The income replacement approach is a great way to determine the amount of life insurance your family needs. It assumes that the major goal of life insurance is to replace the lost earnings of a family breadwinner. To do this calculation, you'll need to figure out the value of the income that breadwinner would have earned during his or her lifetime.
I'll walk you through it using a sample breadwinner named John, who is insuring himself to protect his wife and kids.
Here's how to do it:
- Start with your after-tax earnings You use after-tax ("net") rather than before-tax ("gross") earnings because they represent the amount actually available to spend on your family's needs.Example: If John Doe's gross salary is currently $60,000 and the federal and state combined income tax liability is 35 percent of that salary, his after-tax salary is $39,000.
- Subtract the income you spend on personal expenses You can take away the part of your earnings that pays for things like clothing, food, individual transportation expenses, and other expenses that would cease if you passed away. If you’re not sure how much to subtract, use 25 percent.Example: John earns $39,000 after tax. To subtract the percentage of income devoted to personal expenses, we multiply $39,000 by the average 75 percent family support ratio to get $29,250 for the after-tax amount actually devoted to family support.
- Add your employer's retirement plan contributions (optional) These contributions are an income source that will cease when the insured person (you) passes away. Although these contributions don't go directly toward your family's expenses, they can help with your spouse's retirement saving needs. It's up to you whether you want to include them.Example: Let's assume John participates in his employer's 401(k) plan. Under the plan, the employer matches his contributions at a rate of 50 percent. If John contributes 6 percent of income to the plan, or $3,600, then the employer contributes an additional 3 percent, or $1,800, to his retirement account. You should add this latter $1,800 amount to the after-tax salary figure of $39,000.
- Estimate how many years of income you need to replace The future earnings stream you want to protect reflects the income you'll earn over the number of years you expect to work.Example: John is 40 years old and anticipates retiring at age 65. His expected future economic life is 25 years. The lost income stream if he died today would be for 25 years.
- Take into account anticipated salary growth and inflation It's likely that your earnings will increase over time, due to inflation and raises or promotions. To account for inflation, use the average rate of 3 percent. If you also want to address anticipated raises, use the cross-industry average of 2 percent.Example: John chooses to calculate a standard rate of inflation (3%) and the standard rate of expected pay raises (2%). His combined total growth factor would be 5 percent (3% + 2%).
- Add all these together to get your total anticipated future income You should calculate your expected future income stream using the following figures:
- Current after-tax earnings (which you can multiply by the family support ratio)
- Number of years you expect to work
- Earnings growth factor (accounting for inflation and salary raises)
This income stream represents the future value of your earning power. It's a great way to start when shopping for life insurance - to make sure you never miss a moment.