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How Life Insurance Works

How much life insurance do I need?
Life insurance can help pay for your childrens' college education if you should die early.
Life insurance can help pay for your childrens' college education if you should die early.
James Woodson/Digital Vision/Getty Images

Life insurance is just one part of a larger financial plan. How much life insurance you buy depends on the specific financial needs and circumstances of your family. How many kids do you have? Do you plan on paying for their college education? How big is your mortgage? What other debts do you have?

The trick is to strike a balance between being over-insured and under-insured. Paying too much in premiums can be just as damaging to your overall financial plan as paying too little [source: California Department of Insurance].

The easiest way to think about life insurance is as income replacement. The first step is to figure out exactly how much income you provide to your family. This is not simply your salary. You have to subtract income tax and the amount of money that you spend on personal expenses like clothing, food, travel, memberships, etc. What's left is the real amount of money that you contribute to the family.

The next step is to figure out how long you're going to need to replace your income. As a general rule, you only need life insurance until your dependent children are out of the house or until your retirement savings kick in. So if you're 30 years old, you might want a policy that covers you for the next 30 years. Take your adjusted annual income and multiply it by 30 years. That's the amount of coverage you need. This amount is also called the face value or death benefit of a life insurance policy.

But remember that the amount of life insurance you buy needs to fit within your budget. There's no point in buying a policy with a high face value if you can't afford the premium payments. At some point, you'll default on your payments and the policy will be canceled.

If you can afford to pay a higher premium, though, you should think about purchasing a plan that will cover major life expenses like paying for your kids' college education and covering the mortgage. Then there are other possible expenses, like taking care of aging parents or childcare costs if you're the primary caregiver for the children.

If you start adding it all up, it may seem like a lot of money. But once again, you need to strike a balance. If your life insurance premiums prevent you from paying back high interest debt like credit cards, then you're paying too much. For most people, the idea of life insurance isn't to set up your family for life, but to help them get through the first five to 10 years after your tragic loss. That's why some experts fall back on the old life insurance rule of thumb: Buy enough to replace your salary for five to seven years.

So where should you buy life insurance anyway? From a pushy door-to-door insurance salesperson? And how do you avoid paying for something you really don't need? Read our life insurance shopping tips in the next section. ­