What Is Life Insurance for Income Replacement, and Why Does It Matter?
Your income pays for everything. If it ends or gets interrupted for months or years, you need a Plan B – and fast. Why? Because if your loved ones depend on your income, you’ll want to be sure they’re protected financially if the unexpected were to occur.
The good news is that you’re thinking about income replacement while there’s plenty of time to do something about it. Your Serenia Life advisor can help you put up a wall of defence against unexpected income loss. And it doesn’t include cashing in your savings or moving in with your wealthy aunt.
KEY TAKEAWAYS
- Most people need a Plan B to replace some or all of their income if they die, get sick, or get injured.
- There are many ways to calculate how much life insurance you need. We can help you pick the one that works for you.
- Term life insurance and permanent life insurance both offer income replacement options in different ways.
- Get advice from tax, insurance, and estate planning experts before you make a purchase.
Introduction to income replacement in life insurance
Your long-term financial plan was likely created with the idea that you would save, invest, stay invested, and benefit from decades of compound growth. It makes sense as long as you stay committed to that approach. But what happens when your income gets switched off?
If you’re lucky… your financial advisor can work with you to turn some of your assets into income. For example, you start taking money from your long-term savings sooner than you hoped for. This isn’t ideal for a whole host of reasons we’ll discuss below.
If you’re not so lucky… You may have to sell investments or cash in your savings to stay afloat. This is also not ideal and the money may run out.
Keep reading if this sounds like you:
- You’re the primary income-earner, and you have dependents that rely on you.
- You’re a single or married parent that’s concerned about how your family will maintain their current lifestyle if you die.
- You’re a young professional with high lifetime earning potential and are comparing your life insurance options.
- You’re sold on the idea of life insurance as a way to replace income but aren’t sure how much coverage you actually need.
If you’re in one of these boats, you’re not alone. As an income earner, you should be looking for a way to replace the money you bring in without having to sacrifice all the financial gains you’ve made through hard work and saving. Purchasing life insurance will ensure your investments can reach their full potential through uninterrupted compound growth .
The importance of life insurance
For many Canadian individuals and families, life insurance is a non-negotiable “must have,” like auto insurance or fire insurance on your home. The stats show that many people already appreciate the importance of coverage, but there’s still a long way to go.
A 2024 study by LIMRA, a trade association supporting the insurance and related financial services industry, found that:
- Only 57% of Canadian adults say they have life insurance coverage. The positive news is that this represents a three-point increase from a similar study conducted by LIMRA in 2019.
- Despite the increase in ownership, nearly a third of Canadians say they are living with a life insurance coverage gap. This coverage gap makes it less likely for Canadians to feel confident they could withstand a financial shock.
- 4 in 10 Canadians say their families would face financial hardship within six months should the primary wage earner die unexpectedly. Another quarter said they didn’t know how long their families would be financially stable.
These stats make a compelling need for most Canadians to either get or increase life insurance coverage as a primary source of income replacement.
How does income replacement factor into life insurance?
If you were to die during your working years, very few of your family’s regular expenses could be shut off. They can scale back on some things, like shopping or travel, but they must keep up with:
- Daily living expenses like groceries
- Utilities, like hydro and water
- Taxes
- Mortgage or rent
- Child care and education
- Debt obligations
- Home, rent, or auto insurance
- Retirement contributions
If you had life insurance coverage, your beneficiaries (i.e., the persons you choose to receive your life insurance payment in the event of your death) would typically receive a tax-free, lump-sum payment from the insurance provider. That can be a welcome relief during a very challenging time. The next step is to turn that money into a reliable income stream over a long period of time. That’s why your beneficiaries have the option of periodic payments.
Lump-sum vs. period payments
Turning a large sum of money into a steady income stream takes some financial know-how. Depending on the amount and what kind of expenses it needs to cover, an advisor may recommend that the money gets invested and withdrawn gradually. This could mean:
- Depositing the money into a savings account, earning interest, and scheduling regular transfers to the beneficiary or trustee.
- Turning the lump-sum into a term certain annuity that can be structured to last for a specific number of years, or into a life annuity that ensures lifetime income for the beneficiaries. Here’s a step-by-step guide on how to move a large sum of money into payments that will last.
Always seek financial and tax planning advice before committing to any of these approaches.
How long should income replacement last?
Start by asking how long you expect to keep working to generate income. Then, factor in some typical milestones:
- When your children become financially independent
- When your spouse reaches retirement age
- The day you’re finally debt-free
Most of these targets can be met with term life insurance policies that expire when you outgrow the need for income replacement specifically.
