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Life insurance can be a valuable financial tool for many individuals, whether you want to protect your growing family or provide for a beloved charity. However, choosing the appropriate amount of life insurance coverage for your needs can be challenging. There are many important things to consider, like your current income and assets, the number of financial dependents you have and your family’s current lifestyle. Before choosing life insurance coverage limits, here are a few things to keep in mind, and a few calculations to help you arrive at a number. It’s usually a good idea to consult with a certified financial planner before purchasing a policy to ensure that you are purchasing the right policy to meet your financial goals.

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What is life insurance?

Life insurance provides a financial payout to one or more beneficiaries of your choosing in the event of your death. Depending on the type of policy, life insurance will cover end of life expenses — such as a funeral or outstanding debts — or will provide compensation to sustain dependents’ quality of life or future financial needs. In effect, life insurance provides a degree of guarantee that your beneficiaries’ financial needs will be covered (up to the policy limit, or death benefit) in the event that you pass away.

Who needs life insurance?

Most people can benefit from a life insurance policy, depending on their situation and financial obligations. If you have dependents who rely on you financially, such as kids, a disabled parent or sibling, a spouse or anyone else, you could be a good candidate for some form of life insurance coverage. Even if you do not have any financial dependents at this time, life insurance could still be a good option, and buying a policy while you are still young and healthy can help you lock in a lower rate.

How much life insurance do I need?

The answer to the question of, how much life insurance does a person need depends on several factors, including:

  • Your age
  • The ages of your spouse and children
  • Your income
  • Your mortgage and other debts
  • College expenses for your children and/or spouse
  • The bill for final expenses

Your circumstances can vary the amount of insurance you need in a policy, but recommendations from experts also advise thinking about what is most practical for your immediate and future situation.

“You want them to get through this traumatic event with some palatable options, but that’s it,” says Glenn Daily, a fee-only insurance adviser based in New York City. “One famous agent once said the goal of life insurance is to let your family ‘stay in their own world.’ It doesn’t necessarily mean they have to maintain their current lifestyle. Maybe your spouse would decide to do something entirely different.”

There are several ways to figure out how much life insurance you should purchase. You might choose to speak with a certified financial planner who can assess your financial situation and make a recommendation based on your family’s potential needs. You can also use a free online coverage calculator to give you a general idea of how much coverage is necessary for you.

Another option is to use one of the popular models devised by insurance companies and financial experts. Here are three common approaches that might help you pick a life insurance coverage limit:

1. The DIME Formula (and 10 Rule)

The old “how much life insurance do I need rule of thumb” was to take your income and multiply it by 10. This was the industry’s standard for many years. However, this fails to account for several things.

Most notably, it does not take into account your family’s living expenses. This could vary wildly if you have one child or four. Moreover, it does not account for single-income families.

As grim as it sounds, it’s important to ask yourself what would happen if you and your partner both die and only one has coverage? The 10 Rule left many questions unanswered. In its place came the Dime Formula, which takes into account the following:

  • Debt and final expenses: Come up with a solid number based on all the debts you owe, and include the costs of final expenses for each parent.
  • Income: For income, a good rule of thumb is to think about how many years your family would need income in your absence. Multiply the number of years by your annual income.
  • Mortgage: Include the total amount owed on your mortgage and the property taxes assessed. Similar to income, think about how many years your family would need the money to cover property taxes then multiply your annual tax total by those years.
  • Education: Determine the total cost of educating each of your children through high school as well as college.

Once you come up with that final number, you might want to consider doubling that for both parents. That way, if something were to happen to both you and your partner, your children and other financially-dependent family members would have sustainable income well into the future.

2. Shortfall calculation

The shortfall approach works backward from the annual income you would want to leave your spouse and family for X number of years. After you decide on this target number, subtract all other sources of annual income that will be available to them, such as your retirement accounts, pension, savings, your spouse’s salary and Social Security. The resulting number is the shortfall you’ll want to replace with life insurance.

“People overlook that they’ll likely have other assets,” says insurance literacy advocate Tony Steuer, author of “Questions and Answers on Life Insurance.” “Right now, you may be just starting to save for retirement, but by the time you actually retire, you’ll have $500,000 or $1 million in your retirement plan, so you may no longer need that $500,000 life insurance policy.”

