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Determining how much life insurance coverage you need is a four-step process:
Step 1: Determine Your Family's Short-Term Needs
Short-term needs are financial obligations and/or expenses arising within six months of death. Examples of short-term needs include expenses you pay now such as:
Loan balances (automobile loans, etc)
Outstanding credit balances (credit cards, revolving lines of credit, etc)
Mortgages (first and second mortgage, home-equity loans, lines of credit)
Add to these current expenses any death-related expenses that must be paid in the short term:
Funeral expenses
Final medical costs
Estate settlement costs and probate
Estate taxes due (if any)
Charitable contributions you would like to make upon your death
If you don't already have one, your survivors should be left with a liquid emergency fund sufficient to get them through any unexpected financial needs. Most advisors recommend between three and six months' worth of living expenses
Step 2: Determine Long-Term Needs
In addition to covering your survivors' short term needs, some level of monthly income will be needed to maintain their current standard of living and meet financial goals such as saving for retirement and funding college for children.
The value of these future obligations is discounted back to present value amounts to provide a dollar amount that, if invested, could provide an adequate income stream to fund all of your long-term goals.
Step 3: Calculate Your Total Available Resources
By this point, you should have a good idea of your family's total cash needs in the event of your untimely death. With any luck, you have already begun to set money aside to cover some of these costs. Other resources that may be available to your family include pensions, annuities, funds from retirement accounts, employer-provided or other personally-owned life insurance, and possibly Social Security.
The total value of these future resources is discounted back to present value amounts. This gives us a single dollar amount that we can use to offset your total needs.
Step 4: Provide Funds To Cover A Shortfall
In most cases, comparing total needs to total resources will result in a shortfall. That's where life insurance comes in. Without it, your survivors will be left with the choice of either finding or creating additional resources (such as having the surviving spouse return to work) or experience a decline in the quality of their lifestyle.
Life insurance is uniquely suited for covering such a shortfall. It is a means of sharing the financial risk of premature death with many, many others who have similar concerns.
You pay a relatively small premium to an insurance company in exchange for their promise to pay your beneficiaries a specified death benefit in the event of your death. You may find it ironic that a financial need arising from death can be alleviated by a financial resource that is created after death. That's why life insurance, although something no one hopes to ever need, is indeed for the living. It's also a vital issue we can help you investigate in greater detail to ensure your family's financial future will be protected.
1. "Life Insurance Awareness Month," LIMRA International, September, 2006
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