Determining how much life insurance to buy can be a bit of a Goldilocks problem. You certainly don’t want to buy too little. But you also don’t want to buy too much, and be spending money you could put to other uses. You want to get it just right.
Getting it just right can be a challenge because there can be so many variables — different debts with various lengths, and other financial concerns such as children’s college costs. And how much life insurance you need at age 30 is likely different than what you need at age 40 or age 50 and up.
Laddering life insurance is a way to tackle life insurance needs that change over time. By buying different life insurance policies, you can create a peak amount of coverage when you need it. But you’re not paying for a large amount of life insurance during years you don’t need so much.
Who Needs Life Insurance?
If someone else would be adversely financially affected by your death, you need life insurance. That means if you’re single and have no dependents, it’s very unlikely that you need life insurance at all.
Are you are married with no kids, and own a house? It’s likely you need life insurance so your spouse could continue to live in the house even after the loss of your income.
And do you have minor children? Without question, you should have life insurance.
What Type of Life Insurance Should I Buy?
Life insurance comes in two basic forms: Term life insurance, which lasts for a set period of years, or permanent insurance, such as universal life insurance, which is meant to last for your entire lifetime, so long as you continue making payments.
Term insurance is a much simpler product because it offers only life insurance coverage without cash value, making it much more affordable to purchase.
How Much Life Insurance Should I Buy?
While there is no exact rule, some simple recommendations use between five and 15 times your annual income for life insurance coverage. But rules that involve multiplying income tend to be too simplistic.
There’s also the DIME Rule (Debt & Final Expenses, Income, Mortgage, Education). This rule says you should add up these expenses to calculate your life insurance need: Debt (include funeral expenses here) + income (multiply your annual income by the number of years you want to provide it, such as 10 or 20 years) + mortgage (the balance) + education (such as private school and college with housing and books).
“For Millennial couples, the typical reference point for life insurance needs is the coverage that their employers offer each year as part of a company benefits package, says Kevin Mahoney, CFP, founder & CEO of Illumint, a Washington, D.C.-based financial planning company that focuses on young families. “This introduction to life insurance roots people in a single, overall dollar amount. Instead, Millennials should think in terms of multiple amounts and timelines that align with specific life goals.”
Some of the factors to consider include:
Age: When you’re younger and have little savings built up, you may need more insurance.
Current and future earning power: If you’re on a path to a high-earning occupation, you may want more life insurance earlier rather than buying additional coverage later on. For example, if you’re in a surgical residency program earning $55,000 annually, you likely need a different amount of insurance than a social worker making $55,000 annually, because your future earning potential is much higher.
Debt: How much and what type of debt you have also plays a role. If you are married and have a $250,000 mortgage, you need life insurance. But if your only debt is 0,000 of federal student loans, which are discharged at your death, you don’t need life insurance to cover that loan.
Children or other dependents: When you have young children, you almost assuredly need life insurance so that their needs would continue to be met if your income was gone. But you likely need a lower amount of insurance when your children are in high school than when they were toddlers, because you have fewer years of supporting them ahead.
Your budget: Some people end up buying less insurance than the amount they need because they simply don’t have the room in the budget to pay for more. So, if a recommended coverage amount is $1,000,000 term life policy, some people may opt for a $500,000 policy instead. While not ideal, it may be all they can afford, and having some life insurance in place is better than none at all.
Another budget factor is whether you are saving a lot, or saving almost nothing. If you are saving 30% of your income, for example, this lowers your life insurance need in two ways: You’re building up savings that survivors can use, and your monthly commitments are only 70% of your income, so you can assume survivors won’t need coverage amounts equal to your full income to meet their daily expenses.
Your financial wishes: Do you feel strongly about your kids graduating from college with no student loans? Are you dead set on paying for your kids’ weddings? If your answer to questions like these is yes, then you need more life insurance than someone who wants life insurance to meet only basic needs for their kids.
Insurance Needs Usually Decline Over Time
As you consider all the factors above, you’ll notice most of them are not fixed amounts — they can change over time. Your insurance needs usually change over time, too, and for most people, life insurance needs go down over time.
When you’re younger, you may have large mortgage debt, and many working years ahead of you. This is why the rules of thumb for life insurance that are based purely multiplying annual income are too simplistic. A 30-year-old who earns $100,000 a year and has a new mortgage and twin toddlers has a totally different insurance need than a 50-year-old who earns $100,000, owes only $50,000 on their mortgage, and has twins who are already in college.
A Solution? Laddering Life Insurance
While an insurance need is highly personal and can’t be precisely predicted, it can often make sense to build a plan that includes several different life insurance policies to match expected needs as they change over time. This is referred to as a “life insurance ladder.”
In a ladder, you have multiple policies that expire in different years as your life insurance needs gradually tapers down. In some cases this is better than buying one large policy that tries to match the time frame of your longest debt. Laddering life insurance is a way to adapt life insurance coverage as your life changes.
In a life insurance ladder, you have a policy for each major financial obligation, with different coverage end points, so that you’re not paying for coverage long after your need for it is gone. This also typically reduces the total amount you’ll pay over time.