3. Income generator

Some prefer to set their sights on building up a large life insurance investment that would generate earnings to provide a beneficiary with annual income. For instance, $1 million invested using a conservative average annual yield of 4 percent could provide $40,000 a year to a spouse or family in perpetuity.

“While the need for life insurance is temporary for most dependents, there are exceptions, such as a special-needs child who will never be self-supporting, where the need lasts the rest of their life,” says Steuer, who also is the director of financial preparedness for the insurance consumer group United Policyholders.

Daily says that while no single model fits all families, everyone can benefit from test-driving one or more.

“The good thing about looking at the future and not just the present is that you’re going to get some idea of whether your insurance needs go up, down, or remain about the same,” he says. “That’s going to have some relevance for what type or combination of insurance you should buy.”

Factors to consider when buying life insurance

You may be asking yourself, “how much life insurance should I have?” Consider these factors:

  • Your age: Life insurance premiums generally increase with age. If you’re young, getting a term life insurance policy (which provides coverage over a certain number of years) is generally considered the most cost-effective way to provide financial protection for your family.
  • Age of spouse and children: This helps you estimate how many years of income replacement financial dependents would need if you passed away.
  • Mortgage and debts: When choosing a life insurance coverage limit, make sure to account for your home mortgage, car loans, student loans and other debts into your decision. Most debt does not disappear when you pass away, so your family members would likely become responsible for making the payments.
  • College expenses: Factor in future education expenses for the kids and possibly your spouse. Tuition and fees for four-year colleges have been increasing by up to 5.2 percent, on average.
  • Your current income: If you have no outstanding debt, no major future expenses (like college tuition) and have a healthy savings account, you may not need to replace your full income. Some advisers recommend a 50% replacement as a starting point.
  • Funeral expenses: The average cost for a funeral, burial and related expenses run more than $7,000, while the average cremation cost ranges from $2,000 to $4,000. It’s a good idea to purchase enough life insurance to cover those end-of-life costs, otherwise, it could create financial stress during an already difficult time for your loved ones.

Sources: Etti Baranoff, Glenn Daily, Tony Steuer

Learn more: Average cost of life insurance

Choosing your life insurance policy

Once you arrive at a ballpark coverage figure, it’s important to decide what type of life insurance is best for your needs. The two main types of life insurance are term life insurance and permanent life insurance, which comes in several different forms, like whole life insurance and universal life insurance.

Term life insurance and permanent life insurance differ in a few ways. First, term life insurance offers protection limited to a certain amount of time, usually between 10 and 30 years, although shorter and longer term lengths can be found from some insurers. Permanent life insurance, on the other hand, offers lifetime protection under most circumstances, as long as you continue paying the premium.

In addition, term life insurance is usually the cheapest option while you are young and healthy. However, the premiums get more expensive with age. Permanent life insurance may have more expensive premiums, but it provides the added benefit of cash value. With each premium payment, your cash value grows in a savings account, and once you hit a minimum threshold you can withdraw or borrow the money at any time, and for any purpose.

So, which policy is right for you? Steuer suggests letting your individual circumstances dictate whether to use a cash-value whole life (permanent) policy, term life or a combination.

“One tactic I recommend is to separate the planning for your spouse from the planning for your children, because the timeline for needing coverage may differ,” he says. “If you have a 15-year-old child, then you really only need a 10-year term policy to see the child through college. But if you’re 45 and plan to work for another 20 years, your non-working spouse is going to need a 20-year life insurance policy, at least.”

When choosing a type of life insurance, however, it’s important to understand what you can realistically expect from your policy. All three experts caution against falling for the siren song of cash-value life insurance products that promise big investment returns that you might tap into while you’re still on this side of the lawn.

“That’s one of the main reasons people overbuy,” says Steuer. “You want to strip out all the distractions and address your actual needs. Don’t expect something from your life insurance that you wouldn’t expect from your other insurance policies.”

Baranoff puts it even more succinctly: “Life insurance is for widows and orphans.”

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