How Much Is Enough Life Insurance?

Calculating is not an exact science, but there are some sound guidelines to follow.

By Gary Foreman

 While none of us like to think about it, parents of young children should be concerned about life insurance. Should either or both parents die, insurance could be vital to the children's well-being.

Methods for Calculating
There are two basic methods for deciding how much insurance a family needs. One way would be to replace the income of the deceased. A second method is to buy enough insurance to cover expenses.

Your choice will depend on your present financial situation. If you struggle to pay your bills, look at the expense method. Otherwise replacing the lost income should be sufficient.

There are calculators that will do the number crunching for you. But unless you understand the process, it's hard to know whether they're giving you a good answer.

To get to a perfect figure would require seeing into the future. You can only estimate longevity, investment return, and future inflation rates. But you can get reasonably close.

Insurance to Replace Income
First, we'll look at using life insurance to replace income. We will work with the model of a family where only one parent works. This way, we can illustrate what happens when you lose a spouse who draws a paycheck, and what happens when you lose the person who works inside the home.

In most cases, you'll want to replace all of the income that's lost when an employed spouse dies. To be more precise, you'll only want to include the after-tax pay and make adjustments for expenses (like a second car) that are incurred earning that income. Don't forget to add the value of health insurance or other employee benefits to the income number.

Life insurance is often paid off in a lump sum. We are going to assume that the sum will be invested and the income it generates is what is spent.

How can you calculate how big a lump sum you will need to create a specific annual income? The calculation is simple division. Take the amount of annual income you want and divide it by the investment return you'd expect to earn on the lump sum (i.e. life insurance proceeds).

For instance, if you need $50,000 a year and think you could earn 5 percent on the money, you need a lump sum of $1,000,000 ($50,000 divided by .05 = $1,000,000). That $1,000,000 would provide $50,000 to spend each year without touching principle.

The investment return that you use will make a big difference in the calculation. For instance, if you assume a 7 percent return, you need only $714,000.

It is best to overestimate your needs a little. Yes, you'll be buying and paying for a little more insurance than you need. But, if you underestimate you won't realize your mistake until too late.

If a stay-at-home spouse dies, the target is a little harder to figure. Unless there's someone like a grandparent who could move in and take over, the survivor will need to pay to have things done. And that can get expensive. Add up laundry, cleaning, cooking, day care, and a hundred other chores and you have an idea of what the at-home spouse's "salary" is. Then calculate like you did for employed spouse.

Insurance to Cover Expenses
Another way to look at the problem is to have enough insurance to cover your expenses. The calculation is the same. Just use expenses instead of income in your calculation.

Insurance companies will often encourage you to buy enough insurance to pay off your mortgage or other debts. That's nice, but it's not really necessary.

When you consider how much money you'll need, be sure to take inflation into account. Even a modest 3 percent inflation rate will cut the amount your income will buy in half every 24 years. So if you lose a spouse in your 30's, your dollar will lose half its value before you retire.

You should also consider what would happen if both parents die while the children are small. Hopefully, someone has agreed to raise the children. If so, the question becomes how much is needed to allow the children's guardians to house the children (bedroom addition? a bigger home?) plus the extra expense of feeding, clothing, and schooling the children.

One final thought. You will want to make sure that the insurance policy is set up properly. Choosing the correct owner and beneficiary can have important consequences.

Gary Foreman is a former certified financial planner who currently edits The Dollar Stretcher Web site .