What is Life Insurance?
Life insurance is insurance that pays out a specific amount of money on the death of the insured person. A life insurance policy is simply a contract between an individual and a life insurance company that says that a life insurance company promises to pay a specific amount, known as the death benefit, as long as you pay an agreed upon amount of money for the policy, commonly referred to as a premium.
You get to list specific people or entities as the policy’s beneficiary, and once the individual listed on the policy passes away, the death benefit is paid in full to them.
As long as your premiums are paid and your policy remains in good standing the insurance company has an obligation to pay the beneficiaries listed in the policy.
Life insurance death benefits can be used for whatever purpose the beneficiaries deem appropriate.
For some, securing a life insurance policy allows for a spouse or significant other to pay down or pay off a mortgage balance if the policy owner passes away, or to pay for childcare if there are minor children in the household at the time of death.
For others, life insurance proceeds are used to pay off debts, pay estate taxes, or fund retirement savings for the future. No matter how the death benefit is used, the beneficiary receives the payment as an income-tax free benefit from the life insurance company.
In most cases, paying for a life insurance policy gives them the opportunity to spend pennies on the dollar to secure a large benefit in the future for a spouse, a sibling, a parent, or other loved one so that they may remain financially stable.
How Much Life Insurance Do You Need?
Everyone faces different financial needs when a loved one passes away, making it somewhat difficult to determine with complete accuracy how much life insurance coverage is sufficient. There are several rules of thumb which can be applied to the calculation, however, to help take the confusion out of the process, one of the most common and simplest calculations involves multiplying annual income by 10 which in theory provides enough life insurance coverage to protect the primary breadwinner’s contribution to the household for years into the future should he or she pass away. When there are minor children in the picture, adding $100,000 to the total is often recommended to cover expenses like childcare and funding a college savings account. For individuals who do not work because they stay home to raise children, or for someone who makes significantly less than a spouse or partner, the 10 times rule may not be sufficient in determining coverage needs.
The Different Types of Life Insurance Policies
Several different types of life insurance policies exist in the market today, but there are two broad categories into which coverage falls: term insurance and permanent insurance.
What is Term Life Insurance?
Term life insurance works as a temporary policy, meaning that it is only guaranteed for a certain term; some term policies are guaranteed for 5 or 10 years, while others may last as long as 30 years. Other term policies are designed to renew on an annual basis, giving policyholders the ability to choose to extend the length of the policy for another year or let it expire at the end of that one-year term period.
Life insurance policies that fall under the term category offer level premiums which means that the money paid in exchange for the coverage does not increase for the length of the term. For example, a $20 monthly premium is due in month one, and a $20 monthly premium is due in the last month of the policy. They also provide a level death benefit for the duration of the term selected. Term policies are a smart way to purchase a large amount of life insurance for a set period with a known premium.
What is Permanent Life Insurance?
The other broad category of life insurance is permanent insurance. Unlike term coverage, permanent life insurance provides a guarantee of the death benefit for the duration of the insured’s life – not a set term. As long as premium payments are made in line with the contractual agreement, the insurance company is required to pay the death benefit to the policy’s beneficiaries at the time the individual passes away. Because permanent life insurance policies have a longer, unknown term, they are typically more expensive than term life insurance policies. Additionally, permanent life insurance policies have a built-in savings component, known as the cash value, that works to offer a benefit to the insured individual while he or she is still living.
Permanent life insurance policies may be purchased with a level death benefit and a level premium, just as term policies are, but permanent coverage comes in a variety of different types. Next, learn about the options for permanent life insurance coverage and how each work regarding premiums paid, death benefit guaranteed, and cash value accumulation.
What is Whole Life Insurance?
Whole life insurance is one of the most common types of permanent insurance. It provides a death benefit that is guaranteed for an individual’s whole life, so long as premiums are paid as agreed, and the total amount paid to beneficiaries may increase over time if the insurance company pays dividends to policyholders. When a whole life policy is put in place, the premiums do not change for the life of the policy, making it beneficial to establish a policy earlier in life, when the health of the individual is strong. Policyholders can choose whether premiums will be paid for the full duration of the policy or a set number of years, depending on cash flow and affordability.
Individuals who have a whole life insurance policy have a portion of their premiums set aside into a cash value account within the policy. The cash value is managed by the insurance company, and its growth is guaranteed for the life of the policy based on the strength of the company offering it. If additional dividends are paid due to higher than expected profits of the insurance company, policyholders have the option to add those to the cash value or the death benefit. The cash value of a whole life insurance policy is tax-deferred, meaning any fixed returns are not taxable when they are generated but rather when they are distributed from the policy. For individuals seeking out a permanent policy that provides steady growth on cash value balances and a fixed premium, whole life is a strong choice.
