While most people know they should have life insurance, many do not understand exactly how it works or why it is necessary. Life insurance provides protection and financial resources for dependents if a wage earner dies, but there are other reasons to carry a policy. Some types of coverage can even provide a tax-shelter for a family’s retirement nest egg or money to meet immediate and future financial goals.
The definition of a life insurance policy is a legal contract that states the obligations of both the policyholder and the company. In the policy, the company agrees to pay a stated sum of money to the policyholder’s beneficiaries if the insured person dies within the term period. In return, the owner agrees to pay the company premiums. If the insured person is not the policyholder, the person who purchases the contract usually has to prove that they have a financial interest in the life of the insured when buying the policy.
Why Do I Need To Buy Life Insurance?
Simply put, if someone else depends on you financially, you may need life insurance. The money, or death benefit, your family receives will cover mortgage payments, daily living expenses, credit card and medical bills, tuition or education costs, outstanding student loans, etc. A life policy would mean that your family would not have to experience financial hardship, be burdened with debt, or have to sell assets to survive. Learn more about whether you need life insurance.
While life insurance is most commonly used to provide financial support for your spouse and dependents after you die, there are other reasons to have own a policy. Seniors often carry a small death benefit that will pay for medical bills and funeral expenses so their family is not left with a financial burden. Individuals who have debts that have been co-signed may carry insurance so their co-signers will not be left to pay their debts if they die prematurely. For example, a special kind of coverage called “mortgage insurance” can guarantee that a family will be able to remain in their home if a wage earner dies. Additionally, a small life insurance policy on someone in their 20s or 30s can help cover student loans that their parents co-signed for.
All policy types have a stated death benefit that is paid upon the death of the insured person and permanent life insurance also has a cash value which can be used during the person’s lifetime. Some contracts have riders that provide extra benefits, like double benefits for accidental death. The contract will state the amount of the premiums that the policyholder must pay periodically to keep the policy in force.
How Much Life Insurance Do I Need?
A death benefit essentially serves as income replacement and how much life insurance you need depends on your family’s existing financial obligations and sources of income. While retirees and senior citizens usually only need a small policy to cover final expenses, wage earners in their 20s, 30s, 40s, and 50s with families should carry between 5 and 15 times their annual salary to provide support for their dependents if they die prematurely. Work-at-home parents should carry life insurance to cover expenses such as childcare, housekeeping and essential services that they normally provide. Anyone with outstanding loans should carry enough insurance to pay off their liabilities, such as the mortgage, car, business, student and/or other personal loans.
In general, most financial planners and life insurance agents recommend the following breakdown:
- In your 20s, buy a death benefit 15 times your gross annual income.
- In your 30s, you need a death benefit 12 to 15 times your gross annual income.
- In your 40s, purchase coverage equal to 10 to 12 times your gross annual income.
- In your 50s, find life insurance protection between 7 and 10 times your gross annual income.
- In your 60s, you will need a death benefit in the amount of 5 to 7 times your gross annual income.
As you can see, these ranges are based on your age, but everyone’s needs are different. If you feel you have extenuating circumstances, then consider the following factors when determining how much life insurance you need.
- Total annual income your spouse and kids need to survive in the event of your untimely death.
- The number of years you want to provide this level of income.
- Your spouse’s current gross income.
- Existing financial liabilities and debts.
- Existing investments and assets, such as pensions, 401Ks, IRAs, annuities, etc.
- Final expenses, including funeral and burial costs, medical and legal bills.
- Interest rates or investment returns, assuming the death benefit will be invested.
- Total amount of current life insurance policies, possibly through an employer.
In the end, how much life insurance you need is really dependent on how much of a death benefit you want to leave your heirs. Under-insuring yourself could cause future hardships, while buying too much life insurance could result in bloated premiums that take away from your current lifestyle. Check out this guide on choosing a death benefit.
Different Types of Life Insurance
While all life insurance provides a death benefit to protect your beneficiaries, some policies also have a cash value feature that can be used during the insured person’s lifetime. There are two basic types of life insurance: term and permanent. Term life insurance is temporary and payouts the death benefit only if the insured person dies within the policy term period, which can be 1, 5, 10, 15, 20, 25 or 30 years. Whole, universal and variable life are permanent forms of life insurance and provide coverage throughout your lifetime, paying out the death benefit whenever you may die. Whole and universal life insurance can also be used as investment vehicles because they have a cash value that accrues over time by directing some of your premium dollars to the investment account.
What Is Term Life Insurance?
Term life insurance is temporary coverage and can be purchased for a term as short as 3 months or as long as 30 years. It is the cheapest form of life insurance since it only pays the death benefit if the insured person dies during the specified term period. The shorter the policy term, the lower the premiums will be. Term life insurance rates are fixed and the younger and healthier the insured person is when the policy is purchased, the cheaper the life insurance quotes will be.
