Financially Speaking: Life insurance: How much do you need?

No one likes to think about death. Unfortunately, it's going to happen to all of us one of these days.

Life insurance was created to help people protect the financial stability of their families in the event of their premature death. With so many insurance products available today, it's becoming more difficult to determine how much life insurance you need, and which type of insurance is appropriate.

Simple rules of thumb are often used to estimate someone's life insurance need. The income rule calculates your life insurance need at six to eight times your gross annual income. For example, if you earn $60,000 per year, this rule calculates your needed coverage at $360,000 to $480,000.

The income-plus-expense rule calculates your insurance need at five times your gross annual income plus the total of your outstanding debt, plus estimated final expenses and special funding needs such as college expenses. Using this rule, if your income is $60,000 and your combined debt plus funding need totals $150,000, you would need $450,000 of life insurance.

The income replacement method assumes you should purchase enough life insurance to replace the income you could potentially earn throughout your working career, considering future inflation, increases in your earning capacity, and the investment performance of the life insurance proceeds over time.

These rules are overly simplistic, in my opinion, because they fail to consider several important factors:


You may be able to reduce your life insurance need by some or all of the value of your existing investments, although you will need to consider the effect of income taxes and any limitations on the accessibility of those assets. For example, retirement plan assets that might be subject to early withdrawal penalties.
If you are married, have you considered your spouse's future earning capacity after your death? He or she might be able to earn enough to cover your debt payments. Conversely, the death of a parent might create a need to obtain professional household or child care services and that expense should be included in your calculation.
You might have already accumulated a vested pension benefit that is available to your survivors.
Liquidity is a consideration that is frequently overlooked. Although there is no federal estate tax in 2010, it will very likely resume after Dec. 31. The value of real estate or a closely held business could easily take the value of a decedent's estate above the federal or state exclusion. Life insurance can be a cost-effective vehicle to provide your estate with the cash needed to pay the tax and avoid a forced liquidation.
Even if estate taxation is not a problem, life insurance can be used to equalize bequests to your heirs. For example, if one of your two children works in a family business valued at $1 million, you could leave the business to one child and a $1 million life insurance policy to the other.
If there is no one who would be financially harmed by your death, you might not need any life insurance at all.

An experienced independent life insurance agent can help you determine the appropriate amount of life insurance you need and the type of policy to purchase. You should also obtain expert advice regarding ownership and beneficiary designations in order to avoid inadvertently creating a tax problem.