Updated on 11.23.15

#15: Life Insurance

Trent Hamm

25 Rules to Grow Rich By

This is part of a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.

How Much Life Insurance Do I need?

Rule #15: You need enough life insurance to replace at least five years of your salary–as much as 10 years if you have several young children or significant debts.

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I agree with the spirit of this rule: most people don’t leave behind nearly enough life insurance to ensure the continued success of their family after a tragedy. To me, not having adequate life insurance is a classless act – you’re making a potential tragedy worse by being greedy now.

I also agree with the sentiment about leaving behind more life insurance if you have children, but this is where the rule gets quite vague. What does “if you have several young children” actually mean? It’s a very vague statement that makes me sit back, stroke my chin, and whip out my trusty pencil.

First of all, life insurance should cover your funeral and estate management right off the top. To ensure that everything is taken care of, you should have a minimum of a year’s salary put away. Even if you live entirely alone, this should exist to eliminate any burden you might put on other family members in the event of your passing.

Life insurance becomes important as soon as you begin to build your own family. If your income is even slightly responsible for the well being of anyone else, you need to put away two more year’s worth of salary in insurance to cover the hardships that would overcome them simply recovering from your loss. Beyond that, you want each person dependent on you to be able to continue to live something approximating the life they’re accustomed to, so you should have two years’ worth of insurance for each other dependent as well.

These suggestions add up to a very nifty formula for figuring how much life insurance you should have. Take the number of dependents in your household, double it, and add one. Multiply that number by your annual salary and that’s the approximate number you should be looking at. Let’s rewrite this rule.

Rewritten Rule #15: You should leave behind a year’s worth of life insurance to cover your funeral, plus two years’ salary for each dependent you claimed on your last tax return (including yourself).

You can jump ahead to rule #16 or jump back to rule #14.

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  1. Trent Hamm Trent says:

    It’s never too early to buy. The advantage of being in your late 20s (like you are and I am) is that term life insurance is extremely cheap… we are a very good risk for the insurance company. Plus, if you invest your money well, when you get old you won’t need insurance.

  2. I don’t really believe in having life insurance to cover my own funeral. My estate (what I’ve made through now) should more than cover all that. It might be a slight temporary burden to get that all straightened out, but my loved ones are prepared enough to afford it, especially when they’d be making money on my death when that estate stuff gets figured out.

    As for the two years for every dependant, I’d rather go with 10-12 times my income. That should allow my family to replace my income with the interest alone — at least in theory. Plus it seems like an easy calculation.

  3. I find that there’s often little need to buy insurance until you have dependants. There are exceptions, but as I covered above, make sure you can you cover your debts. Also most employers give you two times your salary in life insurance as a perk. You may find that’s enough for funeral expenses and related costs.

    I have a friend who sells life insurance and even he said it wouldn’t make sense for me until I have a family.

  4. thewegger says:

    From what I’ve been taught, there are two good ways to estimate an appropriate amount of life insurance: income replacement & needs.

    Income replacement – pretty much self evident. You want to generate a benefit that can be used to purchase into an annuity that will provide an approximation of your regular income to your dependents.

    Needs – an amount equal to all the obligations you might have. Some examples are mortgage, loans (car, student, etc.), health insurance for your dependents, burial expenses, estate taxes, college funds, etc.

    IMO, there’s no “rule of thumb” that can easily replace some careful planning on your part. Make sure to reevaluate every year or so.

    Also – be careful with from universal, whole, and other forms of permanent insurance. For most people, term life is good enough to cover their insurance needs, and maxing out a 401(k) and/or IRA is a better investment.

    If you have money left after that, you might want to consider permanent life insurance, but there are still a lot of better investments out there. It could be argued that disability or long term care insurance would be of greater benefit to you and your family than permanent life.

  5. silverbax says:

    This isn’t taking into account the extended cost of lost salary. If a person makes $50,000 a year, and dies at 35, the dependents would have gotten $1,500,000 from that person’s salary if the person had lived and retired at 65. That’s why people say you need 10 times the salary. One year’s work of salary isn’t nearly enough to replace the long term income.

  6. Peter says:

    I somewhat agree with the general rule as stated above, but really think that everyone should take a bit of time and consider their individual situations.

    Whenever I see discussions about life insurance I tend to cringe because they always seem to want a person to replace everything and cover all possible debts, now and future. Additionally, it appears to me that the numbers become hugely inflated. I think this is because many of the estimates assume you never want to touch the principle but even more so because many folks want to not just provide but have the family “win” from their deaths.

