For most people, deciding how much life insurance to buy is difficult. Calculating the need for lump sum (single payment) insurance that protects against a loss of annual income can be hard to assess.

A common rule of thumb is that you should have life insurance equal to ten times your gross income - enough to take care of your family for several years and/or to raise your children. However, this is a very rough estimate and doesn't consider factors like the number of children you have. Depending on who you ask, estimates will vary from five to thirty times your gross income.

For professionals, it is more common to estimate using one of two methods of "needs analysis": income-based needs or expense-based needs (the latter of which is considered the most accurate). The details of how each of these is calculated vary widely, but the basic principles are agreed upon.

You are working in your first post-college job, earning $30000 per year. You are in a 25% tax bracket (so your after-tax salary is 75% of your salary).

You've married and have just had your first child, which your spouse is currently staying home to take care of.

You've decided to buy a house, which has landed you $180000 into debt.

Your spouse has $2700 in credit card debt.

You figure that about $10000 of total expenses are directly yours, so that amount of money won't needed each year if you die.

You've searched the internet and estimate the total typical costs of raising a child at $10,000 per year up to age 18.

You want to contribute $20000 total towards your child's education.

The internet has also informed you that an average funeral costs $6000, though related costs typically increase that to $10000.

You might not have realized it, but you are 21 years old and plan on retiring at age 61.

Ignore inflation, assume investments return 2%, and assume that you would want the money available for your family starting tomorrow.

Rule of Thumb Method

1.By the "ten times your income" rule of thumb discussed above, you need $_________________ of life insurance.

Income-Based Method

The income-based method says that you should have enough money to replace your income, less any of your own personal expenses, taxes, etc., so that your family's lifestyle is unaffected. Typically, this is estimated as 60% to 90% of your current income. For this lab, you can use 75% of your pre-tax income.

To simplify the life expectancy question, the income-based method often assumes that you just want this amount paid in perpetuity out of the insurance proceeds. Assuming a rate of return of 2%, the amount of insurance you need is then:

insurance = income to replace 0.02

Note: this is just the standard perpetuity formula... PV = PMT I/Y

2.By the income-based method, you need $___________________ of life insurance.

Expense-Based Method

In the expense-based method, a more detailed list of the actual needs after death is totaled to determine the insurance needed. Use the following steps to complete the calculation:

3.Fixed needs$_________________

Add up all of the following one-time things:

debts that should be paid off (all of them)

emergency needs (assumed to be a half-year of after-tax salary)

education needs (just the total cost)

final expense needs (cost of the funeral, estate lawyer, final taxes, etc.)

4.Dependent income needs$_________________

First, consider how much income per year the family will need without you: subtract your own personal expenses from your after-tax income.

Then,take the present value of that, for as many years as they need support (consider this to be from now until retirement - how long the income would have been earned had you survived).

Total life insurance needs: $_________________

Add up steps 3 and 4 to find the amount of insurance needed for the expense-based method.