From Insurance for Dummies by Jack Hungelmann

If you die early, exactly how much money will your loved ones need? How much will it take to pay off debt? How much to replace your income? Is providing funds to cover college costs for your children important, and if so, how much money will that take? How do you account for inflation?

Looking at a hypothetical family

So that you can get a better feel for evaluating how much coverage you need, look at a hypothetical family: Flip and Jennifer and their three children — Michael, age 11; Molly, age 10; and Flip Jr., age 7. Flip is a 38-year-old systems engineer earning $70,000 a year. Jennifer, age 37, is a high school math teacher earning $50,000 a year.

If either one of them dies prematurely, Flip and Jennifer’s goal is to have enough life insurance and other resources to enable the survivors to maintain the current status of living, to pay off all final expenses, and to pay for the cost of four years of college at the state university, currently costing $30,000 per student ($7,500 a year). If their children want to attend a more expensive school, they can either get a scholarship or pay the difference themselves.

Flip and Jennifer chose not to consider retirement because each of them has an excellent retirement plan at work.

Assessing liquid assets

Any stocks, bonds, or other liquid assets that Flip and Jennifer have can be used at death to meet financial obligations and reduce the amount of life insurance needed. Flip and Jennifer have $10,000 in cash, another $20,000 in liquid investments, $80,000 combined in 401( k) retirement accounts, and $75,000 in home equity.

I don’t recommend using retirement money to cover today’s needs, even in a situation as dire as the premature death of a spouse. The survivor will still need those funds at retirement. I also don’t usually recommend using home equity. Number one, it’s not very liquid, and number two, the surviving spouse will probably want to keep the house. If the couple have no life insurance, $30,000 is available for the survivors to live on — the current assets in cash and liquid investments. ( I have many clients who would prefer not to count the $30,000, keeping it instead for a family emergency fund — an excellent idea.) You never know what unexpected surprises lie ahead for your survivors. So it’s good in your planning to err a little on the high side of what you think they will need.

Deducting “free” life insurance

Flip and Jennifer each have, through their jobs, employer-paid life insurance equal to one times their salary. That counts against any life insurance needs. They also buy supplemental group life insurance at work, which is not used for the calculation because, in most cases, you can buy it for less in the open market. Most often, personally acquired life insurance is both cheaper and better than supplemental group term. Group insurance costs are greater than individual because the group often insures anyone regardless of medical problems or smoking status.

Using the multiple of income method

Financial experts typically recommend that you have at least enough lifeinsurance and liquid assets to equal a multiple of five times your annualincome, ignoring inflation, and seven to eight times your income factoring ininflation. If you have children, be safe and err on the side of too much. I recommendthat you use a multiple of 7.5, factoring in inflation. Why? Becauselife insurance is cheap — especially for young families, when the need for lifeinsurance is greatest.When buying life insurance, aim high. For the people you love who surviveyou, too much is far better than too little.