The answer depends on your age and the reason you are buying a policy, according to Tom Nicoski, senior vice president and head of insurance for U.S. Bancorp Investments.
Following are specific situations that can help dictate how much life insurance you might need.
If you have a young family or a dependent spouse, you’ll need life insurance to replace your income. The goal is to make sure your family can maintain the same standard of living for at least the near term, says Nicoski.
The rule of thumb, he continues, is to buy a policy worth 8 to 10 times your annual income. For example, if your annual salary is $100,000, he recommends buying an insurance policy with a $1 million death benefit.
But that’s just a starting point. Younger individuals often buy term life insurance, which provides coverage for a predetermined time period before expiring. A policy might last for 10, 20, or 30 years and is relatively cheap.
That means it’s important to consider not just your income today, but your potential income growth. Someone who makes $100,000 a year today might be making $150,000 in 5 or 10 years. (Also note that life insurance proceeds generally aren’t taxable.)
“Don’t be afraid to buy more than you’d need today,” says Nicoski. “It makes a lot of sense to have even more insurance than you’d need just because of the cost.”
Also consider the specific circumstances of your family, including the age of your children, whether you plan to have more, and what your spouse earns. If you have a young family, you might want a policy that lasts 20 or 30 years. You’ll want to think about the time-value of money and how inflation will decrease the value of the benefits over time.
Rather than buy one large policy, you might consider laddering policies. For example, you could buy a 10-year term life insurance policy and another 20-year term life insurance policy. This can provide a financial buffer for your surviving spouse to cover costs like daycare while building a career.
“Some say you might need more due to a growing family,” says Nicoski. “It’s all part of the equation.”
Life insurance needs change over time. As people grow older, they tend to worry less about their ability to support their family monetarily and worry more about the financial costs of their own potential long-term care. The good news is that some life insurance policies also have a rider that function as long-term care insurance (LTCI) policies. If the policy benefits aren’t needed for long-term care, they become available as a death benefit, says Nicoski.
The amount of coverage needed varies from person to person, but it typically ranges between $500,000 and $750,000.
Life insurance can be used to provide an inheritance. For example, you might want each of your three children to receive $500,000. In that case, you’d want a life insurance policy with a $1.5 million death benefit.
In 2021, an individual can leave $11.7 million to heirs without paying federal estate or gift tax. However, if assets above that limit are illiquid, like a farm, business or other real estate, families may have to sell these assets to pay the tax. A life insurance policy with death benefits that cover projected estate taxes can give beneficiaries the liquidity they need to preserve the estate.
If you co-own a business, you might want to consider buying a life insurance policy on your business partner. Many businesses have buy-and-sell agreements that state that the surviving partner can buy out the heirs of a deceased partner. For example, if you and a partner each own 50 percent of a business worth $5 million, you’d want a life insurance policy with a $2.5 million death benefit. Make sure you get a fair-value assessment of the business before buying a policy.
Life insurance is an important aspect of financial planning and making sure you have the right amount can be complex. “It really circles back to the plan you put together with your financial advisor,” Nicoski says. “No matter your reason for buying it, consulting with a professional about your life insurance choices can help.”
Read why it's important to include life insurance in your financial plan.