How to Use Life Insurance to Replace Your Income
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Your death could place a sizable financial burden on anyone who relies on you to pay bills. This is where life insurance can help.
Using life insurance to replace your income can give your beneficiaries the funds to cover expenses after you die, and give you peace of mind. Nearly one-third of Americans who have bought coverage say that income replacement was the reason they did so, according to a new NerdWallet survey, conducted online by The Harris Poll.
Learn more about the life insurance income replacement method, and how to calculate your coverage amount.
Why it's important to have life insurance to replace your income
The loss of a breadwinner's income can be devastating for a family, and many people don’t have enough savings to cover such an event. After six months, 44% of American households say they’d feel financial hardship if the primary wage earner were to die, according to the 2022 Insurance Barometer Study from LIMRA and Life Happens, nonprofit insurance trade associations.
As with many insurance products, life insurance offers coverage for the unexpected. The payout from a life insurance policy typically goes directly to your beneficiaries, who can use it to cover ongoing expenses in your absence. There are a few exceptions to this, like when the beneficiary is a minor and the death benefit is paid out to a guardian instead.
Even if you’re not the primary earner, loved ones may rely on services you provide — and income replacement can help them pay for those services in your absence. So whether you’re a stay-at-home parent, one of multiple earners in your household, or the sole breadwinner, a life insurance policy can offer financial security to those you leave behind.
What type of life insurance can replace your income?
In general, there are two types of life insurance: term life and permanent life.
Term life insurance lasts for a set period of time, such as 10, 20 or 30 years. It’s typically the cheapest type of coverage and sufficient for most families. You can match the term policy length to the length of time you want coverage. For example, a 20-year term life policy could cover your income while your kids are still at home, while a 30-year policy could cover your income for a good portion of your working years. If you die while your policy is active, your life insurance beneficiaries receive the death benefit. Ideally, by the time the term expires, your loved ones can support themselves and you no longer need coverage.
To compare, a permanent policy such as whole life insurance pays out up to a maximum age, which is usually 90 to 120, and typically builds cash value. Since these policies are designed to cover you for your entire lifetime, permanent life insurance typically costs more than term life. The average life insurance rate for a 20-year, $500,000 term life policy for a 30-year-old woman is $189 a year, according to Quotacy, a brokerage firm; for the same client, the average annual premium for a $500,000 whole life policy is $4,015.
If the only reason you’re buying a policy is to replace your income, you may not need permanent life insurance. Those who rely on you now may be financially secure by the time you retire, making lifelong coverage unnecessary.
How to calculate income replacement
When calculating how much life insurance you need to replace your income, one guideline is to multiply your annual salary by the number of years you want to cover. For example, if your annual salary is $60,000 and you want to give your beneficiaries five years of coverage, you’ll need a $300,000 policy. Keep in mind this only reflects your base salary. You’ll also want to account for any anticipated raises and additional expenses like college fees.
You may have heard the “10 times income” recommendation shared online, but there are no hard-and-fast rules when it comes to calculating coverage. Speak with a fee-only advisor if you want more guidance on how much coverage to get. These advisors don’t receive commissions from insurance providers, so they’re not biased about the amount of coverage you buy.
Use our income replacement calculator to estimate your coverage amount.
Include daily tasks in your calculations
Consider the value of daily tasks when calculating your coverage amount. Any free child care, cleaning and cooking you provide can be expensive to replace if you die. For example, the average weekly cost of a nanny in the United States is $694, according to 2021 data calculated by Care.com, an online marketplace for family services. Care.com also reports that a house cleaner typically costs from $16.25 to $21.25 an hour, based on pay rates in 20 cities across the country. If you’re a stay-at-home parent, you likely do these tasks for free, and replacing them would be costly. A life insurance policy can help pay for these services in your absence.
Take into account any workplace coverage
If you have group life insurance through work, you may want to include the extra coverage amount in your calculations. But keep in mind that these policies are sometimes tied to your employment, which means you may lose the coverage if you leave your job.
Reevaluate coverage if your income changes
It’s important to reevaluate your life insurance needs if your job, income or family situation changes. You may want to buy more than one life insurance policy to supplement your existing coverage. Or you may choose to adjust your coverage if you become the sole breadwinner, or your expenses increase or decrease.
Important: Your ability to raise or lower the death benefit amount may depend on the insurer. If you think you’ll need to change your coverage over time, ask the insurer about adjustment options before you buy.
The primary purpose of life insurance is to replace your income. Here are four other common reasons for buying coverage.