to invest” each year is reduced by $72,453.93 (Bilal’s former net income). This figure is after a 25% income tax reduction.
The column on the right indicates interest earned (4%) on the remaining capital. If you look at year 2, you can see the “initial capital” is only reduced by approx. $30k even though Jennifer was paid out $72k in the first year. Also, notice the “income required” amount increases year over year by 2% inflation.
Bottom line: Jennifer is paid out $72,453 present value, after-tax, every year for 23 years.
Fully Indexed Life Insurance Payout Calculation
Term Insurance Is Your Best Bet for Income Replacement
Now I want to make this clear, we are talking about term life insurance right now. Term is the most affordable coverage available which allows people to purchase more protection. But please remember this type of policy provides a temporary safety net for your family for a defined period of time: 10, 20 or 30 years.
There is no guarantee they will receive a payout.
If you want coverage until the day you die you need permanent life insurance – which I will not be dealing with here. This is because term insurance works for MOST people MOST of the time. Permanent insurance is much more expensive and has a lot more nuance so I will save that for a different post.
How Much Life Insurance Do I Need?
Protecting Your Mortgage
When it comes to figuring out how much life insurance you need, you’ve likely been bombarded with information from agents and financial institutions telling you how important it is to protect your mortgage.
I’m here to tell you that focusing solely on protecting your mortgage is a mistake. If you think hard about it, “protecting your mortgage” should really be about “protecting your income”. After all, your income is what makes it possible to qualify for and pay your mortgage in the first place.
INCOME PROTECTION = MORTGAGE PROTECTION
Many banks or financial institutions who underwrite mortgages in Canada offer mortgage protection to their clients. They call it mortgage life insurance. Personally, I wouldn’t touch mortgage insurance sold through the bank with a ten-foot pole.
If you want to find out why personal life insurance trumps mortgage life insurance every time, when it comes to protecting your home and income, read my post here. It’s one of the most informative and in-depth mortgage insurance articles on the internet.
Sometimes Our Needs Change
Ugh this is one of the biggest drawbacks of underinsuring yourself. Let’s say you get your life insurance when you are in your mid 30’s.
You have no idea that in your 40’s your business is going to take off and your salary will triple! GREAT for your family….
….but not so great for your life insurance coverage. That $500K policy you took out is now woefully inadequate. The thing is you’ve been working so hard you have let your health slip. Unfortunately you have some moderate medical issues.
IF you decide to get some more coverage it’s going to cost you a lot more because you no longer qualify for those sweet preferred rates….and you are now 10 years older. To give you some idea of how much more our client will pay for his insurance I am posting some basic numbers.
At the time, we figured 30 years would bring us close to our retirement age and thus help cover any years where there was only one income to live on in the event one of us had died.
The term policy was much cheaper than a whole life policy, the death benefit amount ($1 million) was set, and we knew exactly how much we would be paying each month (or year) for the next 30 years.
Example of How Age and Health Impact Your Rates
A male client who is 35 years old and has a preferred rating is looking for $500K of coverage for a 30 year term. His premiums are about $50.00.
If that same client 45 years old with a standard rating that same coverage costs him about $152.00.
Now obviously these are today’s rates so I can’t reach into the future for rates that are a decade away and our client may need less coverage and a shorter term. BUT these figures you show you how much more a client pays 10 yeas later with a reduced rating.
The last thing you want to do is wait until you are older and less healthy to buy more coverage. My best advice is to max out what you can afford. The beauty of term life insurance is that it’s super flexible and if you no longer need it you can just drop it.
Layering Your Life Insurance
Another tactic you can use to make sure you have enough coverage without overdoing it, is layer your policies.
So what you would do is sit down with your independent life insurance agent and plan how you see paying down your mortgage and taking on debt. We would then make sure you have multiple policies that create coverage that drops off as your debts drop off.
For example, you would hold the most coverage during your most vulnerable years and then as you needs dwindle your policies end making your life insurance burden less costly.
Is $1 Million of Life Insurance CRAZY?
I think when people hear $1 million of coverage they think it’s a crazy figure. The thing is, it’s not. Especially if you live in a big city like Toronto, Montreal or Vancouver, where a house can cost you a million plus.
As I mentioned above you should at least have 10 times your gross salary but quite honestly a lot of my clients opt for more (up to 15 times) because it provides wiggle room.
So let’s say you make $80K per year and have a $500K mortgage. I would recommend at least $1 million in coverage to allow your beneficiaries to carry on as usual.
Do NOT Forget About You Children's Education
The above mentioned information takes care of your family living the life they have now. It does not provide a lot of cash for continued education.
If you want to have enough cash to pay for that I suggest adding on at least $100K of coverage per child. This helps you foot these expenses and chances are you will need this help if you’re a single parent. Education is VERY costly.
Don't Forget A Stay At Home Parents TIME is Valuable
One big mistake a LOT of clients make is to underestimating the value of a stay at home parent. They skimp on coverage in this area because they don’t attach an income.
This is a real problem because what a stay at home parent offers cannot be replaced – and even when you do get someone to pick up some of the pieces it costs a pretty penny.
To put it into perspective let’s say you have two kids. You work full time and your partner takes of them. If they die of cancer this year and you employ a Nanny to help you with dinners and taking the kids to and from school it’s gonna cost some serious cash.
Your kids are 5 and 7. Which means it’s likely you will need help until your youngest turns 14 or 15. Which is nearly a decade of service. You find an awesome nanny and she wants $55K per year to provide full time help.
Her services will cost you over $500K for that period. OUCH.
Please, please give your stay at home partners their due. They provide a lot more than you’ll ever know.
How Much Life Insurance Do I Need? Find Out By Calling Policy Architects Today
How Much Life Insurance Do I Need? Well I could provide a bunch of fancy-schmancy calculators that you can play with to calculate your debt, income and goals OR I can just tell you to schedule a call with Policy Architects.
There’s a LOT more we can work through on a call than you can do by playing with some meaningless numbers. The reality is MOST people need an outside perspective to get real. It’s a lot easier to fool yourself than it is to fool an agent.
If it looks like you are fudging some numbers we will set you straight. It also helps to talk goals through so we can formulate a customized plan for your future.
Remember not all life insurance companies are created equal and there are a plethora of products to consider.
While I can give you a basic heads up about 10x’ing your gross salary and some tips to help you get adequate insurance there are a lot more details you need.
Give us a call today. We can help you find the perfect policy for your family.