How to Figure Out How Much Life Insurance You Need to Buy

Life insurance is a necessary expense if your family -- or someone you care -- depends on you financially. Although the reason we need life insurance is something no one likes to think about, but an insurance policy can be invaluable in protecting the financial security for your family despite your absence.

However, for many families, the urgency of keeping balance with everyday expenses pushes one solid tool for doing that -- buying life insurance -- to the bottom of the to-do list. To avoid doing so, the solution is to purchase only the policy you need at the cheapest available price.

Factors you need to consider when buying your life insurance are:

• Your age - as the risk of death increases with age, premium rates are higher the older you are. If you're young and want to get a policy, choosing term life insurance would be a cost-effective approach to cover your risk and have your future options open.
• Age of spouse and children - this will help you determine how much income replacement your dependents will need to maintain their standard of living if you die prematurely.
• Mortgage and other debts - your financial portfolio should be well balanced and need-based. If you have any existing loans, mortgages, or other debts, wrap those into your life insurance planning.
• Education expenses - estimate future education costs for the dependents. This calculation can be tricky because you need to consider the tuition and fees of college at the time your dependents enroll. Costs for four-year colleges have been rising by up to 5.2% a year.
• Funeral expenses - on average, a funeral, burial and related expenses tend to cost between $9,000 and $15,000. Don't stick your loved ones with the final bill. Use $12,000 as a ballpark number.
• Income replacement - once you cover debts, college funds, and funeral expenses, your dependents might not need to replace 100% of your income. Many insurance advisers therefore recommend 50% replacement of current pretax earnings as a starting point.
• Income uncertainty - since life by its very nature is all about change, it would be wise to estimate what it would cost to keep your family running if your annual income suddenly drop. Consider whether you can decrease the expanse of insurance you need, or even exclude it completely.

[Read: How to Choose the Right Health Insurance Plan for You]

Life Insurance Rules of Thumb

When it comes to getting a life insurance, there are some broad rules of thumb to help you estimate how much you need. However, the key is buying the right policy for your dependents -- not some generic unit.

To address customer's concern, financial planners and insurers have developed methods to help you zero in on this perpetually moving target. While rule of thumb can suggest a good starting point for further analysis, they shouldn't be followed blindly. Here are three common approaches that most insurance advisers use.

1. Multiple of income: Many financial advisers recommend that you should buy life insurance policy -- for the death benefit or payout amount -- equal to five to seven times your annual income.
   
   "So if you're earning $70,000 annually, anywhere between $350,000 and $449,000 would be the standard life insurance amount to allow your family members to pay the bills and live their lives as planned despite your absence," says Lisa Harrison, an executive general manager of customer division at Suncorp Life, Australia.


2. Income generator: Some customers prefer to build up a large life insurance investment that would generate income to give a beneficiary with annual returns.
   
   For instance, if you leave your dependent $1 million of life insurance using a conservative average annual yield of 4%, that could produces about $40,000 of annual income for the rest of your loved one's life.


3. Shortfall calculation: This approach runs backward from the yearly earnings you would like to leave your financial dependents for X number of years. Decide your target amount.
   
   You then need to subtract all other sources of yearly earnings that will be available to your dependents, including your pension, savings, retirement accounts, and Social Security. The outcome of the calculation is the shortfall that you'll like to replace with life insurance.

Online Tools to Calculate Your Life Insurance Cost

Some online tools that can help you get more customized answers are (useful for residence of United States only):

• Bankrate.com | life insurance calculator - This tool may help you determine your life insurance expenses depending on several factors, including your age, the ages of your dependents, education expenses for your children and/or spouse, your mortgage and other debts, your funeral expenses, and your income.
• MassMutual.com | lifetime economic value tool - this tool measures all of the financial investments you'll contribute to your family -- or dependents -- over the course of your career. Using a simple algorithm -- requiring only your current age and annual income -- it generates a broad life insurance estimate.
• LifeHappens.org | life insurance calculator - This tool estimates your needs in a similar manner like the Bankrate's tool. It measures all the important factors against your current investments, savings, and retirement funds to estimate the expense.

[Read: Health Insurance Plan Options – Managed Care vs. Fee-for-Service Plans]