Term life has more flexibility in coverage than permanent life policies because it offers temporary coverage for a predetermined period of time and is more affordable for families on a budget. Because term insurance expires, it is usually used to cover debts and obligations that will be paid off over time, such as mortgage payments or a business loan with a personal guarantee.
Furthermore, term policies are customizable to your needs. For instance, return of premium term life insurance is more expensive than traditional coverage, but will refund and return some or all of the premiums paid at the end of the term period if no death benefit is paid out. Term policies are also renewable after expiration, but do require that you re-apply and demonstrate insurability to qualify. Because life insurance is based on your risk of death, each renewal will result in an increase in rates.
What Is Permanent Life Insurance?
Permanent, or cash value, life insurance offers lifelong coverage as long as you continue to pay the premiums. All permanent life insurance policies provide a cash value feature that grows tax-deferred, but the cash value is different than the death benefit, or face value of the policy. The cash value builds by deferring a portion of your premiums, and depending on the type of coverage you buy, is invested in securities or grows at a fixed rate guaranteed by the insurance company. The life insurance cash value is the amount of money you are given if you cancel (surrender) the policy before you die, while the face amount (death benefit) is the amount your beneficiaries will be paid upon your death. Beneficiaries do not have rights to the cash value of the policy.
For families looking to save for retirement or build a nest egg for the future, the cash value feature offers flexibility and benefits to help you reach your goals. There are many ways you can utilize the investment portion of your insurance coverage:
- Policyholders can borrow from the insurance company while using the cash value as collateral. The loan doesn’t require the traditional approval and underwriting process banks have and thus allows you to borrow money even if you don’t have a good credit history. If you don’t repay the loan plus interest, the amount will simply be deducted from the death benefit paid to your beneficiaries upon your death.
- When your budget is tight for a month or two or you find yourself unemployed, the cash value can be used to pay your premiums or buy additional coverage.
- Using the cash value, the life insurance policy can be exchanged for an annuity.
- If you are ever financially strapped, you can surrender the policy and get paid out the cash value in a lump sum. However, the value above and beyond what you’ve paid in premiums would be taxed as income.
There are 3 main types of permanent life insurance: whole, universal and variable coverage.
Whole Life Insurance
Whole life insurance is the most common and traditional type of permanent coverage. Similar to all cash value contracts, the death benefit is guaranteed at some point when the policyholder dies. Whole life insurance rates are fixed and generally must be paid for the life of the policy, unless you opt to buy Single Payment or Limited Payment whole life. The insurance company cannot cancel the policy due to the insured person’s age or health and there is a savings feature (cash value) that guarantees a fixed rate of return. Whole life can be used as a tool in financial planning to save for future goals like retirement.
Universal Life Insurance
Universal life insurance, also known as Flexible Premium Adjustable Life Insurance, has flexible premiums with a minimum and maximum payment option, while giving you the option to change the death benefit within certain guidelines set forth in the contract. Universal life allows the policyholder to use money in the accrued cash value to pay premiums if the policyholder is unable to make the payments. With universal life insurance, the cash value can be invested in a number of securities, such as stocks, bonds, mutual funds, fixed-income investments, money markets, etc. The death benefit and cash value are linked to the performance of your investments, and the cash value is not guaranteed. If the cash value reaches zero due to investment failures or premium payments, the policy lapses, although some policies can guarantee a minimum death benefit.
Purchasing life insurance is a big decision and one that could potentially last for the rest of your life, or the majority of it. Evaluating the pros and cons of each type of insurance and determining whether term or permanent life insurance is right for you will guide you in the right direction.
Investing in permanent life insurance has tax advantages because the returns are tax-deferred until withdrawn from the policy. You can use up to 90% of the cash value as collateral for low interest loans with no repayment schedule. If the insured person dies before the loans are repaid, the balance is deducted from the death benefit. The death benefit is exempt from income taxes, although, in some circumstances, beneficiaries may have to pay estate taxes. Review our page on FAQs regarding life insurance and taxes.
How To Buy Life Insurance
While comparing life insurance quotes can help individuals find the best rates, it is also important to compare insurance companies. Life insurance is a long term commitment and it is vital to choose a company with a good reputation and financial stability. A cheap premium is not a good value if the carrier is not able to honor their obligations in the future.
Choosing A Company
Fortunately, because of strict laws and regulations requiring insurance companies to maintain reserves to meet policyholder needs, most life insurers are in excellent financial health. Nonetheless, don’t take the company’s word for it and verify their financial strength. Rating agencies such as JD Powers, A.M. Best, Fitch Ratings, Moody’s Investor Services, Standard and Poor’s Insurance Rating Service, and Weiss Ratings all offer consumers free access to their financial assessments of different insurance companies. To make it convenient, we’ve compiled a list of the top companies.
