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How much life insurance do I need?

Life Insurance
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Good question! And not an easy one to answer. Special circumstances, such as pre-existing medical conditions or tax-efficient estate planning, can significantly complicate the question of how much life insurance you need. The insurance industry itself throws out many different formulas. For this series, we're going to boil life insurance down to its most basic purpose: replacing your annual income until the age you would have retired. Figuring out needs from this angle will do the trick for most people.

Start with your current annual before-tax salary (see What factors might supplement replacement income? if you don't earn a salary but are the primary caregiver for dependents). The other number you'll need is the time, in years, until you reach retirement age.

Given these two numbers, you can figure out how much your family will need to replace this lost income over this length of time should something happen to you.

View Replacement Income Table

Looking at the table, you'll see that to replace $40,000 per year, in today's dollars, for 25 years, you should plan to leave your family a lump sum of roughly $803,000. If you want this table in handy calculator form, check out the Income Replacement section of ReliaQuote's calculator. (Leave other sections blank for now.)

Sound like a lot? Before you sell the goldfish and put the kids to work, you may want to tweak this number. For example, there are some factors that can reduce the amount of life insurance your family will need, such as Social Security benefits, your spouse's income, and your savings. Then again (yeah, this is the capital B-U-T), there are also some good reasons to increase the replacement income number.

For a ballpark number, figuring out your replacement income need is a good start toward answering "How much life insurance do I need?" As you move through the next few questions -- which focus on tweaking this estimate -- you may start to feel like you're filling out an income tax form. However, it's not too tough, Fool, if you keep one key distinction in mind:

There are two types of adjustments:

  • those that act on annual replacement income, and
  • those that act on immediate needs at death.

In concrete terms, the life insurance beneficiary just gets one big check, but two things happen to this check. First, immediate expenses are paid. Second, the remaining sum is invested so that replacement income can be paid out, on an ongoing basis, from both the lump sum and the investment income it generates.

As you work through the adjustments to replacement income, we'll try to be clear about whether you are adjusting the ongoing annual needs of your dependents (changing replacement income table row) or their immediate needs at your death (add or subtract from the number in the table body).

In the other Q&A's in this section, we'll attempt to help you refine your life insurance needs. However, be sure to follow this exercise with some additional research. Ask friends in similar circumstances, try some Web calculators, and call a few insurance agents. If someone insists that you need a lot more or less life insurance than the rough figure you come up with after reading this series, be sure they can explain why.