How much life insurance coverage is enough?

For many people, life insurance is not a usual subject for a conversation. It is something that people find hard to think about, or to discuss with their families. And yet, abstract from the fears and emotions, life insurance is an extremely important component of the personal financial independence plan.

In a person’s life, obligations and liabilities usually occur before the accumulation of the financial assets. People move out, start families, take on debt (such as mortgage or student loans) way before they are able to accumulate enough financial assets to ensure that these obligations are taken care of if they are suddenly gone.

Life insurance policies ensure that those left behind (your partner, kids, other dependents) have enough income to be financially comfortable. This may mean their day-to-day needs are covered, they have funds to pursue higher education, or they have an opportunity to pay-off debt.

In Canada, the payout from life insurance policy is a lump sum. It is highly recommended to have a plan agreed with for your beneficiaries or the executor of your will which would detail how the payout should be used (cue don’t spend it all at once but have it generate future income).

The question then is how much life insurance coverage is enough. The answer will depend on the future income you want to ensure for your beneficiaries, the period of time you would like the future income to be available, and the type of instruments you’d want the payout to be invested in.

I have developed a template to calculate the term life insurance payout required to achieve your future income goals. This and other templates are available at my store:

Term life insurance policies guarantee a payout during a certain number of years provided that the premiums are paid. Term life insurance policies are usually offered in 5 year increments (5-, 10-, 15-year policies and so on). In Canada, the payout from life insurance policy is tax-free to the beneficiaries, but income earned on it may be taxable (unless tax-advantaged accounts are used).

There are several assumptions to consider in the template:

Future income will be adjusted for the inflation rate to account for the loss of purchasing power over time.

The template assumes “worst-case scenario” from the tax prospective, i.e. that the earned income is taxable. The type of investment matters for the tax treatment of the earned income. E.g. in Canada, if the payout is invested into fixed income instruments (GIC or savings account) outside of TFSA, the interest will be fully taxed. If the payout is invested in the stock market outside of TFSA, only 50% of the capital gain will be taxed, and dividends will also enjoy favourable taxation rules versus fixed income instruments.

Gains, dividends and interest will be taxed in the hands of your beneficiaries, and this needs to be taken into account when assuming the applicable tax rate.

Assumed annual rate of return should match the type of investment you are planning to be used. For example, fixed income instruments will provide a lower level of return compared to the stock market. Investments in the stock market will also have different rate of return depending on the inherent risk of the stock or ETFs you want to be used.

Disclaimer: I am not a certified financial planner and this article does not constitute financial advice. Please do your own research before acting on the material of this article.



Power of math and forecasting for financial independence

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