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FamilyThe question of how much insurance to carry is a daunting one. The bottom line is that you need coverage if you have a family or others who depend on you. Ably tackling the how-much issue is AdviceIQ contributor Neal Frankle, CFP, the founder of Wealth Resources Group in Agoura Hill, Calif. His blog is at Wealth Pilgrim. Neal’s take:

Figuring out your life insurance needs sounds trickier than it actually is. The important thing is first determine whether you need life insurance, which kind is best for you and carefully calculate how much you need.

All we have to do is be clear about what your situation is, what risk to mitigate and voila, you have your answer.

First question: Do you need life insurance at all? If you have dependents to protect and don’t have enough savings, you definitely need insurance.

Second question: Which kind of insurance should you get? If you want to protect your family against the destruction of your business or estate taxes after your death, whole life or universal life insurance has to be considered.  But if your main concern is to protect your family against a loss of your income, term insurance is the way to go.

Finally, how much insurance do you need? This question is also pretty straightforward. It takes a few steps, but it’s not rocket science. Let’s go through it:

1. How much debt do you have other than your mortgage? If you have any other debt, you are spending more than you earn. Do you add to your debt each month? Do you pay it down each month? If you have debt, you have to buy more life insurance to pay it off.

2. How much do you spend each month? The most accurate way to determine your monthly needs is to use a personal budget software package like YNAB, but you can also use your bank statements to estimate your spending.

You can’t protect your family if you don’t know how much you need every month. Don’t just guess. You might think that $500,000 in term coverage is sufficient. After all, it’s a lot of money. But give it careful thought.  You may find that this is not enough.

If you die and your family gets the $500,000, what can they do with it? They might invest it using an income diversity strategy and maybe earn 5%. That amounts to just $25,000, of yearly investment income. So, if you earn $25,000 in salary, a $500,000 term policy is plenty. But if your family depends on more than $25,000 each year, you need more coverage.

3. How much do you save each month? If you put away money every month and live within your means, keep it up. In fact, you probably don’t need to replace all of your income, so you need less term life insurance.

4. What are your longer-term saving goals? How much money do you need to retire and pay for your immediate future? Are you saving enough to fund your future automobile purchase, retirement and education for the kids?

If you have funds set up for nonrecurring but expected outlays, fine. Otherwise, you need more coverage.

5. How much income do your survivors need if you aren’t around? This is the only thing that really matters when it comes to determining how much life insurance you need. But to answer this you have to first add up your answers for the above questions.

Let’s say you know you spend $6,000 each month to pay all your bills including taxes. You calculate this using a personal budgeting software program so you know you are on target.

Let’s also assume that this $6,000 pays for everything including future college education, automobile purchases and retirement. Of the $6,000, you earn $3,500 and your husband earns $2,500.

You run a financial plan and figure that by age 65, your maximum Social Security benefit and income from your investments will replace your earned income. That’s when you retire. (Without a financial plan it’s really tough to know how much insurance you need.)

After you do this exercise, you know that you need to replace your income until you reach 65. That’s $3,500 per month for you and $2,500 for your husband.

Your monthly income is equivalent to $42,000 a year. You need enough term insurance so that if you pass away, you could invest the proceeds and earn $42,000 after tax. How do you calculate that?

If you assume you could earn 5% on the money, simply divide $42,000 by 5% and you have your answer. In this example, the number is $840,000. That’s how much savings you need to invest at 5% to earn $42,000.

You can’t use other money you saved to offset this $840,000. If you have savings for retirement, that doesn’t count because you still need that money after you retire. The $840,000 is what your survivors need to get through until they don’t need your income. You can offset it with other insurance you already carry or if you have savings that isn’t earmarked for retirement or other purposes.

What about inflation? As the years roll by, your cost of living goes up. That means you need more money to replace your income. On the other hand, as the years pass, you need less insurance. Why?

Because, in this example, the life insurance is only meant to replace your income until you reach age 65. By the time you reach that age, you have enough to self-insure (meaning you pay for sudden expenses out of your own pocket): At that point, you will have passive income from pensions, Social Security and investment income. Also, your children should be independent by then, too. And as you get closer to 65, your risk is lower.  You have fewer years to carry the family.

This isn’t a scientific approach – it’s a ballpark calculation. But it’s pretty close to what you need, and it’s a calculation you can do yourself. It’s also a heck of a lot better than a wild guess.

If inflation or interest rates change radically, you have recalculated your needs. That’s why, if it were me, I’d recommend a term life insurance policy of $1 million in this person’s situation. Periodically review your life insurance coverage with your advisor to determine whether you still have enough or too much. (Source: Forbes.com)
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