A Viewer asks: How much life insurance should a couple with two small children have? Anita H.

While none of us like to think about it, Anita is wise to be concerned with life insurance. Should either or both parents die, insurance could be vital to her children's well-being.

There are two basic methods Anita can use to decide how much insurance she needs.

• To replace the income of the deceased.
• To buy enough insurance to cover your expenses.

Your choice will depend on your present financial situation. If you struggle to pay your bills look at the expense method. Otherwise replacing the lost income should be sufficient. There are calculators that will do the number crunching for you. Unless you understand the process, it's hard to know whether they're giving you a good answer.

Anita doesn't need a perfect answer…to get that would require seeing into the future. She would need to know her longevity, investment return and future inflation rates. She can only estimate those things, so just try to get reasonably close.

Life Insurance Replacement to Income
First we'll look at using life insurance to replace income. We'll assume a family where only one parent works. That way we can do one illustration when you lose a spouse who draws a paycheck, and another illustration for the person who works inside the home.

In most cases you'll want to plan to replace all of the income that's lost when an employed spouse dies. To be more precise, you'll only want to include the after tax pay and make adjustments for expenses (like a second car) that are incurred earning that income. Don't forget to add the value of health insurance or other employee benefits to the income number.

Anita now has an amount of income that she needs to replace each year. But life insurance is often paid off in a lump sum. We're going to assume that she'd invest the life insurance proceeds and spend the income that it generates.

How-to Calculate Annual Income
How may Anita calculate the lump sum she'll need to create a specific annual income? The calculation is simple division. Take the amount of annual income you want and divide it by the investment return you'd expect to earn on the lump sum (i.e. life insurance proceeds).

For instance, if Anita needed $50,000 a year and thought that she could earn 5% on the money, she'd need a lump sum of $1,000,000 ($50,000 divided by .05 = $1,000,000). That $1,000,000 would provide $50,000 to spend each year without touching her principle.

The investment return is used will make a big difference in the calculation. For instance, if she assumed a 7% return she'd only need $714,000.

What Rate Should Anita Pick?
Anita should probably pick something between CD's on the low end and the long-term stock returns (8 to 10%) on the high end.

It is best to overestimate your needs a little. Yes, you'll be buying and paying for a little more insurance than you need, but if you underestimate, you won't realize your mistake until it's too late.

Consider “Salary” of a Stay-at-home Spouse
If a stay-at-home spouse dies the target is a little harder to figure. Unless there's someone like a grandparent who could move in and take over, the survivor will need to pay to have things done, and that can get expensive. Add up laundry, cleaning, cooking, day care and a hundred other chores and you have an idea of what the at-home spouse's "salary" might be, then calculate like you did for the employed spouse.

Insure to Cover Your Expenses
Another way to look at the problem is to have enough insurance to cover your expenses. The calculation is the same, just use expenses instead of income in your calculation. Insurance companies will often encourage you to buy enough insurance to pay off your mortgage or other debts. That's nice, but it's not really necessary.

When you consider how much money you will need, be sure to take inflation into account. Even a modest 3% inflation rate will cut the amount your income will buy in half every 24 years. If you lose a spouse in your 30's your dollar will lose half its value before you retire.

Consider If Both Parents Go
Anita should also consider what would happen if both parents die while the children are small. Hopefully they have someone who's agreed to raise their children. The question then becomes, how much is needed to allow the children's guardians to house the children (such as: bedroom addition or a bigger home) plus the extra expense of feeding, clothing and schooling the children.

One Final Thought
Anita will also want to make sure that the insurance policy is set up properly. Choosing the correct owner and beneficiary can have important consequences.