The 10 Times Your Income for Life Insurance Rule Is Stupid

Corey —  December 6, 2010 — 8 Comments

Life Insurance Rules of Thumb Are Stupid - Like This Sign       Like so many other rules of thumb, the 10 times your income for life insurance rule is a stupid way to make a major decision for your finances. (Sames goes for the 15 times your income, or 20 times your income, or any # times your income…) I keep writing about stupid rules of thumb because they can be so dangerous to your financial future. These simple rules of thumb are nice and easy for a quick guess or check on where you’re at now, but you should never use them as your primary decision making tool!

       The problem with using one of these simple rules for calculating your life insurance needs is that they ignore your personal situation. What if you don’t need all of your income to be replaced? What if you only need the income to last a few more years? These simple rules ignore these factors if they don’t give you some way to adjust.

How to Figure Out How Much Life Insurance You Need

       Your first step should be to decide if you actually even need life insurance at all. There are cases where you probably don’t need life insurance. It would be foolish to buy it if you don’t need it.

       If you decide you do need life insurance, the next thing you want to do is think about what you need it for. Are you in one of the rare cases where permanent life insurance makes sense or should you stick with term (which is the best option for just about everybody)? Do you need it to replace your entire income (so your survivors can still fund other goals like retirement or education)? Do you just need it to cover the bare essentials for your survivors? How much would that cost? Will your survivors be able to provide for some or all of their own needs?

       Then you need to figure out how long that income needs to last. This is pretty simple – how much longer would you probably be working assuming you don’t die prematurely? That’s generally how long you’ll need the income to last. You can choose to cut it short or maybe extend it a little longer than you estimate, but you need to know why you’re making that choice.

       After you’ve got those two numbers worked out then you can start using a number times your income need. This chart below is designed to help you figure out how much you need based on the number of years until you retire (or number of years you need your replacement income to last):
 

Life Insurance Factors

 
       So if you need to replace an income of $40,000/year and you have 40 years until retirement, you’ll multiply $40,000 by 25 to get $1,000,000 of insurance coverage needed.

       Next, add in any immediate costs like funeral costs or debts you want to pay off immediately at death. Then, subtract any savings that could be used to fulfill any of the goals you included when you were figuring out how much income you need. I generally exclude retirement savings because that money is set aside for non-working years and the amount you need to save for retirement going forward should account for your current savings. That will leave you with the total amount of insurance coverage you need to buy. If you’re married, just repeat this process for your spouse (from their perspective).

       All that’s left is to buy life insurance for the amount and term you need. If your situation is relatively straightforward, you can probably do all this yourself. But if it’s complicated, I’d highly recommend at least sitting down with a CERTIFIED FINANCIAL PLANNERTM to discuss your situation. If you can find someone who works on an hourly basis or by the project, it won’t cost you too much to get a second opinion.

Think for Yourself!

       Even though this method involved multiplying your replacement income by a certain number, you didn’t get to that step until you thought through several aspects of your situation. That’s the point of all the articles I’ve been writing about stupid rules of thumb. You need to think for yourself to figure out what really makes the most sense for your unique situation. Once you take the time to do that, you can be sure your decision is going to be a lot more accurate than following a stupid, over-simplified rule of thumb.

(photo credit: Chris Ingrassia on Flickr)

This article was included in the Carnival of Personal Finance.

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Corey

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Corey is currently pursuing a Master of Arts degree in religion. While he enjoys learning and writing about Christianity, another one of his new passions is writing about personal finances in order to help others make wise decisions with their money.

8 responses to The 10 Times Your Income for Life Insurance Rule Is Stupid

  1. Very insightful! Thanks for the info.

  2. I totally agree that simply multiplying your income by 10 is an inadequate way to determine how much life insurance is needed. As you say, each case needs to be determined based on individual circumstances. However, I wouldn’t call people who use the 10X method stupid; it IS a method, just not a great method, and definitely wiser than no life insurance at all, or not even thinking about life insurance.

    I realize that the word “stupid” is part of your series, so I am not over reacting to it, just commenting on how it struck me.

  3. I understand, Joe. But I’ve never called anyone who uses the methods stupid. It’s only the methods themselves that are stupid and only because they’re over-simplified ways to handle what are usually complex situations.

    I knew that using the word “stupid” would get some reactions. That was part of the point. But I hope it’s clear in the articles that I’m not saying people are stupid – just the rules of thumb. I want people to see they need to think about their individual circumstances. It’s just too dangerous to base all your financial planning on rules of thumb.

    I’ll be sure to make it clear from now on though. Thanks for commenting, Joe!

  4. Paul,
    I know you well enough to know that you are not going to go around calling people stupid. I understood that you were referring to the methods, not people. It is just that some people might infer that those who use stupid methods must be stupid people.

    My guess, however, is that 99% of your readers took your meaning exactly as you intended.

  5. Paul,

    As a CFP, I totally agree with your premise. I have found that 10x annual income is almost always inadequate.

    If I DID use a rule of thumb I would recommend

    ANNUAL INCOME DESIRED TO BE REPLACE DIVIDED BY EXPECTED RATE OF RETURN ON LIFE INSURANCE PROCEEDS(expressed as a decimal)

    i.e.

    $40,000 / .07

    $571,428

    This would provide $40,000 for an extended period of time (running out progressively because of inflation)

    Good thoughts,

    Derrik

  6. Right, Derrik. For anything over 15-20 years you’d need to factor in an adjustment for inflation. The multiplication factors I used take inflation into account. They’re based on Monte Carlo simulations, which aren’t going to give you a perfect answer but they’re better than the deterministic models.

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