What is life insurance?

Life insurance is an agreement between you and an insurance company that the company will pay your beneficiaries a tax-free benefit if you die within the conditions of the policy. It can serve as financial protection for your loved ones who would lose your income in the event of your death.

There are two main types of life insurance: term and permanent. Term life insurance offers coverage for a set period of time. If you pass away during the term that your policy is still in place, your beneficiaries receive a benefits payout. Permanent life insurance offers coverage for your entire life, as long as you continue to pay your premiums on time. When you pass away, your beneficiaries receive a payout on the policy. Permanent life insurance policies offer a component that can accrue cash value, which accumulates on a tax-deferred basis.

Calculate your coverage needs:

As a general rule, you can calculate how much life insurance you need by adding your income (times the amount of years you want to be protected) + your current debts + your future financial commitments (like college costs for your kids and your final expenses) minus your liquid assets (like your savings and current life insurance coverage).

Let's look at an example of how this could work:

John currently makes $50,000 a year and wants coverage for at least the next 18 years, when his youngest child should be done with college. He currently owns a home and he has $130,000 left on his mortgage. He wants to leave at least $10,000 for his own funeral and at least $20,000 to help pay for his children's college. He also has $15,000 in savings and $100,000 in life insurance from his current employer.

To play it safe (many financial professionals will recommend getting slightly more life insurance than you think you need), John could round up and look for a 20-year, $1,000,000 policy.