    For example, with 50K in income, if you die at 35, you could leave 250K, which becomes a million in 30 years at 5% if untouched, for retirement. Add 100K for paying off an outstanding mortgage, 20K for credit card debt, depending on age lets say 50-100 K per kid for college, and 20K for the funeral. So you can easily get up to 500-600 K in expected insurance requirements and more if you want to start actually replacing ongoing income.

    But I feel that you need to ask a couple of critical questions and take into consideration other things than just replacing your income for your family’s life.

    Questions you may want to consider:

    If I leave enough to pay off the mortgage, will my spouse honestly have a serious problem raising the family on their income (My mortgage is the biggest bill I have)?

    Would I have honestly paid for my kid to go to a more expensive school without their footing some of the bill via work, scholarship, loans, etc. (if they can be expected to do it while your alive, they should do it when you’re dead)?

    How much will my family get from Social Security and how much of my income will that replace (50K with two kids at home could yield up to 30K a year (2500 per month) in benefits until the oldest turns 18)?

    Are there any employer benefits that you would get upon death (less and less likely now a days, but for state and federal employees who die while employed there could be survivor benefits)?

    How much is in you’re 401K, IRAs or Roths? The more you have there, the less you need to replace since your spouse gets them anyway and can roll them over to their names. (e.g. if you already had 150K in a IRA, you would only need 100K to make up the shortfall in the example given above).

    Other than major accident, how healthy are you and what is your family health history like (e.g. what is the likelihood you will live into your 60s and beyond, heart disease, diabetes, cancer)?

    How sure are you that even if you leave all this money behind, that your spouse and family have the knowledge and understanding to actually spend/save/use the money in anything close to a responsible manner? How many lottery winners are broke in a year or two? To me this could be worse since they won’t be experiencing joy, but sorrow, and many people make poor decisions when they are grieving, especially when the event is a shock.

    Based on these questions I relooked the life insurance angle and considered it more along the lines of my overall estate planning. From that I created a “what the hell do I do if he croaks” file for my wife. This is very similar to what Ben Stein put in one of his Yahoo column “Signed, Sealed, Delivered it’s yours” where he discusses leaving plans for the loved one for when you are gone. For myself I lay out a couple of options, show who to call for benefits, and show a path which will hopefully provide for a solid path forward. Additionally I update it every year or so and go over it with my wife.

    Based on the plan and many discussions with my wife, we’ve essentially settled on 4 times my income. We both feel that with this she and kids would do fine, though they won’t win much in the way of extras. No new mansion, no new 50K Lexus SUV in the driveway, no Ivy League funded education for the kids. She would need to eventually increase her hours at work, possibly to full time, particularly once the kids start leaving the nest. But all in all we both feel pretty good about what we’ve set up.

    Obviously I have taken some time in looking at this, and did not come to this number at one sitting. What I did want to show from the above is that there are many considerations and that even the rule put forth here would have me with at least 8 to 10 times my salary. I will also point out that as you get older, and hopefully become more self insured, you need less insurance which should be a good thing.

  7. John says:

    There’s a lot here that’s good, and a lot here that’s not.

    Let me preface all this by saying I’m a Financial Professional with Prudential Financial – a major part of my job is providing adequate life insurance for my clients.

    The Good:

    Setting up your life insurance early is a GREAT idea. For people in their 20’s in good health, they can put together a $1,000,000 term policy for only $500 a year (approximate). Many of these term policies come with guaranteed conversion options that allow the person to convert to a whole life policy with no new underwriting. Here’s where I start to disagree with a lot of what’s written here.

    The Bad:

    There seems to be a Orman-esque idea that permanent insurance (whole life or universal life) is unnecessary. I just can’t agree with this, ever. There is never a time when you don’t need life insurance, young or old. An infant should have a small policy (just enough to cover their burial should the unthinkable happen). After retirement, you should have a permanent policy that will be large enough to at least bury you. Term policies will only allow you to be insured to a certain age (usually the legal limit is between 80 and 85). In addition, without getting too complex, there are MANY major estate planning applications for those who have a high net worth.

    Peter brings up a lot of good points about the 401k’s and IRA’s – and a GOOD life insurance agent will take this information into account. A bad one will not.

    Wegger – you’re absolutely right. Everyone should be sitting with a professional to discuss this. Even MORE right – you need to balance life insurance with disability and long term care planning (whether insurance or something else, LTC is something that needs to be broached in every household.)

    Lazy Man – Your friend is right, but there’s no reason not to start early and get it while it’s cheap. In addition, you never know when you might develop problem that makes you uninsurable. A 22 year old friend of mine was just diagnosed with a tumor. He’s “cured”, but no insurance company will look at him now (trust me, I’ve looked).

  8. I wish to have 10x annual income too but the premium payable is too high a cost. May be life insurance (term life) in Malaysia is too expensive…

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