If there’s anyone—including a spouse, children, parents or others—who relies on your income to make ends meet, you probably know you can buy life insurance to make sure they’re looked after when you’re gone. The next question becomes: how much life insurance do I need?
Read on to find out how to determine your life insurance coverage needs, so that you can protect your loved ones without spending more than you should.
What does life insurance cover?
Like insurance, life insurance provides financial assistance when, or if, certain events outlined in the policy take place. In this case, that event is your death, and the financial assistance goes to your loved ones to help them manage without your income.
If you have life insurance coverage in effect when you die, the insurance company will pay a tax-free death benefit to your family or other designated beneficiaries. The amount of that death benefit depends on the amount of coverage purchased. The greater the coverage, the more expensive the policy.
As such, it’s important to determine the right amount of coverage so your loved ones get the help needed, but you aren’t paying more than necessary. After all, you must continue to pay your premiums each month to keep the policy active. If you opt for too much coverage and have trouble making your payments, your policy could lapse and your beneficiaries wouldn’t receive any benefits.
So, how much life insurance is enough?
Some experts suggest a certain multiple of your income, say 10 or 15 times your annual earnings, to estimate life insurance coverage. But this type of one-size-fits-all advice can be wildly inaccurate. Depending on your circumstances, that amount could be too much, not enough, or just right. Instead, it’s better to look at the particulars of your situation and come up with a figure that makes sense for you.
More specifically, life insurance coverage depends on many factors, including how many dependents you have, their ages, their lifestyle, the amount of outstanding debt, whether they have other sources of income, and what level of financial support you want them to have after you’re gone.
Do you want to provide just enough to cover the essentials, like shelter and food, or do you also want to provide for your kids’ educations when they’re older? Maybe your intention is to offer some tax-free funds to your heirs so they won’t have to sell off the family cottage to pay for estate taxes?
It’s also important to consider what other assets and insurance you have to help support your loved ones. For example, if you have limited debt and sizable savings or investments, those funds will reduce the amount of insurance coverage needed. Similarly, you may already have some life insurance coverage (often one, two or three times your annual salary) through your employer, which could also lower the additional coverage you purchase.
Having said that, if you leave or lose your job, your workplace life insurance coverage ends. And, depending on your age, adding more coverage to your personal life insurance policy at that point could be very expensive, as age is one of the main factors in determining premiums.
Calculating your life insurance needs
Some life insurance providers offer calculators that help you assess your coverage needs. For example, PolicyMe has an online tool that asks you questions about your family and lifestyle, financial commitments, your family’s savings and income to provide a free estimate.
If you want to take a crack at the calculations yourself, here is the equation to use:
Total cost of what you want to provide for your loved ones
– Total assets/income available to your loved ones after your death
= Life insurance coverage amount
To come up with a life insurance coverage figure appropriate for you, you’ll first need to identify which of the following costs you want to cover for your loved ones, as well as what assets and other sources of income they can access after you die.
Costs you may want taken care of for your loved ones:
- Your funeral and estate fees. A funeral in Canada can cost up to $20,000, but the average cost is about half that much. You also want to add those costs to settling your estate.
- Mortgage and/or other debt repayments. This includes the outstanding balances on your mortgage loan, student loans, credit cards, lines of credit or HELOC, or any other personal loans forgiven at death.
- Childcare. If you have young children and your spouse works, be sure to include the total cost of full-time daycare until they are school age, plus part-time daycare and/or camp (if necessary) after that.
- Post-secondary education. This might include some or all the tuition for college, university or post-graduate degree(s).
- Living expenses such as food, rent/condo fees, clothing, utilities, transportation, home/car maintenance, property taxes, retirement fund contributions, etc.
- Extras such as travel, gifts, etc.
Assets/income available to your loved ones after your death:
- Savings. Include any non-retirement savings you and your spouse have, such as TFSAs, RESPs and non-registered bank accounts and investments.
- Spousal income. If your spouse works, include his/her after-tax annual salary and multiply by the number of years remaining until retirement.
- Other income. If you have an investment property or other non-registered assets/investments that generate income, add the after-tax amounts of those earnings.
- Employer-provided life insurance. Include the amount of the tax-free death benefit your workplace policy would pay upon your death.
- Other assets. This might include a vacation property or some other asset that could be liquidated (assuming you are okay with that) to help support your loved ones.
Life insurance calculation example
Let’s assume you want to provide for the cost of your funeral and estate fees ($15,000); pay off your mortgage and other debts ($500,000); cover the cost of summer camp for your two tweens for a few more years ($25,000), and pay for a four-year post-secondary degree for each of them ($160,000). Your family’s annual living expenses (not including mortgage) would total $60,000, and you want to cover that amount until your spouse retires in 25 years ($1.5 million).
That puts the total costs you want to provide to your loved ones at $2.2 million.
Now subtract all the assets and income available to your loved ones after your death. Let’s assume you and your spouse have combined non-retirement savings of $50,000; your spouse earns $50,000 a year (after taxes) which will provide $1.25 million in income until his/her retirement, and you have a workplace life insurance policy that pays a non-taxable death benefit of twice your annual salary (or $150,000).
The total assets/income available to your loved ones after your death is $1.45 million.
Your life insurance coverage needs in this example, therefore, would be:
$2.2 million in costs
-$1.45 million in assets/income
= $750,000 in coverage
Finding the right type of insurance policy
Once you know how much life insurance you need, you can start shopping around for policies. There are two main categories to choose from — term life insurance and permanent life insurance. The main difference between them is the period of coverage:
- With term life insurance, you purchase a policy that covers you for a specific period — anywhere from five to 30 years.
- Permanent life insurance covers you for as long as you live (assuming you continue to pay your monthly premiums).
Since permanent life insurance costs about 10 times more than term life insurance, the latter is the affordable option for most Canadians.
There are dozens of providers in Canada that can sell you a life insurance policy. To find the best rates, consider using an online life insurance platform that lets you easily compare premiums from a variety of providers at once. Some services will then refer you to a licensed broker or the individual insurance provider to complete your purchase once you’ve decided on a policy. Others, such as PolicyMe, offer competitive rates and use an online application process to simplify your purchase even further.
READ MORE: The Best Life Insurance Companies in Canada?
Life insurance is an important financial safety net for those who depend on your income. But before you rush off to buy a policy, first ask yourself, “How much life insurance do I need?” Then, use an online calculator or the steps outlined above to determine the most appropriate death benefit for your beneficiaries.
Keep in mind, however, that if the policy premiums are outside your budget, it’s much better to decrease the coverage to a level you can afford. That way, you can provide some financial aid for your loved ones without worrying about defaulting on your payments and having the policy lapse—which would not only leave them unprotected but could also make it harder and more costly for you to obtain life insurance in the future.