“The coverage that a couple buys should tie directly to the funds they want to make available for future financial goals. Most commonly, these goals include a child’s college education, mortgage repayment, and work flexibility later in life. Multiple policies can let you do this more accurately than any single policy,” explains Mahoney.
Case Study: DIME vs. Laddering
Let’s look at a hypothetical 28-year-old male named Tyler who recently married and purchased a home. Tyler and his wife each earn about $70,000 annually, and their mortgage debt is $220,000.
If we use the DIME Rule (Debt & Final Expenses, Income, Mortgage, Education), Tyler’s insurance need would be as follows:
Debt & final expenses: With no debt outside his mortgage, this is just final expenses. According to the National Funeral Directors Association, in 2017 the median funeral expenses were $7,360, for a funeral with viewing and burial.
Income: With his wife working and earning a comparable income, she would not necessarily need additional income, but Tyler wants to provide at least one year’s worth so she can take time off if something happens to him, and not be financially stressed on top of her grief. Need: $75,000.
Mortgage: The mortgage debt is $220,000. However, he does not necessarily need to have enough to pay the entire thing off, as his wife may sell it well before the 30-year mortgage is repaid. Tyler decides to add $200,000 for this, knowing it would give his wife options.
Education: With no children, this is $0.
Total need based on the DIME formula: $7,360 + $75,000 + $200,000 = about $282,000, so Tyler decides to buy a 20 year, $300,000 policy.
Three years later, Tyler and his wife find out they are expecting a child, so he goes to buy an additional policy. He could just replace the first policy with a big new policy, but instead he wants to add one that will give him the right coverage amount while his kids are young, but not lock him into paying too much as his insurance needs drop over time.
Using the DIME Rule once again:
Debt & final expenses: This is unchanged since he bought the first life insurance policy, so his additional need is $0.
Income: With a newborn dependent, Tyler wants to ensure his income is replaced for at least 10 years, instead of the one year he had planned on before. He has gotten raises and is now making $85,000. With the existing year already included in the first policy, the additional new need is $765,000
Mortgage: The mortgage debt has now dropped to $208,000, so his existing policy is more than enough. Additional need: $0
Education: Tyler and his wife intend to send their child to public school for K-12, but Tyler wants to ensure there’s at least some coverage for college years, and they won’t have much saved for that purpose in the coming years. He wants to provide one year of tuition, which he estimates will cost $65,000 in 18 years. Additional need: $65,000
Total new insurance need: $765,000 + $65,000 = $830,000, so he rounds down to $800,000
Tyler decides to make this a 30-year term life insurance policy, so he can have it run until he is 61, but could also opt to stop paying for it if he no longer has an insurance need before then.
Tyler now has $1.1 million of life insurance for the next 17 years, which will drop to $800,000 when his child is a junior in high school. He saves a bit on premiums, as his coverage reduces when the child is older and his mortgage is substantially reduced.
Three years later, at age 34, they are expecting another baby. Tyler revisits his life insurance again.
Debt & final expenses: This is unchanged, so his additional need is $0.
Income: Tyler is now making $90,000, and will have two young children. He decides to add another $400,000 based on this. New additional need: $400,000.
Mortgage: They bought a new house, but were able to use some home equity to put down a large down payment, and their new mortgage debt is now $240,000. Tyler wants to be certain his family can stay in that home if he is gone. He had already purchased $200,000 for this purpose, so he adds another $40,000 so the debt is completely covered.
Education: They decide to also cover at least one year of college for their second child, so they add another $65,000 for this purpose.
Total new need: $400,000 + $40,000 + $65,000 = $505,000. Tyler settles on $500,000.
Tyler is now deciding what term length he wants. He and his wife regularly max out their retirement accounts, and get the employer match at work, so their savings has been building steadily. He is pretty confident their home will be paid off and they’ll have enough to retire by the time they turn 60. If that’s the case, his life insurance need drops dramatically, as the accumulated savings would soften a financial blow if he passes away. Tyler decides to make this a 20-year, $500,000 policy, which costs about $27 a month.
Tyler has built himself a ladder of life insurance policies that will taper off as his insurance needs do. As for now, he will carry $1.6 million of insurance until his two children are both teenagers. This is around 17 times his annual income.
Coverage will drop when he is age 48 to $1.3 million, and stay at that level until his eldest has reached age 22. At that point, his life insurance coverage will drop again, down to $800,000, which is what he will keep in place until he reaches age 61, when both his children should be completely financially independent from him.
Building Your Own Ladder
Everyone’s individual circumstance is unique, and someone with a similar income may choose different coverage options than our example. If you’re completely committed to fully funding college for your children, you may want more life insurance than our example. If you’re struggling with monthly cash flow, you may decide to buy less insurance, as the total policies would be about $105 a month for a period of 14 years.
You may even decide to fully replace a previous policy with a larger policy, if it makes sense as your circumstances change.
Life insurance ladders are a great way to make sure you’re spending the least amount of money possible to insure yourself at different points in the future, and offer lots of options as the unknowns of our lives unfold.
Ryan Frailich, Contributor
© 2022 Forbes Media LLC. All Rights Reserved
This Forbes article was legally licensed through AdvisorStream.