The amount of insurance you should have depends on personal circumstances, such as whether you are married or have children.
- Determine cash needs. These include funeral expenses, estate taxes, emergency fund, college fund and nonmortgage debts.
- Determine available assets such as savings and investments.
- Subtract the second result from the first. This will tell you your total cash needs.
- Determine annual-income needs. Subtract Social Security survivor benefits and any other income available to the surviving spouse from the annual after-tax income needed after one spouse's death.
- Divide the result above by a projected interest rate (converted to decimal form) to determine the amount of insurance needed to compensate for the income shortage.
- Add results from 3 and 5 for your total life insurance needs.
Example: Cash needs minus savings (Line 3) = $30,000. * Total income shortage (Line 4) = $40,000. * (Line 5) $40,000/.05 = $800,000. * (Line 6) $800,000 + $30,000 = $830,000 = life insurance needs.
If you want to determine the amount of insurance to purchase on your own, the simplest technique is to use a multiple of your income. But the formula of 10 times salary may be too high or too low for any specific situation. Because life insurance proceeds are tax-free to the beneficiary, use your after-tax salary when applying the multiple.
Remember that the person whose salary you would be replacing is also a consumer: If they are gone, expenses should decrease, so you may want to reduce this after-tax income in your calculation.
Life insurance has two major functions: Replacing the earning power of any breadwinners in the family and providing liquidity for an estate. Without insurance, a family might need more cash and be forced to sell assets sooner than desirable, possibly under unfavorable conditions.
The two main types of coverage are term life insurance and permanent cash value life insurance, such as whole or universal life.
Straight term insurance is pure protection; there is no cash buildup. It's inexpensive because the odds are that you won't die while you own it.
Most term policies end at age 65 or 70. Life insurance needs usually decrease as you get older: For example, paying for children's college tuition should no longer be an issue (unless you have a large outstanding debt) and your mortgage is usually reduced or paid off.
Term insurance provides protection at the lowest cost. Any money you have left after paying the lower premium should be invested toward retirement, college education, mortgage reduction, and other financial goals.
The two main types of annual renewable term insurance are policies with decreasing term and policies with level premiums and death benefit terms. They run in five-year increments from five years to 30 years. The shortest coverage period is going to be the least expensive. That is because the odds of you dying are less for a one-year period than for a 20-year period, for example.
You may have inexpensive term insurance available through your employer. Consider this as a supplement to your basic coverage since most employer-sponsored life insurance ends when you leave the company for any reason.
Investment-oriented life insurance has a place in your portfolio only if you have already bought less expensive life insurance for protection and have accumulated sufficient funds through your stock and bond investment program to meet your financial goals.