Common ways income replacement is calculated
There are a few traditional methods you can use to estimate the amount of income you need to replace. If your financial situation is complicated by business ownership or blended family relationships, always work with an advisor or ask a professional to double-check your numbers and assumptions.
Method 1. The ten times income rule
If you plan to work for at least ten more years, we recommend carrying enough life insurance to replace at least ten years of after-tax earnings. This could be higher if you have significant debt. For example, if you earn $80,000 a year after tax, you would need:
$80,000 X 10 = $800,000
While this method is nice and easy, remember that it doesn’t take into account any existing debt, regular contributions to savings or investments, or your family expenses.
Method 2. The needs-based method
When you want to plan for all the possible outcomes, this more detailed “needs-based” approach may work best for you. The option relies on two variables:
- The amount of money your loved ones will need immediately after your death to pay final expenses.
Did you know? Life insurance goes directly to the person you name (and doesn’t have to go through probate, which takes time and costs money), so loved ones usually receive the payout quickly – often soon enough to cover immediate expenses like funeral costs once a claim is made. - The future income that is needed to help everyone maintain their lifestyle and keep up with their own financial goals.
Here’s how to estimate your needs using this method.
| Step 1. Add up immediate expenses in the weeks and months following your death | |
|---|---|
| Final expenses including final taxes, celebration of life | $ |
| Flight or accommodation for out-of-town relatives | $ |
| Utilities (due in the first few months) | $ |
| Upcoming rent or mortgage payments | $ |
| Amount due on auto loans, leases, etc. | $ |
| Amount due on insurance policies, like home and auto | $ |
| Miscellaneous (subscriptions, dog walkers, etc.) | $ |
| Sub Total | $ |
| Step 2. Estimate ongoing lifestyle and financial planning needs | |
| Income needed from the Ten Times rule above | $ |
| Outstanding mortgage balance (if you want to pay it off) | $ |
| Mortgage or rent for at least ten years | $ |
| Contributions to education funds | $ |
| Replacing the family vehicle at some point | $ |
| Home upkeep or renovations | $ |
| Child care | $ |
| Long-term debt, including lines of credit | $ |
| Sub Total | $ |
| Total | $ |
The Grand Total is a reasonable estimate of your needs. The next step is to consider where your family might receive income, thanks to your good financial planning, and include these numbers in your calculation. For example:
- Your RRSP: If a family member is listed as the beneficiary, they can add your savings to theirs for long-term security. Learn how to designate your RRSP beneficiary.
- Your TFSA: A family member named as your successor can absorb your savings into their financial plan and consider turning it into income. Some provincial rules apply, so here’s what you need to know about choosing a successor.
- Other life insurance policies: If you have a group life insurance policy at work, consider how this will offset the amount of life insurance you need to purchase.
| Final Calculation | |
|---|---|
| Total from the table above | $ |
| Deduct the amount available through other sources | -$ |
| Needs-based life insurance amount estimate | $ |
Always seek financial and tax advice before cashing in on registered or non-registered investments.
Method 3. The capital retention model
“Capital retention” essentially means keeping your money. To retain all of the money (capital) that a life insurance death benefit (i.e., a payment made to designated family members or other loved ones after you die) provides, your beneficiary needs to invest it with the hope of earning a four per cent annual rate of return. This is called the 4% Rule, and here’s how it works.
- Your beneficiary withdraws 4 per cent from the invested proceeds of the death benefit in the first year.
- The balance of the amount (the other 96 percent) remains invested, earning 4 per cent plus an additional 2 per cent to offset inflation.
- As long as the balance grows by at least 4 percent plus another 2 per cent for the inflation rate, your loved ones should start each new year with a fully restored balance of 100 per cent.
There are a lot of assumptions being made about interest rates and inflation in this model, but it’s still a great strategy when 4 per cent is enough to meet your family’s needs.
Common mistakes to avoid
It’s easy to underestimate the cost of living, especially when you look far into the future. You forget about things like replacing appliances, re-shingling the roof, renovating your home, retrofitting for mobility needs, helping your kids with a down payment, going on vacation, and so on. It’s better to guess too high than too low.
And we can’t ignore the reality of inflation! Your beneficiaries could need your income replacement for a long time, so you might end up needing more than you think. If inflation rates continue to skyrocket within your lifetime, it’s a good idea to re-evaluate your coverage and reassess whether you have enough.
