Jasper is the sole breadwinner in his family. His wife Stephanie has chosen to dedicate all of her time to raising their 3 young children. Luckily…

The income replacement approach calculates the capital required to generate an income stream that replaces the deceased's earnings for their dependents. The goal is to replace Jasper's after-tax income of $300,000 annually ($25,000 x 12). However, the investment income generated from the life insurance proceeds is taxable to the beneficiary, Stephanie. Therefore, the capital sum must be large enough to generate a pre-tax income that, after taxes, equals the required $300,000. First, calculate the required pre-tax income: Required Pre-Tax Income = After-Tax Income / (1 - Tax Rate) = $300,000 / (1 - 0.40) = $500,000 Next, calculate the capital needed to generate this pre-tax income: Capital Needed = Required Pre-Tax Income / Investment Return = $500,000 / 0.04 = $12,500,000

A. $625,000 is incorrect because it capitalizes the monthly after-tax income ($25,000 / 0.04) instead of the required annual income.
B. $1,041,666 is incorrect as it capitalizes the monthly gross income, not the required annual gross income.
C. $7,500,000 is incorrect because it fails to account for the taxes Stephanie will pay on the investment income. It simply capitalizes the net annual income ($300,000 / 0.04).

1. IFSE Institute, Life Insurance (LLQP) Course, Module 4: Needs Analysis, Chapter on "Calculating the Amount of Insurance". The official curriculum specifies that when using income-based needs analysis, the calculation must account for the tax liability of the beneficiary on the income generated from the invested capital. This requires "grossing up" the target net income to a pre-tax figure before capitalizing it.

2. Kaplan Financial Education, LLQP Insurance Course Textbook, Life Insurance Module, Section 4.2 "Needs Analysis Approaches". This text details the income replacement method, emphasizing the importance of adjusting for factors like inflation and taxes on investment income to determine the true capital sum required to provide the desired net income to survivors. The calculation shown for Jasper correctly follows this principle.