How much life insurance do I need?

Standard formulas -- such as buying coverage equal to eight to ten times your annual income -- are inadequate shortcuts. Online calculators are apt to tell you to raise your coverage by $1 million even if you already have insurance. The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but it’s silly to say that someone with four young children should have the same coverage as empty nesters with no mortgage and a substantial retirement fund.

A simple strategy. The purpose of life insurance is to allow your family members to pay the bills and live their lives as planned despite your absence. That’s why some experts and most online calculators sponsored by the insurance industry seek to figure the chunk of investment capital it would take to replace all of your income for 20 years or longer.  Instead, you can use a simple strategy to calculate how much coverage to buy and to form a plan that’s easy to update. The idea is to assess whether you need extra coverage or different policies only after you project your life-insurance needs as the sum of four categories.

Final expenses. A funeral, burial and related expenses tend to cost $10,000 to $20,000. Your beneficiaries may be able to get the tax-free proceeds from insurance faster than if they waited for money from your estate. Use $15,000 as a ballpark number.

Mortgages and other debts. Total your mortgage balance, car loans, student loans and any other debts that would be a heavy burden on your survivors. They may choose not to retire the mortgage, especially if the interest rate is low, but the money should be available so that they won’t face the prospect of being forced to sell.

Education expenses. This calculation can be tricky because you need to consider the cost of college at the time your kids enroll. But Maurer devised a simple solution. College costs have been rising by about 5% a year, which is the same rate he conservatively expects life-insurance proceeds to grow over time. He recommends looking up current costs for colleges you’re considering, deciding whether you want the insurance to cover all or a portion of the tab, and adding the amount in today’s dollars to your life-insurance calculation.

Income replacement. Once you cover funeral expenses, debts and education, your family won’t need to replace 100% of your income -- and that’s where the art part of the calculation comes in. Maurer recommends covering 50% of current pretax earnings until retirement. You can translate this into a target lump-sum benefit by dividing it by 0.05. For example, if you earn $100,000, divide $50,000 by 0.05, which works out to $1 million. That assumes the insurance benefits will earn 5% a year over the long haul, a conservative back-of-the-envelope figure.

Add all four categories to estimate how much life insurance is appropriate, then tweak the number to reflect personal circumstances. You might increase it if you don’t have a pension, but you could decrease your coverage if your spouse earns a substantial salary. If you or a family member has a troublesome medical history, add $100,000 or even $250,000. If you’re the one with the medical condition, you’ll find it tough to buy additional coverage later at a price you can afford.

For most families, this exercise will work out to an amount in the high six-figures, possibly even $1 million or more. But don’t be frightened. With term insurance, boosting your death benefit by hundreds of thousands of dollars should cost just a few hundred dollars a year.

For example, a healthy 40-year-old male nonsmoker might be considering a 20-year, $500,000 term policy for $360 per year. But he could buy $850,000 of coverage for $576, or a $1-million policy for $645, says Byron Udell, owner of AccuQuote, which represents dozens of life insurers. Women pay less -- just $311 per year for $500,000 in coverage and $558 for $1 million.

The time factor.Also consider how many years you’ll need insurance. If you’re in fine physical shape, you can buy a new policy and lock in the price for 20 years. Because prices for term have been dropping steadily, you may not pay much more to extend your coverage if you reshop in, say, five years.

Some term policies come with the right to convert to permanent life insurance, which you can keep for the rest of your life regardless of health. Premiums will be higher than for term at the beginning, but they usually remain level indefinitely. The best reason to consider whole-life or universal-life insurance isn’t the accumulating cash value, although that’s part of the deal. The real issue is whether you’ll need coverage beyond 20 or 30 years -- or after age 65, when term gets expensive. You might want permanent insurance, for example, if you need to protect kids with special needs who will always rely on you (or your estate) for support, or if you want to leave money to a school, charity or your children and you don’t expect to afford it any other way.

You need more life insurance if you...

Tie the Knot.Your new spouse might depend on you even if he or she earns as much or more than you do.

Have a Child.It takes a lot of money to raise a child--and it doesn't get any cheaper if you're not around.

Buy Your Dream House.When you settle into your family's permanent home, guard against its loss in case tragedy strikes.

Are About to RetireNo more insurance from work. If you die, your spouse could lose pension and some Social Security income.

Term vs. permanent: Get the best of both

Term insurance is popular because almost everyone can afford plenty of it. Some young people buy the amount of permanent insurance that fits their budget, rather than the protection they need. That’s not smart.  The ideal approach utilizes a blend of term and permanent insurance.  Term to cover the remaining period of gainful employment, prior to retirement.  A permanent policy, such as Universal or Whole life can supplement coverage in the early years of the policy and build cash value that can be drawn against in retirement years to supplement income - tax free.