Want some objective advice on how to choose the right kind and amount of life insurance? Here are some tips from Stephen L. Nelson, a best-selling author and CPA.
When you think about life insurance, you are planning for something most people would rather not think about. But life insurance is an important part of managing your finances and making sure your family is safe.
The two ways to look at life insurance
To figure out how much life insurance you should buy, you can use either the needs approach or the replacement-income approach. Using the needs approach, you figure out how much life insurance your family would need if you died to cover their financial needs. Using the replacement-income method, you figure out how much life insurance you need to replace your family's lost income. Let's take a quick look at each way.
How much do you need?
Using the needs approach, you add up all the costs that your family will have after you die, such as funeral and burial costs, medical costs that aren't covered by insurance, and estate taxes. But your family depends on you to pay for things like your child's college tuition, business or personal debts, and food and housing costs over time.
The needs approach isn't as broad as it could be. It's hard to figure out what your family needs and add them up, and it's often impossible to tell the difference between what your family really needs and what you want for them.
Replacing Lost Money
Using the replacement-income method to figure out how much life insurance you need, you figure out how much money you would need to replace your income for a certain number of years after your death.
Sometimes, life insurance companies estimate that you will need four or five times your annual income to replace it. A more accurate estimate takes into account the actual amount your family needs each year, the number of years they will need this amount, the interest rate your family will earn on the life insurance proceeds, and inflation over the years your family will use the money.
Note: When you're figuring out how much money you want to replace, don't forget that if you qualify, Social Security will give you a lot of money if you're a survivor. These perks can easily add up to $2,000 or more a month.
Using Excel to figure out replacement-income amounts
If you have access to a computer with the popular spreadsheet programme Microsoft Excel, you can use it to figure out how much insurance you need to replace a certain number of years of income. For example, say you want to buy enough life insurance to replace the income from a $50,000-a-year job for 15 years. If you think your family will earn 5% on the life insurance proceeds in the worst-case scenario, you can enter the following formula into a cell in an Excel workbook to figure out the replacement income life insurance amount:
=-PV (5 percent ,15,50000)
Excel gives the formula result of 518,982.90, which means that you would need about $520,000 of life insurance, invested at 5%, to pay out $50,000 a year for 15 years.
Two tips for doing math
If you're trying to replace income over a long period of time and want to take inflation into account, you should use a real rate of return instead of a regular, or nominal, rate of return.
To find the real rate of return, take the interest rate and subtract the inflation rate from it. For example, if you think inflation will be 2%, you could use this formula instead of the one shown above:
=-PV (5 percent -2 percent ,15,50000)
Here's one last tip for doing math: Most likely, you should round up your number. For example, if the formula gives you the number 518982.90, you might want to round this number up to $600,000. Or $750,000.
