When you buy life insurance, you enter into a contract with an insurance company that promises to provide your beneficiaries with a certain amount of money upon your death. In return, you make periodic payments, called premiums. The premium amount is based on factors such as your age, gender, medical history, and the dollar amount of life insurance you purchase.
In the event of your passing, life insurance provides money directly to your beneficiaries. They can use the money for:
- Making up for your lost income
- Funding a child’s education
- Paying off household debt
- Paying for your funeral and other related expenses
Certain may provide benefits for you and your family while you’re still living. For example, permanent life insurance offers a cash value component, which can be put to good use during your lifetime.
Types of Life Insurance
There are two main categories of life insurance.
Term life insurance offers protection for your loved ones for a specified period of time—usually from one to 20 years. If you stop paying premiums, the insurance stops. Term policies pay benefits if you die during the period covered by the policy; but they do not build cash value.
Permanent life insurance policies do not expire; they are intended to protect your loved ones permanently, as long as you pay your premiums. Some types of these policies accumulate cash value.
How Much Life Insurance Do I Need?
Your goal should be to develop a life insurance plan (through one or more policies) that, following your death, compensates for the loss of your economic contribution. Here are two ways to determine how much life insurance you may need.
Calculate replacement income need. This is a well-established method to determining the financial contribution you can expect to make to your family from now until you would retire. It’s more than just replacing your income; it takes into account everything you provide for your family, including:
- Benefits/health insurance
- 401(k) and retirement savings
- Personal services you perform for your family, such as child care, cooking, home maintenance, etc.
- Less, your personal consumption—annual spending on personal needs, such as food, clothing, entertainment, etc.
This chart represents the amount of money you would need to receive today in order to replace a lifetime of earned income.
Survivor needs analysis. This approach is based on replacing an amount of income needed for your surviving spouse and children to maintain a desired level of income and lifestyle. Your survivors’ needs are then compared to their assets, existing life insurance and income sources to determine any additional life insurance requirements. An insurance professional or financial advisor can help you determine an accurate figure and choose appropriate coverage.