When considering life insurance, you're planning and preparing
for an event most of us would rather not think about. But life
insurance represents a critical step in managing your personal
finances and ensuring your family's well-being.
The Two Approaches to Life Insurance
You can use one of two approaches to estimate how much life
insurance you should buy: the needs approach or the
replacement-income approach. Using the needs approach, you
calculate the amount of life insurance necessary to cover your
family's financial needs if you die. Using the
replacement-income approach, you calculate the amount of life
insurance you need to equal the income your family will lose.
Let's look briefly at each approach.
You Need How Much?
Using the needs approach, you add up the amounts that represent
all the needs your family will have after your death, including
funeral and burial costs, uninsured medical expenses, and estate
taxes. However, your family depends on you to pay for other
needs, such as your child's college tuition, business or
personal debts, and food and housing expenses over time.
The needs approach is somewhat limiting. The task of identifying
and tallying family needs is difficult, and separating the true
needs of your family from what you want for them is often
impossible.
Replacing Income
Using the replacement-income approach for estimating life
insurance requirements, you calculate the life insurance
proceeds that would replace your earnings over a specified
number of years after your death.
Life insurance companies sometimes approximate your replacement
income at four or five times your annual income. A more precise
estimation considers the actual amount your family members need
annually, the number of years for which they will need this
amount, and the interest rate your family will earn on the life
insurance proceeds, as well as inflation over the years during
which your family draws on the life insurance proceeds.
Note: Do remember as you quantify the income you want to replace
that Social Security provides generous survivors benefits if
you've qualified. These benefits can easily total $2,000 a month
or more.
Calculating Replacement-Income Amounts with Excel
If you've got access to a computer running Microsoft Excel, the
popular spreadsheet program, you can use your computer to
calculate the amount of insurance you need to replace a
specified number of years of income. Suppose, for example, that
you want to buy enough life insurance to replace the income from
a $50,000-a-year job for 15 years. If you figure your family
will earn 5% on the life insurance proceeds should the worst
case scenario occur, you enter the following formula into a cell
in an Excel workbook to calculate the replacement income life
insurance amount:
=-PV(5%,15,50000)
Excel returns the formula result 518,982.90 indicating that you
would need roughly $520,000 of life insurance, invested at 5%,
to payout $50,000 a year for 15 years.
Two Calculation Tips
If you want to factor in inflation because you're trying to
replace income over a long period of time, you should use a real
rate of return rather a regular, or nominal, rate of return.
To calculate a real rate of return, subtract the inflation rate
from the interest rate in the formula. For example, if you
expect 2% inflation, you could replace the formula shown earlier
with this formula:
=-PV(5%-2%,15,50000)
Here's a final calculation tip: You probably want to round up
your number. For example, if the formula provided earlier
returns the value 518982.90, you might want to round up this
value to $600,000. Or $750,000.
About the author:
Seattle certified public
accountant & Stephen L. Nelson CPA has written more than 150
books. His bestselling book is Quicken for Dummies, which sold
more than 1,000,000 copies. His books have sold more than
4,000,000 copies in English and have been translated into more
than a dozen other languages.
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