Determining How Much Life Insurance You Need

When considering life insurance, you’re planning and preparing for an event most of us would rather not think about. But life insurance represents a critical step in managing your personal finances and ensuring your family’s well-being.

The Two Approaches to Life Insurance

You can use one of two approaches to estimate how much life insurance you should buy: the needs approach or the replacement-income approach.

Using the needs approach, you calculate the amount of life insurance necessary to cover your family’s financial needs if you die.

Using the replacement-income approach, you calculate the amount of life insurance you need to equal the income your family will lose.

The Needs Approach

Using the needs approach, you add up the amounts that represent all the needs your family will have after your death, including funeral and burial costs, uninsured medical expenses, and estate taxes.

However, your family depends on you to pay for other needs, such as your child’s college tuition, business or personal debts, and food and housing expenses over time. Because it’s different to remember and correctly tally everything, the needs approach is somewhat limiting. The task of identifying and tallying family needs is difficult, and separating the true needs of your family from what you want for them is often impossible.

The Replacement-Income Approach

Using the replacement-income approach for estimating life insurance requirements, you calculate the life insurance proceeds that would replace your earnings over a specified number of years after your death.

Life insurance companies sometimes approximate your replacement income at four or five times your annual income. A more precise estimation considers the actual amount your family members need annually, the number of years for which they will need this amount, and the interest rate your family will earn on the life insurance proceeds, as well as inflation over the years during which your family draws on the life insurance proceeds.

Using the Quicken Savings Calculator to Estimate Life Insurance Needs

If you’re a Quicken user, you can use the Quicken Savings Calculator to calculate what life insurance you need to replace earnings over a specified number of years. You can then add to this figure any additional needs-based insurance.

The total insurance would be the amount calculated by Quicken as necessary to replace earnings plus the amount calculated by you as necessary to pay for any additional needs.

If you perform this analysis, be careful not to count items twice. For example, if you consider paying off your mortgage on the family home to be a final expense, your estimate of the annual living expenses should reflect this.

Similarly, if you include the costs of a spouse’s returning to and finishing law school as a prerequisite for supporting the family, reduce the number of years your family will need replacement income.

To use the Quicken Savings Calculator to estimate the life insurance necessary to replace earnings over a specified number of years, follow these steps:

1. Display the Investment Savings Calculator dialog box.
2. Click the Opening Savings Balance option button in the Calculate For section (in the lower-right corner of the dialog box).
3. In the Annual Yield text box in the Savings Information section (at the top of the dialog box), enter your estimate of the annual interest rate you expect your savings, investments, and life insurance proceeds to earn when they are invested. Because this money might need to provide basic living expenses for your family, you might want to assume that this money is invested in conservative, lower-risk investments, which means you should expect lower interest rates.
4. In the Number Of drop-down list box, select Months.
5. In the Number Of text box, enter the number of months you will use the life insurance proceeds and the interest earned on those proceeds to replace earnings of the insured. You might need replacement income only until a child completes an education or until your spouse returns to work.
6. In the Contribution Each Month text box, enter the monthly amount your family members will withdraw from the life insurance savings money at the end of each month to supplement their living expenses. For example, if you want your family to be able to withdraw $4,000 at the end of each month, enter -4,000. (You enter the amount as a negative number because your family will be withdrawing this amount from your savings, not adding it.)

Note: If you have children and pay social security taxes, there’s a good chance that social security survivors’ benefits will provide several hundred dollars a month. Call your local social security office for more information.

1. Enter the Ending Savings Balance as 0.
2. In the Predicted Inflation text box, specify the annual inflation rate you expect over the years your income needs to be replaced.
3. Mark the Inflate Contributions checkbox to tell the Investment Savings Calculator that you want the monthly amounts withdrawn from the life insurance savings money to grow each month by the monthly inflation rate.
4. Make sure that the Ending Balance in Today’s $ checkbox is marked.

As you enter the values, Quicken calculates an opening savings balance, which equals the amount of life insurance needed to produce enough money to support or supplement the support of your family over the number of months you specified.

The assumption is that your family will place the life insurance in a savings account or an investment that will produce the annual return you forecasted and, at the end of each month, withdraw a monthly amount to replace your income.

To see a schedule that shows the monthly withdrawals and the end-of-month life insurance proceeds balance, click the Schedule command button. Quicken displays the Deposit Schedule dialog box. The Number column identifies the months. The Deposit column actually shows the withdrawals. (This is confusing, but remember, you’re using the Investment Savings Calculator to do something the folks at Intuit never intended.) The Total column shows the balance after the monthly withdrawal. And note that the monthly withdrawal amounts increase every month by the monthly inflation rate. Allowing for increasing withdrawal amounts is important if you want to replace earnings over a long period of time.

If you use the approach described here to plan life insurance needs, remember that you must add any additional special needs (such as final expenses or extraordinary debts) to the opening savings balance amount in order to come up with a life insurance amount that both replaces earnings and provides for special needs.

If you have more questions or would like us to consult with you in-depth about estimating your life insurance needs, visit our contact page.