Key things income replacement does not do
What your beneficiaries do with the money they receive from your life insurance policy is up to them. But there are a few things they just can’t do. We’ve listed them below:
- Life insurance does not replace benefits, like employer health insurance, or living benefits, like critical illness insurance and disability insurance, that don’t apply after death.
- Life insurance payouts do not automatically take inflation into account. That’s why we recommend including the possibility of inflation in your calculation from the very start.
- Life insurance does not guarantee lifetime income, unless structured that way. If you want to turn the one-time benefit into a lifelong income stream, adjusted for inflation, you need to ask about alternatives such as a Single Premium Annuity (SPA), which converts a one-time investment into guaranteed, regular income.
Types of life insurance that support income replacement
All forms of life insurance support income replacement in one way or another. Here’s how to match your needs to a more precise solution.
Term life for income replacement (why it’s usually best)
Here’s why term life insurance remains the most popular form of coverage in Canada and why so many people choose it for income replacement.
Strengths
- Maximum income replacement for minimum cost
The cost of owning a life insurance policy is a fraction of the amount your loved ones could receive in a tax-free death benefit. It would be unrealistic and impractical for you to try saving the equivalent amount over the same time frame. - Matches the actual risk
The amount of income you need to replace goes down as you edge toward retirement, your kids find their financial footing, and the mortgage gets paid off. It’s not a bad thing if you outlive your policy because term life insurance allows you to carry the coverage you need, for only as long as you need it. - Frees up cash for investing
Term life insurance policies are relatively inexpensive compared to permanent life insurance options. The low cost takes a smaller bite out of your paycheque, so there’s more money to invest in retirement via TFSAs, RRSPs, GICs, or other non-registered accounts. - Simple and transparent
Term life insurance is a simple contract between you and an insurance company. As long as your policy is in good standing, your loved ones know exactly how much money they will receive – and it has nothing to do with interest rates or unpredictable market volatility.
Limitations
- No payout if you outlive the term
You could indeed outlive your term life insurance policy and regret the money you spent over the last 10, 20, or 30 years. But would you regret fire insurance if your home never burned down? Renter’s insurance if no one ever nicked your laptop? It’s the same kind of trade-offs. - Renewal later in life can be very expensive
This is true if you don’t know how to work around it. Ask about riders (i.e., coverage that gets added on to an insurance policy to provide additional payouts under specific circumstances) and conversion options that let you renew or upgrade your coverage at an affordable price later in life. - Requires discipline to invest in a personal savings account
If you plan to invest or save the money that you would have otherwise spent on a life insurance policy, you may find it practically impossible to grow it to the point that it would provide meaningful financial protection for your family in the event of your death. Not to mention, it can also be challenging to leave funds that are easily accessible untouched. You know what they say: Out of sight, out of mind!
Permanent life for income replacement (where it falls short)
The strength of permanent life insurance is that it’s one of the most complete financial planning solutions you can buy. It can certainly provide income replacement but that’s not its primary job. Here’s how to evaluate the overall benefits of permanent coverage and what it offers beyond basic income needs.
Strengths (limited for income replacement)
- Guaranteed payout whenever death occurs
The one-time, tax-free death benefit from a permanent policy is what makes permanent life insurance so attractive. Unlike term life insurance, coverage cannot expire once you’ve made all the payments. - Investment component and cash value1 access
The growth portion of a permanent life insurance policy is what makes it unique, more flexible, and more expensive than classic term life insurance. All cash-value life insurance policies offer guaranteed growth and multiple ways to borrow against2 the cash values, and one of those reasons could be temporary income replacement. Here’s what you need to know about this all-in-one wealth-building option.
Limitations
- Very inefficient for income replacement
If your only goal is income replacement, permanent coverage is an expensive way to buy it. For example, if you were to die in the first decade of coverage, your loved ones might have been better served with a cheaper policy. That’s something for you to review carefully with the help of an insurance or investment advisor. - Income dependency rarely lasts forever
Some people feel they don’t need to worry about income replacement later in life when their children are grown, and there’s not a lot of debt or expenses. For them, a term life policy will do the job. Permanent life insurance tends to attract people who are more focused on tax-efficient wealth transfer. - Complexity and risk of underperformance
Permanent life insurance is complicated and requires commitment. It takes about 20 years to cover the total cost, and the cash value grows in untraditional ways that shouldn’t be compared to typical equity investments like mutual funds.
