Many of us have some level of life insurance through work. However, more often than not, the amount of coverage we have through work is not sufficient. But how do we know how much we need? These simple approaches set out a way for you to estimate the right amount before you approach an insurance advisor.
When to buy more
If you are married and/or have children who rely on your income, you may wish to have life insurance that will replace your income. If you have a mortgage that you are responsible for paying down, life insurance can also be purchased to repay that mortgage. This way your family does not have to downsize or worry about future mortgage payments upon your death.
You might want to fund your children’s RESP, make a charitable donation, pay off other debts, gift to a friend, or fund other goals.
How much do you need?
A general rule of thumb is that you should be covered for at least 10 times your annual income, so if you earn $70,000, you’d be looking at $700,000 in coverage. But every individual situation is different and should be examined as such.
An insurance advisor will dive a little deeper to quantify your unique situation and desires. They will consider your annual income, your net worth, your debts and the amount of life insurance that you have in place. The advisor will consider what you need the money for, how much you need each month and how long you need it to last.
Let’s talk about Fred. In this example, Fred is a 33-year-old married father of 4. He has 3 goals for his insurance coverage:
- Pay off his $200,000 mortgage.
- Top up children’s registered education savings accounts for a total of $200,000.
- Replace his $70,000 annual after tax income that he spends to fund his family needs.
He has $140,000 in life insurance from work. Fred is looking at a $960,000 policy. If he died, the money from his life insurance could be allocated as follows:
- $200,000 toward the kids’ RESPs ($50,000 is the maximum amount you can contribute to an individual RESP).
- $700,000 (his annual earnings times 10) to invest to cover day-to-day expenses that his wife Julie and children will incur over the years.
- $60,000 remainder from his personal policy and $140,000 from his job will be used to cover his mortgage.
Another approach to estimate the size of policy that you need to replace your income is to perform a calculation based on what you think the money will earn when you invest it. Let’s say you die and you need to replace $70,000 in disposable income. Assuming the money from your policy can be invested at 7%, divide $70,000 by 7% to approximate the amount of coverage you require. In this case, the amount is $1 million.
This method shows that the rule of thumb of taking your income and multiplying it by 10 may be a little low. But other factors come into play, so always go through the numbers with an insurance advisor to establish the right amount before you buy. Perform annual reviews as well in case your situation changes and your coverage needs to be adjusted.
Other facts that these methods do not consider might come in to play, including what you can afford, your savings and your age. As you get older the risk of death increases causing the insurance to become more expensive. You may have purchased life insurance to simply replace your income until you reach age 65. The closer you are to 65, the more likely it is that you have enough to “self-insure”, meaning that your savings and passive incomes could cover a loss of your income. Your children are older as well, more likely to be self-sufficient and there are fewer years of income to be replaced.
These basic approached give you a general idea of the right amount for you before you connect with an insurance advisor. With a little thought before meeting them, you can feel more confident that you agree or disagree with their recommendations, increasing your control over the amount chosen and comfort with your financial health.