Life Insurance
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A Viewer asks: How much life insurance should a couple with
two small children have? Anita H.
While none of us like to think about it, Anita is wise to be
concerned with life insurance. Should either or both parents die,
life insurance could be vital
to her children's well-being.
There are two basic methods Anita can use to decide how much
insurance she needs.
- To replace the income of the deceased.
- To buy enough insurance to cover your expenses.
Your choice will depend on your present financial situation.
If you struggle to pay your bills look at the expense method.
Otherwise replacing the lost income should be sufficient. There
are calculators that will do the number crunching for you. Unless
you understand the process, it's hard to know whether they're
giving you a good answer.
Anita doesn't need a perfect answer…to get that would require
seeing into the future. She would need to know her longevity,
investment return and future inflation rates. She can only estimate
those things, so just try to get reasonably close.
Life Insurance Replacement to Income
First we'll look at using life insurance to replace income. We'll
assume a family where only one parent works. That way we can do
one illustration when you lose a spouse who draws a paycheck,
and another illustration for the person who works inside the home.
In most cases you'll want to plan to replace all of the income
that's lost when an employed spouse dies. To be more precise,
you'll only want to include the after tax pay and make adjustments
for expenses (like a second car) that are incurred earning that
income. Don't forget to add the value of health
insurance or other employee benefits to the income number.
Anita now has an amount of income that she needs to replace each
year. But life insurance is often paid off in a lump sum. We're
going to assume that she'd invest the life insurance proceeds
and spend the income that it generates.
How-to Calculate Annual Income
How may Anita calculate the lump sum she'll need to create a
specific annual income? The calculation is simple division. Take
the amount of annual income you want and divide it by the investment
return you'd expect to earn on the lump sum (i.e. life insurance
proceeds).
For instance, if Anita needed $50,000 a year and thought that
she could earn 5% on the money, she'd need a lump sum of $1,000,000
($50,000 divided by .05 = $1,000,000). That $1,000,000 would provide
$50,000 to spend each year without touching her principle.
The investment return is used will make a big difference in the
calculation. For instance, if she assumed a 7% return she'd only
need $714,000.
What Rate Should Anita Pick?
Anita should probably pick something between CD's on the low
end and the long-term stock returns (8 to 10%) on the high end.
It is best to overestimate your needs a little. Yes, you'll be
buying and paying for a little more life
insurance than you need, but if you underestimate, you won't
realize your mistake until it's too late.
Consider “Salary” of a Stay-at-home Spouse
If a stay-at-home spouse dies the target is a little harder to
figure. Unless there's someone like a grandparent who could move
in and take over, the survivor will need to pay to have things
done, and that can get expensive. Add up laundry, cleaning, cooking,
day care and a hundred other chores and you have an idea of what
the at-home spouse's "salary" might be, then calculate like you
did for the employed spouse.
Insure to Cover Your Expenses
Another way to look at the problem is to have enough insurance
to cover your expenses. The calculation is the same, just use
expenses instead of income in your calculation. Insurance companies
will often encourage you to buy enough insurance to pay off your
mortgage or other debts. That's nice, but it's not really necessary.
When you consider how much money you will need, be sure to take
inflation into account. Even a modest 3% inflation rate will cut
the amount your income will buy in half every 24 years. If you
lose a spouse in your 30's your dollar will lose half its value
before you retire.
Consider If Both Parents Go
Anita should also consider what would happen if both parents
die while the children are small. Hopefully they have someone
who's agreed to raise their children. The question then becomes,
how much is needed to allow the children's guardians to house
the children (such as: bedroom addition or a bigger home) plus
the extra expense of feeding, clothing and schooling the children.
Getting some life insurance quotes
now may save financial problems in the future.
One Final Thought
Anita will also want to make sure that the insurance policy is
set up properly. Choosing the correct owner and beneficiary can
have important consequences.
Gary Foreman is a former purchasing manager who currently
edits The Dollar Stretcher Web site -http://www.stretcher.com.
You can find more Life
Insurance Information here
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