Budget Rates Life Insurance
There is a simple way, a complicated way and a really simple way to calculate how much life insurance you need to protect your loved ones from the loss of your income. Before we get to that, let's consider some basics. If someone is depending on you to support them, what happens if you die? What will replace the income they have been counting on to buy food and shelter? Either you have investment funds set aside for them to use until they can be self-supporting, or you buy life insurance to fill that need.
So, how much life insurance do you need? It depends on your situation. If you have a young family, you will need to provide for them until they are able to do so themselves... either after high school or college. So you might need to provide an income stream for 20 years. What if your children are on their own, and you and your wife are just starting to plan for retirement? If your wife is counting on your income, as well as hers, to fund a retirement plan, you will need to provide income until retirement age. That might be 10, 20 or 30 years.
Now that you know how long you need to provide income, how much annual income do you need to provide? You should consider after-tax income because life insurance proceeds are not taxable. So, if your beneficiaries are counting on, say, $60,000 per year, maybe your after-tax income is $45,000.
So, let's do the simple way first. You need $45,000 per year for, say, 20 years. That comes to a lump sum of $900,000. That's the easy answer.
So what is the complicated answer? Well, you first must consider that the $900,000 would not just be put into an interest-free account. Rather, your beneficiaries would put it into a safe investment vehicle. Let's say the investment would pay 5% interest annually. So, you would actually need less than $900,000 to fund this plan. On the other hand, $45,000 10 years from now is not the same as $45,000 now. It will buy a lot less due to inflation. So, you would need a bigger lump sum to fund this.
So, your needs shrink due to the interest rate at which funds can be invested, and your needs grow at the rate of inflation. The difference between the interest rate and the inflation rate is the net amount by which your needs will shrink from the simple answer of $900,000. If the interest rate and the inflation rate are the same, then the simple answer is also the complicated answer.
That brings us to the really simple way to find out how much life insurance you need to protect your loved ones from the loss of your income. Just use the calculator below. You will see that if you put in equal numbers for inflation and interest, the complicated answer, the easy answer and the really easy answer are all $900,000!