How much life insurance do you need?
The question of how much life insurance to carry can be a daunting one. The bottom line is that you need coverage if you have a family or others who depend on you.
I don’t consider myself an expert when it comes to life insurance. That being said, I also think the process of figuring out how much insurance you need is pretty straight forward. It takes a few steps, but it’s not rocket science. Let’s go through 4 questions from the perspective of the survivor:
Step 1: Do you have any immediate needs at death?
When someone dies, there can be some immediate expenses that occur right away. Some common examples include funeral costs, legal fees, and accounting fees,
One of the bigger immediate needs may be the need to pay off a debt to release your family of those obligations. In that case, you may want enough life insurance to pay off all debts when you pass away.
The other big need that may arise at death is the need to pay tax on the final tax return of the estate.
Related article: Estate planning – taxes and fees
At death, all assets are deemed to be ‘disposed of’ or sold just prior to death. That means capital gains on rental properties, vacation properties, mutual funds or stocks could create significant tax liabilities. Sometimes it makes sense to sell assets to pay for any tax owing but if you don’t want the asset to be sold, it’s important to have cash or liquidity in the estate and that’s where life insurance can come in handy.
Step 2: Do you have ongoing needs?
We’ve talked about immediate cash needs that can arise at someone’s death but there also may be ongoing financial needs as well. These ongoing financial needs really relate to whether or not you have people dependent on your income or earning power.
The question I often pose is this: If you were to pass away, would your family (spouse or kids) suffer significantly without your income? If so, life insurance can come in handy to replace income or earning power.
To calculate the amount of life insurance you need is really dependent on whether you have dependents and if so, it’s a matter of leaving a lump sum of money that can be used to replace income.
For example, if Sam is the primary earner in the family and he takes home $5000 per month, what happens if Sam dies. Will his family will continue to need $5000 per month to live or some other amount. If Sam wants to ensure his earning power, he can take $60,000 ($5000 x 12 months) and divide by 3%, 4% or 5% depending on different assumptions. In other words, Sam could use $1.5 million dollars to replace his income for a long period of time. You can adjust this number to accommodate your personal values and beliefs. For example, I had a couple that thought they only needed to replace income until their kids were independent and for them, that was 7 years. If we use the same login above, $60,000 for 7 years is $420,000 of insurance.
Step 3: How many assets will you have?
If we continue with the same example above, Sam might have money invested, which could be used to cover the needs. Some examples include:
- Existing life insurance
- CPP Death Benefits
- Tax-Free Savings Accounts
- Non-RRSP investments
- Emergency Funds
When it comes to the RRSPs, some people debate whether these should or should not be included. If you want to keep the RRSP for retirement, then you may not want to include them in the calculation.
Step 4: What ongoing income will you have?
In many cases, the survivor will continue to have income or resources to draw from in the event of losing their spouse to death. For example, a surviving spouse may get a survivor’s Canada Pension Plan, or investment income or will continue to work. Factoring this income into the calculation will reduce the amount of life insurance needed.
Determining the proper amount of insurance is a combination of using rules of thumb and calculations but it’s also a matter of budgets. The key is to be realistic and also keep in mind that life insurance is the unselfish benefit. It’s about providing for others.
You can use the chart below to help visually understand the process of determining how much life insurance you might need to protect those that you love.
|immediate needs||immediate haves|
|Group life insurance|
|CPP death benefit|
|Ongoing needs||Ongoing haves|
|Annual Household expenses|
|Survivor’s annual income|
|Annual retirement savings|
|CPP survivor benefit|
You can also download an excel spreadsheet version of the chart and customize it as needed: How Much Life Insurance Do You Need? (387 downloads)