A simple way to determine how much life insurance you need is to take the amount of income you want to replace and multiply it by the number of years you want to replace it. Keep in mind that there will be no personal expenses for you—food, clothing, travel, insurance and even taxes on your income—if you are no longer here. So instead of using the amount you earn, use the amount you actually contribute to your household. If the person to be insured is a stay-at-home parent and does not earn an income, figure out how much will be needed to pay someone to take over those responsibilities.
Now, how long will you want to replace this income? You probably want to provide for your family until your children are grown and out of college. You may want your spouse to have enough to last until he/she can collect on social security and other retirement benefits. Let’s say, then, you are 40 and you want life insurance that will provide for your family for 25 years. Take the amount of annual income you want to replace and multiply that by 25. That’s how much life insurance you want. This amount is called the “face value” or “death benefit.”
This may be a pretty big number. So, now the issue becomes how much life insurance you can afford and that will depend, in part, on the kind of life insurance you purchase. Basically, there are two kinds: term and permanent. (Permanent can include sub-categories like whole life, universal life and variable universal life, but for now we will keep to a basic explanation of term and permanent.)
Term life insurance covers you for a set number of years, or term. It is pure insurance, and is similar to the insurance you have on your car or home. It can be a good choice if you want coverage for a certain number of years, for example until your kids are out of college or your mortgage is paid off. It is also less expensive than permanent insurance, and is least expensive when you are young and healthy. For these reasons, term life insurance is a popular choice for young families.
Permanent life insurance, on the other hand, does not expire at the end of a specified term (assuming you continue to pay the premiums, of course). Generally, the coverage stays in effect during your lifetime and the premium, depending upon the type of policy, can either stay the same or fluctuate based upon the financial performance of the policy. Permanent policies also build cash value over time that can be borrowed from the policy (reducing the proceeds paid at your death), can be used to help pay the premiums, or can be refunded to you if you cancel the policy.
The amount you pay for life insurance must be an expense you can live with. Buying life insurance to provide for your family for 20 or 25 years may be out of the question, even with term insurance. A viable alternative is to cover five to seven years of expenses, which will give your family time to adjust and cope with your absence. If you can afford more, there will always be a need, like paying for college and paying off the mortgage.
Life insurance proceeds are exempt from income taxes and can be exempt from probate. Depending on how much insurance you decide you need, a life insurance trust can keep the proceeds from being subject to estate taxes. Life insurance can also be used in business succession planning (in the event of your disability, retirement, and/or death) and in estate planning. An experienced and qualified professional can help you determine the correct uses and amounts of life insurance for your personal and financial circumstances.