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How Much Life Insurance Is Enough

Posted on August 11th, 2010 | admin

You don’t want to pay for more insurance than you need, but how much is that? Figuring it out is not a simple calculation because you must take into account both your present requirements and future circumstances. For example, a couple with no children won’t need as much coverage as a family with three youngsters. However, that situation will change as soon as the first baby comes along.

There is also a school of thought that older people whose children have grown up and left home don’t need the same level of coverage as younger families. However, at that point a different set of factors may have come into play. If only one spouse works, more coverage may be needed to provide for the financial security of the other if the breadwinner should die. Or you want the cottage that has been in the family for many years to go to your children after you pass away. Capital gains taxes on the estate may make that difficult unless adequate insurance coverage is in place.

Everyone’s situation is different, which is why there is no magic formula for deciding how much coverage you need. So let’s simplify things a bit.

Income Replacement

One of the key benefits of life insurance is income replacement. If you die, the proceeds from the insurance policy can be invested to provide income for your survivors for the years to come. This is especially important if you have young children and/or if your spouse or partner has limited earning ability. The starting point is to figure out how much income would have to be replaced if you were hit by a truck tomorrow. That gives you a target, but you have to make allowance for inflation as the years pass, otherwise the purchasing power of the investment income will steadily decline.

Obviously, you can’t provide for the worst case scenario – 30 years of inflation at an average of 6 percent annually. You would have to buy far more coverage than you could afford. Instead, pick an appropriate average figure to work with. For example, let’s say you expect that it will be 16 years before your youngest child leaves home. Rather than buying enough insurance to cover the full 16 years (which would imply that you expect to die tomorrow), use the halfway point of eight years to determine the appropriate income target. Using the multiplier for 3 percent inflation at eight years, the family would need $1,270 in income for every $1,000 required today. If the current income you need to replace is $40,000, that means you would need enough insurance to generate $50 , 800 annually.

That’s more than would be required at the outset, so the difference can be invested and drawn on in future years. How much insurance protection would that require? If you assume the money is invested to yield 6 percent annually, you’d require about $850,000. That seems like a lot, certainly more than most families carry. But you probably don’t need that much.

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