Life Insurance: How Much and What Kind Do You Need?

It’s never easy to think about, but in the event the unthinkable happens, life insurance can help loved ones meet the unexpected needs that arise if you die. With September being Life Insurance Awareness Month, we wanted to look at the reasons people buy life insurance, the types of life insurance that are available, and methods of calculating how much insurance you should own.

Why Do People Buy Life Insurance?  

The most common reasons people purchase life insurance, according to the Life Insurance Marketing and Research Association, are to:

• Cover burial and other final expenses
• Replace lost wages if the person dies
• Transfer wealth to others
• Provide funds to pay off a mortgage
• Supplement retirement income
• Provide funds for heirs to pay estate taxes

Nearly half (44%) of households said they would face financial hardship within six months if the primary wage earner were to die prematurely, according to the 2022 Insurance Barometer Study, with 13% of households reporting that financial hardship would hit within one month.

There is a substantial gender gap in life insurance ownership. While 51 million men said they need life insurance coverage, nearly 12% more women (57 million) said they need coverage, according to the 2022 Insurance Barometer Study. USAA’s survey also found that 81% of men say they have taken steps to prepare their family’s finances in the event something unexpected were to happen versus 72% of women.

Source: 2022 Insurance Barometer Study, Life Happens and LIMRA

What Kinds of Life Insurance are Available? 

There are two main types of insurance: term and permanent.

• Term life insurance is sold for a set duration of time, usually between 10 and 30 years. It is designed to give a payout to your beneficiaries in the event that you die during the term of the insurance. The price of your monthly premium is constant for the term but typically increases with your age when you renew. Term life insurance is usually the cheaper option of the two because you are only buying death protection for the period that you need coverage. After that period has passed, the policy expires.
• Permanent life insurance does not expire after a given term and will usually last until you die, provided you keep it in force. In general, your premiums stay the same, you get a guaranteed rate of return on the policy’s cash value, and the death benefit amount doesn’t change. Permanent life insurance is typically more expensive than term coverage because in addition to paying for insurance, a portion of your premiums accumulate as a cash asset, growing tax-free/deferred within the policy, allowing the policyholder to borrow against their cash account it to meet other financial obligations. Although this makes for a compelling sales pitch, the additional cost of the premiums usually makes the “cash value” aspect not worth it, and almost all investors have other tax-free investment options available that provide greater control over one’s assets and the potential for more favorable returns.

How Much Life Insurance Should I Own? 

Determining how much life insurance one needs  depends on what the insurance is meant to protect.  Typically, life insurance is taken out to either replace income or preserve an estate and provide for liquidity needs.

A rough rule of thumb used in the insurance industry is to take your current income and multiply it by 10. This can result in an overly coarse estimate, failing to consider your individual circumstances, and it does not account for the value a stay-at-home parent provides that isn’t compensated but would cost money to replace. At HCM we prefer to calculate the appropriate amount of coverage.  An example of a more nuanced approach is the DIME Formula:

• Debt and final expenses: Add up your debts, other than your mortgage, plus an estimate of your funeral expenses.
• Income: Decide for how many years your family would need support and multiply your annual income by that number (this should include the cost to replace any unpaid contributions someone might make that would cost money to replace).
• Mortgage: Calculate the amount you need to pay off your mortgage.
• Education: Estimate the cost of sending your kids to school and college.

Once you determine the total amount of your family's financial needs, subtract that total from the available assets your family could use to help defray some or all of these expenses. The difference, if any, represents an amount that the life insurance proceeds, and the income from future investment of those proceeds, might cover.

It’s important to note that, as your financial obligations change over time, so too will your insurance needs. For example, once your kids have finished college, the need to carry insurance to cover that cost goes away. In fact, some people don’t need any insurance as they get older as they have accumulated sufficient assets along with Social Security and other income sources (pensions, etc.) that they can cover their obligations and no longer pay premiums.  This is why most people will benefit from term protection for those identifiable periods (children in school) before their personal wealth is sufficient to meet their needs. Similarly, it is possible to have more life insurance than one needs, wasting funds that could be better allocated. 

September is Life Insurance Awareness Month, a good time to review your life insurance to help ensure that it matches your current and projected needs.

The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. Any guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company. Optional benefits are available for an additional cost and are subject to contractual terms, conditions, and limitations.

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Mike Hengehold, CPA/PFS MST RICP® Mike is the Founder and President of HCM Wealth Advisors. Over the last 30 years, he’s provided financial planning guidance to a myriad of families to help them realize their financial dreams. Mike is an avid homebrewer and animal lover, and when he’s not at work you can often find him on the golf course working on his short game.