Life insurance should be a familiar topic to those with a spouse, mortgage, or kids. Understanding the details involved in purchasing life insurance is essential for making smart decisions.
There are many types of life insurance policies, and we can only cover those relevant to most people here. For many, choosing a type of life insurance is simple – the vast majority of new policies purchased fall under the "term life insurance" category described below. But for those with more complex needs, particularly regarding estate planning and tax management, we encourage you to contact a financial planner to better understand all policy options.
What is Life Insurance?
Life insurance is a contract between the policy owner (the person insured) and the insurance company. In the event of the policy owner's death, the insurance company agrees to pay a certain amount of money to the policy's beneficiary – the person or people you specify to receive the benefit. In exchange for this arrangement, the policy owner must pay a periodic fee, known as the premium, to maintain coverage. For example, a husband could pay a premium of $50 per month in exchange for a sum of $500,000 to be paid to his partner upon his death.
Most people consider two main types of life insurance: term and whole life. A term policy is temporary and guarantees coverage at a fixed rate for a specific period – typically between 5 and 30 years. At the end of the policy term, the insured stops paying premiums and is no longer covered. The main advantage of term policies is low cost, at least for younger people – often under $100 per month for $250,000 or more in coverage. As you get older, premiums increase – sometimes dramatically. Thus, a common approach is to buy a long-term policy when younger.
A whole-life policy is a type of policy that offers a death benefit similar to term policies but also builds tax-deferred cash value over time. It's typically possible to withdraw money from the policy or take out loans against the policy's cash value if needed. A similar kind of policy called a variable life policy, is invested in stocks and bonds, and the value goes up or down depending on the performance of the investments bought by the insurance company with the premium payments. Whole-life policies cost considerably more than term insurance policies, and the implications of withdrawing cash value can be complex in terms of tax liability and the policy's benefit value.
With high broker commissions, fees, and restrictions on withdrawing accumulated value, most experts consider whole life insurance a poor investment compared to simply purchasing term insurance and using the extra money to invest separately in tax-advantaged IRA or 401K accounts. Financial advisors often promote this "buy term and invest the difference" philosophy.
Many experts suggest that term insurance policies are the better financial choice for most people. These policies are relatively inexpensive and fulfill the primary mission of life insurance – to replace lost income. That said, those with more complex estate planning needs and those who may value the automatic investing aspect of non-term policies may want to speak with a financial advisor to determine the best option.
How Much Coverage?
Determining how much coverage is appropriate is a decision only you and your family can make. If you have no dependents or spouse to support, your life insurance amount could be enough to repay any loans and funeral expenses.
The picture gets much more complex if you have kids, a spouse, or a mortgage. Many people feel that a policy equal to ten times their annual salary is sufficient. In contrast, others will project specific education costs, home payoff, and a retirement nest egg for their spouse. Another strategy is to choose the life insurance amount based on your net worth at the time of policy expiration. This strategy works best with a 20 to 30-year time horizon – when you should have already paid for significant expenses (home and children's education) and the need for your income is less pressing.
It can help to remember that an insurance policy's purpose is not to make your dependents wealthy – it is to replace lost income. Nor is life insurance a substitute for a retirement plan – by the time you retire, you should have saved enough to ensure a comfortable retirement for you and your partner. That said, another important consideration is that term policies, for example, are not indexed for inflation. While $500,000 may sound like a lot, its purchasing power in 30 years may be $200,000 (or less) in today's dollars.
Finally, remember that life insurance payments are typically tax-free when considering life insurance coverage amounts.
Shopping for a Policy
There are two ways to purchase an insurance policy – through an individual insurance agent or a policy comparison service. The advantage of working with an individual agent is that they can provide more personal assistance in navigating the options, particularly for more complex or unusual policy situations. The downside of an individual agent is that they may have fewer options than comparison services.
Life insurance policies typically require a medical exam, so you will know how much you must pay once you have completed a medical exam. Most companies can, however, offer a reasonably accurate estimate based on your answers to a list of medical questions. Pricing will vary depending on your age, health, personal decisions such as smoking or riding motorcycles, family history, and gender (women tend to pay less for the same coverage as men).
No matter who you buy your policy from, be sure to research the insurance company's rating before purchasing. Companies such as Standard & Poors and A.M. Best rate insurance companies' financial stability. Most experts suggest buying only from companies with the highest rankings.
Finally, it's best to shop for a policy as soon as you determine it's needed. Procrastinating only increases the cost and the chance that you'll die without a policy. It also raises the chance that you will be diagnosed with a medical problem that will result in higher insurance rates.
If you need clarification on how much coverage is appropriate for your situation, please consult a qualified professional.