When permanent life might make sense for income replacement
Permanent life insurance gives financial planners a wide variety of ways to meet complex needs. It’s no surprise that wealthier families are happy to pay for this kind of coverage, sometimes in addition to term life insurance, when the tax advantages are clear. For example, you may consider it when:
- A dependent with special needs will need a lifetime income
- A family’s legacy relies on one high-income earner
- The passing down of family investments or properties could trigger high taxes
- Other tax-free or tax-deferred investments are maxed out
If any of these scenarios sound like your situation, seek investment, tax, and estate-planning advice about the advantages of permanent life insurance in family wealth preservation.
Pros and cons of income replacement strategies
Below, we’ve summarized the major pros and cons of using life insurance as an income replacement strategy. Keep in mind that every “con” is simply an obstacle that can be avoided or overcome through good planning. Don’t let anything discourage you or get in your way when it comes to fully understanding your options.
| Pros | Cons |
|---|---|
| Immediate, tax-free liquidity Your beneficiaries receive a tax-free payout, usually in a matter of days, to spend as they see fit. | Coverage ends (term insurance) Term life only pays out if death occurs during the term. Getting a new policy later in life could be very expensive. |
| Predictable and guaranteed payout The value of the death benefit is guaranteed by a contract so your loved ones can budget for the future with complete confidence. | Risk of under- or over-insuring Estimating future income needs can be complex, but it’s not impossible to make some informed assumptions. Annual reviews can ensure you strike the right balance between too little and too much coverage. |
| Cost-effective (especially term life) The cost of life insurance is always cheaper – particularly if you’re young and healthy – than trying to “self-insure” through investments alone. | Inflation risk A fixed death benefit will lose purchasing power over time, so you may need to layer or increase coverage. |
| Protects dependents during vulnerable years When your kids are young, and you likely have more expenses and debt, life insurance is the easiest and least expensive way to replace your income without paying taxes. | Not a substitute for disability insurance or critical illness insurance Life insurance only provides income replacement when you die. Critical illness insurance and disability insurance are still essential income replacement strategies that come at an additional cost. |
| Flexible use of proceeds There are no strings attached to the payout. Your beneficiaries can spend or invest the money however they choose. | Whole/permanent life trade-offs There’s only so much money to go around and permanent life insurance is expensive if income replacement is your only goal. |
In conclusion, life insurance is most effective as an income replacement strategy when:
- You have financial dependents whose lifestyle would suffer without your income
- Your income is essential to household stability, forcing loved ones to sell the home or cash in on other investments
- You want guaranteed, immediate protection instead of buying investments that need time to grow
- You want to create a complete financial plan that includes critical illness insurance, disability insurance, retirement savings, and investments.
The bottom line
For most Canadians, life insurance in some form can provide an affordable and reliable way to:
- Turn lost future income into a lump sum
- Give your beneficiaries the ability to turn on an income stream
- Match your actual household needs to income
Now is the time to consider all of your alternatives, based on your age, the amount of income you estimate your family will need, and all the other important choices that go into a family life insurance plan. We’re here to help you connect all the dots and get started.
Why choose Serenia Life for your income replacement needs?
It’s never too early to put an income replacement strategy in place in case you get injured, become ill, suffer a setback or worse. Let us help you construct a thoughtful, affordable approach based on your long-term needs. Advice is free, easy, and one of the many advantages of a Serenia Life membership.
Not to mention, as a member-based organization whose roots go back nearly 100 years, we encourage kindness by sharing our profits through community outreach, fundraising, and unique member benefits that help Canadians support their families and their communities, including:
- $2,500 post-secondary scholarships
- Up to $600 in financial support for fundraising or up to $400 for volunteer-related expenses
- Financial support when you hire a lawyer to draft or update your will
View a full list of our member benefits.
We’ll help your loved ones stay on track
There will never be a replacement for you, but we can help you replace the income your loved ones will need if something happens to you. Give us a shout, visit us in person, or book an appointment with a Serenia Life advisor today.
Disclaimers
¹Cash values are accessible via a withdrawal, policy loan, or surrender. These may be subject to taxation and a tax slip may be issued. Accessing the policy’s cash value will reduce the available cash surrender value and death benefit
2Policy loan is an easy way to access the accumulated cash value of the policy. A variable interest is charged on the amount borrowed. This may result in taxable consequences. Loan can be repaid at any time. Upon death and the loan is unpaid, the outstanding balance including any accumulated interest will be deducted from the total death benefit, with the remainder paid tax free to the beneficiary(ies).
