How Much Life Insurance Do You Need?

Deciding whether you need life insurance is pretty easy. Figuring out how much you need is not easy at all.

Many people just pluck some figure out of the air that seems reasonable and settle on that. Some lean on an old rule of thumb that says you need eight to ten times your annual income. That's better, but in this day and age you really should approach the problem more scientifically. Here's what you'll need to consider:

Immediate needs. What would it take to pay off the mortgage or other debt and continue funding the children's college funds. Don't forget about funeral expenses, probate costs and, depending on the size of your estate, estate taxes.

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Future needs. Basically, you will need to estimate the income your dependents would need to maintain their standard of living if you were to die tomorrow. Then subtract from that figure the income they could expect to receive in social security survivor's benefits (to get the form you need to estimate that, visit the Social Security Administration Web site.

Income when you're gone. Next, subtract the salaries your dependents now earn or could earn, the value of investments and other income sources. The difference is the amount of income your life insurance should provide. You have to make a number of assumptions in the course of this exercise -- complex assumptions that scare many people away from the task.

For instance:

--What will inflation be in the future? Unless you've got some special insight into this question, assume that it will average 3%.

-- Will the family be able to live on the earnings generated by the proceeds of the policy, or should they expect to gradually use up the capital as well? The answer to this depends a great deal on how much money is involved. If the policy will pay $500,000 and there are other sources of income, then you can reasonably expect that the beneficiaries could use the earnings and leave the principal pretty much alone. On the other hand, if the policy pays $100,000, then the family will need considerable additional assets if the principal is to remain intact.

-- What rate of interest can you safely assume the money will earn? For a conservative after-tax return based on historical norms, you should assume 8%.

-- Will your spouse take a job if he or she doesn't have one now? Will that require a period of training? How much can your spouse realistically be expected to earn? The answers will depend on your own situation, of course. It is impossible to anticipate everything, but it's wise to make reasonable guesses about what sorts of choices the surviving spouse might confront and provide as much breathing room as you can afford.

You can see what makes this task so difficult. Insurance companies will make the financial assumptions for you, using computerized programs developed for the purpose. These can be helpful, but many of the decisions described above are too important to turn over completely to the company trying to sell you the policy.

Eventually you will have to pick some total insurance figure that seems a reasonable compromise between what you'd like to have and what you can afford, using the companies' estimates for reference.

Keep in mind that the purchasing power of the insurance you buy today will be eroded by inflation as the years go by.