A popular approach to buying life insurance is based on income replacement. In this approach, a formula of between five and 10 times your annual salary is often used to calculate how much coverage you need. This rule of thumb, however, likely won’t provide you what you need. A better approach is to purchase insurance based on your specific needs and individual preferences.
The first step is to determine your income replacement needs. Currently, a large portion of your income goes to taxes (insurance benefits are generally income tax free) and to support your lifestyle. So begin by determining your net earnings after taxes. Then add up all your personal expenses, such as housing, health care, food, clothing, transportation and entertainment costs. This represents the amount that your insurance will need to replace annually. You’ll want a death benefit amount which, when invested, will provide income annually to cover this amount.
Income replacement for nonworking spouses is an important and often overlooked insurance need, as well. Coverage should provide for your costs for day care, housekeeping, or nursing care. Add to this any net earnings from part-time employment.
Second, you’ll want to add in any amounts needed to fund one-time expenses, such as college tuition for your children or paying down mortgage or debt.
Finally, estimate and add in any “final expenses” such as estate taxes, uninsured medical costs and funeral costs.