Back to Basics: Life Insurance
What comes to mind when you think of insurance? Maybe the protection you have for your vehicle or home, or perhaps your health insurance. Having these types of policies allows you to reduce your personal risk should something happen to you or your property. You likely have them in place to limit your financial liability in the case of an accident or emergency. And while life insurance works a little differently, it’s no less important.
In most cases, the purpose of life insurance isn’t insuring against death itself but, rather, insuring against premature death. And, unlike other types of insurance, the payout isn’t meant to help you, yourself, recover after a loss. Instead, it’s for the loved ones you’ll leave behind when you pass — allowing them to maintain a comfortable lifestyle and continue progressing toward financial goals you’d otherwise contribute to if not for your death.
The way life insurance works is fairly simple. You can take out a policy on yourself or anyone in whom you have an insurable interest. Insurable interest means that you’d suffer a financial loss when they — the insured — die. Similar to other types of insurance, the policy owner pays the required premiums for the policy to remain in place, or in force. Then, upon the insured’s death, the insurance company pays beneficiaries listed on the policy according to the agreed-upon terms.
But how do you know if you — or, better yet, your would-be beneficiaries — need it? And if they do, how much coverage do you need? There are lots of options available, so let’s start with the absolute basics: What each type is and how each works.
Types of life insurance
Two main types of life insurance exist: individual and group.
Individual insurance includes policies that people purchase privately to suit their needs. Many options exist within individual life insurance, depending upon your unique situation. But they fall into two primary areas: permanent and temporary.
Hence the name, permanent life insurance remains in place throughout the insured’s lifetime — or as long as the policy owner pays the required premiums. These policies tend to be pricier than other options because they build cash value and offer a death benefit. Policy cash values sometimes remain in an interest-bearing or dividend-paying account. That’s the case with whole life or universal life policies. And some policies even offer investment options for the policy cash value. These are typically referred to as variable life insurance.
It might not surprise you to learn that temporary life insurance lasts for a certain period of time but not the insured’s entire life. Also known as “term,” temporary life insurance policies can last for as little as one year or up to 30 years. They expire or dramatically increase in renewal premium cost when the term is up. Unlike permanent policies, term insurance doesn’t build cash value, but this also tends to make term policies more affordable.
Group life insurance is usually employer-provided and is a common employee benefit. Employers can offer each employee up to $50,000 worth of group life insurance with no tax consequences. Of course, employers can pay for more than that. But any coverage amount over $50,000 would make the employer-paid premium taxable to the employee. Most group plans are a form of term life insurance and last as long as you work for your employer.
Which type is best for you?
After learning about the basic types of life insurance, you might already have an idea in mind as to which could be the right fit for you. But before you call your insurance agent, you might want to ask yourself, “Do I need life insurance at all?” If you don’t have dependents to care for or any major debts that would pass to your next of kin upon your passing, you might not need life insurance.
But even a relatively small policy can be both inexpensive and invaluable to your peace of mind. And, with life insurance generally being more affordable the younger and healthier you are, you may choose to purchase a policy sooner rather than later. This could be especially true if you’re buying a convertible term policy. With a convertible term policy, if your needs change and your health isn’t quite the same as it used to be, you can turn a term policy into a permanent one.
It can also be helpful to know whether you have the opportunity to enroll in group life insurance through your employer. With some life insurance potentially available at no cost to you as an employee, it can be the easiest and most cost-efficient way to secure coverage. On the other hand, what’s given to you might not be enough coverage. In that case, you may consider purchasing additional coverage through your employer, if it’s offered. Or you could supplement the coverage with an individual policy.
You may also want to consider what the cash payout to your loved ones could mean if/when you pass away. Would life insurance allow your spouse to pay off your mortgage or other family debt? Could it mean paying for college for your children if you were no longer around to help finance it? Might it allow your family to continue their quality of life, rather than relying on your spouse’s income alone? Give your loved ones time away from work to grieve after their loss without the pressure to go back before they’re ready? Help with funeral or burial costs?
Life insurance can give your family members financial security during one of the most difficult periods of their lives. It can help them thrive financially after a loss. And life insurance can allow them to continue their lifestyles after losing both a loved one and a source of family income. Without it, they could be left in a difficult situation, saddled with debt and stuck having to make financial and lifestyle changes to make ends meet.
If you’ve decided life insurance is the right option for you, you can consider the following as you choose the type that could best benefit your loved ones:
How much can you afford? Term life insurance can offer a good amount coverage for a relatively low price, but that price is only good for the term specified. Permanent policies require a higher premium but also leave some of that cost behind in a cash value. And keep in mind that insurance companies include many factors when determining costs. These can include the insured’s age and health in addition to the death benefit.
How much risk are you willing to take on? If you’re more risk-averse, you might consider a longer period term or whole life policy. These can offer more consistent premiums and longer periods of coverage. But, if you’re a risk-taker, a variable policy might suit your style with the ability to risk and grow your cash value.
How long do you need the coverage to last? If you’re looking to life insurance as a backup until the mortgage is paid or the kids graduate from college, a term policy may be the most appropriate. As some of these needs diminish or disappear over your lifetime, your insurable need could decreases or ability to self-insure increase. As this happens, a life insurance policy could possibly become unnecessary. Generally, permanent policies — especially those purchased later in life — are for estate liquidity purposes. They give your loved ones time to sell illiquid assets at a fairer price or manage a trust or tax situation in a certain way.
With the answers to these questions in mind, it’s time to move on to the last — and perhaps most important — life insurance consideration: How much you need.
How much coverage do you need?
Buying too little life insurance could leave your loved ones in the type of bind you were trying to avoid in the first place. Too much could mean paying higher premiums than necessary during the insured’s lifetime. So, when purchasing life insurance, it’s important to get the right amount of coverage for your beneficiaries’ future needs.
But how do you know what the right amount is? Once you’ve more or less decided on the type that’s right for you, there are two key methods for determining the proper death benefit amount:
Income-based — With this method, you estimate the amount of money the insured would make for a certain period in the future. You’d subtract taxes and the amount the insured would need to live on, and then factor in a growth rate that the death benefit could reasonably earn. The amount you’re left with is the amount of life insurance you’d need based on income.
Needs-based — Although using this method may be more time-consuming, it can also be more precise. When considering your loved ones’ future needs, it’s important to factor in any final expenses, like funeral, burial, and medical. Then, look at any debts or fixed expenses, like a mortgage or children’s educations. Next, review other future expenses for dependents. These can include funds that would allow them to grieve and adjust after the insured’s death. Depending on whether the insured’s spouse earns income or not and at what level, you may also choose to include living and retirement expenses for the spouse. With all needs added up, subtract out funds currently available and factor in a reasonable growth rate. The amount that’s left is the amount of insurance to purchase based on needs.
No matter which method you choose, using life insurance as a safety net to cover future needs for your loved ones is key. And knowing they wouldn’t face a lifestyle disruption because you’ve planned for their needs is the true reward.
It’s also what makes life insurance such a crucial part of financial planning. When you plan for your financial future, your family is an important consideration. Life insurance allows you to set your loved ones up for success and leave a legacy. And it can allow them to thrive financially through a difficult time after a loss — and into the future.
Life insurance can be a feature of any strong financial plan. So speaking with a financial professional who doesn’t have an interest in whether or not you purchase a policy — aka a commission to earn — is a good idea. He or she will likely want to make sure you’re timing your life insurance purchase properly to ensure that it aligns with your unique financial goals and can help you get closer to achieving them.
Not a client yet? See if our ensemble approach is right for you.