Types of Questions You Will Be Asked
Whether you are discussing your life insurance needs with an agent, broker, or directly with an insurance company representative, you should have a basic idea of your personal financial situation and future goals. To accurately gauge how much life insurance you need, you will need information regarding your family income and assets, including retirement accounts, 401Ks, IRAs, savings and checking accounts, annuities, existing life insurance coverage from your employer, your mortgage, tuition and education costs, future lifestyle expectations and how much income your family would need to survive.
In addition to questions about your finances, you should be prepared to answer questions related to your health, diet, exercise, family medical history, lifestyle choices (smoking and drinking), pre-existing medical conditions, occupation, hobbies, and any extenuating circumstances. Obviously young, healthy individuals who are non-smokers will receive the lowest premiums, but you must answer truthfully to avoid misrepresentation or insurance fraud. This will ensure that your family receives a prompt and full payout if they need to submit a claim.
Questions To Ask Yourself When Reviewing A Policy
Since a life insurance policy is a legal and financial document, it is important that you examine every part of the terms and conditions to determine whether it fulfills your long-term goals, especially when you buy coverage that may last a lifetime. To decide if you are buying the best life insurance for you needs, ask yourself the following:
- How long should I keep this policy? If the term period expires and I want to renew, what are the renewal terms and rates? Will I need a medical exam if I renew?
- Can I comfortably afford the premiums throughout the term period? When are my premiums due – monthly, quarterly, bi-annually, annually, etc.?
- What happens if I miss a payment?
- Will my premiums increase or readjust? If so, when and how often?
- Can I convert the policy to permanent life insurance? Will I need to reapply or undergo a medical exam during the underwriting process?
- How much extra am I paying for certain riders? If the policy has a return of premium benefit, how much would traditional term life insurance cost? What percentage of my premiums will be refunded?
- Is my classification, such as smoker vs. nonsmoker, drinker vs. non-drinker, high-risk vs. low-risk occupation, obese vs. athletic, accurate? How much more am I paying by not maintaining a healthy lifestyle?
- What cash value or death benefit amount is guaranteed? Are there factors (i.e. interest rates) that could affect my family’s payout?
- Whole life insurance – what is my fixed rate of return?
- Universal life insurance – what investment options do I have access to?
Frequently Asked Questions
What types of term life insurance policies are available?
Term insurance offers a variety of options or riders tailored specifically to your needs. For instance, no medical exam life insurance allows you to buy protection without undergoing a medical exam for the underwriting and application process. Some companies offer the option of accelerated benefits, also known as living benefits, whereby your beneficiaries receive the death benefit before you die. Then there are ones that waive premiums if you become disabled, while mortgage life insurance is connected to the principal amount on your mortgage and the death benefit and premiums decline as you pay off your home.
Other types of life insurance policies include: level term, return of premium, decreasing term, convertible term, group term, joint, high risk, simplified issue, guaranteed, and senior life insurance.
What happens if I miss a payment?
Although this depends on your State’s Department of Insurance, most companies are required to give you a 30 or 31-day grace period without consequences. During this time, you must make your payment. If you die during the grace period, the life insurance company will pay out your death benefit minus the owed premium. Otherwise, if no payment is made by the end of the grace period, your policy will lapse and terminate. However, if you have purchased a permanent policy and have a cash value component, the insurance company, with your permission, can withdraw the premium from your cash value. In times of unemployment or a tight budget, this method can keep your policy active and in good standing as long as you have enough in your cash value feature to cover the premium.
What happens if my policy lapses? Do I have any recourse?
Although you should never let your policy lapse, it does happen. Assuming you can prove continued insurability, pay off the overdue premiums plus interest, and cover any outstanding loans against the cash value, some life insurance companies will let you reinstate a policy within a certain time period.
When should I review or change my type of coverage or death benefit?
After major life events, it is always prudent to review your life insurance needs and make sure any existing policies adequately cover your family and assets or still make sense as part of your overall financial plan. Such life events can be the birth of children, marriage, divorce, retirement, death, the purchase of a small business, or an increase in financial assets or liabilities.
Since life insurance rates are based on the age and health of the individual when the policy is purchased, the sooner an individual buys protection, the cheaper the rates he/she will pay over the course of their lifetime. However, never buy anything unless you are 100% convinced that it makes sense for you and that the policy you are buying offers the best coverage at the lowest premiums.
While no one wants to contemplate their own death, life is unpredictable. Buying life insurance is an act of love that provides financial security for survivors if the unexpected happens. Even as life insurance protects families from financial loss, it can also be used as an investment to meet future goals like college tuition or retirement. Ultimately, life insurance is a vital part of financial planning for individuals and families and can provide a degree of security and certainty in an uncertain world.