What is Universal Life Insurance?
Another option for permanent life insurance coverage is universal life, which offers more flexibility to policyholders than its whole life counterpart. Under a universal life contract, individuals have the option to select a fixed or a flexible death benefit. A fixed death benefit means as premiums are paid, the cash value grows closer to the initial death benefit selected, reducing the amount of risk the insurance company takes on. This creates a lower cost of insurance for the policyholder over time and potentially lower premiums at the onset of a new universal life policy. A flexible death benefit simply adds the cash value to the death benefit, creating a greater payout to beneficiaries in the future. Over time, policyholders can change the death benefit to better fit their current needs by switching from a flexible to a fixed contract.
Similar to whole life, universal life insurance has a cash value component that is guaranteed to grow at a certain interest rate, set by the insurance company at the time the contract is put in place. Should the insurance company have excess returns in any given year, they may opt to pay policyholders more than the fixed rate of return to increase cash value growth. The biggest difference between universal life and whole life is the flexibility that comes with premium payment, as policyholders have the option to change the premium amount over time. So long as the cost of insurance is covered, a premium can be decreased or increased as the policy owner deems necessary. Decreasing a premium payment on a universal life policy may change the guarantee on the death benefit while increasing it may mean there is no need to pay premiums in later policy years. Because of this flexibility, the initial cost of universal life insurance may be less expensive than whole life coverage.
What is Variable Life Insurance?
Variable life insurance coverage is similar to other types of permanent coverage in that the insurance company will guarantee a death benefit amount in exchange for a premium. The death benefit is either fixed or flexible, like with universal life insurance, and the premiums can be changed over time to increase or decrease the cost or cash value as the policyholder’s needs change. A portion of the premiums are used to fund a cash value account within the policy, as with other permanent options. While these basics are the same, the cash value of a variable life insurance policy differs greatly from whole or universal life insurance.
Instead of receiving a guarantee on the amount of cash value accumulated over time, variable life insurance policyholders are subject to investment risk within the cash value. The insurance company passes the risk of the cash value growth onto the policyholders, who have the option to invest in mutual fund-like sub accounts that are tied to stocks, bonds, and other securities. Because the insurance company does not hold the risk of guaranteeing the cash value balance, the cost of variable life insurance can be considerably lower than whole or universal life insurance policies.
Strategies for Using Cash Value
Cash value balances within permanent life insurance policies, whether fixed or variable, grow without the burden of capital gains tax, similar to the way retirement account returns are tax-deferred. When the funds in a cash value account are taken out, they can be tax-free, depending on how the withdrawal is structured. Most individuals opt to borrow against the cash value in the form of a loan to maintain the tax benefits of a withdrawal. Loans can be paid back over time to ensure the death benefit remains guaranteed at the initial level, or the unpaid balance of a cash value loan can be used to reduce the death benefit when the insured passes away. If a policyholder takes a withdrawal from a life insurance policy without utilizing the loan feature, the gains on the cash value may be taxable.
Taking funds out of a life insurance policy either through a loan or as a withdrawal can be a smart method to use life insurance while one is still living. There are no restrictions on how cash value funds can be used, and there are no limitations on when those funds can be taken out. So long as there is a balance above zero in the cash value account, policyholders have access to those funds. Some individuals utilize cash value to help with a down payment on a home, funding a child’s college education, or paying for a new business endeavor. Others may tap into cash value balances for supplemental retirement income, or as a method to pay for long-term care expenses later in life.
The Term Life Insurance vs. Permanent Life Insurance Debate
For years, there has been an ongoing debate among financial professionals and the individuals who want or otherwise need life insurance surrounding the benefits of term insurance compared to permanent coverage. One common argument is that the cash value accumulation of permanent insurance does not offset the higher cost compared to term coverage, meaning individuals should buy term insurance and invest the difference. On the flip side of that coin, advocates for permanent insurance speak to the tax benefits available through cash value accounts that cannot be experienced with a non-qualified (non-retirement) investment account or conventional savings.
The need for term insurance, permanent insurance, or a combination of the two is unique for every individual and family, so there is no general rule of thumb to be followed. Term insurance provides the greatest benefit for cost-conscious individuals or those who have a temporary need for life insurance coverage for covering debts or expenses that eventually go away (like a mortgage or college funding for children). Permanent insurance, while more expensive, provides coverage for an individual’s entire life which helps offset the burden of estate taxes and final expenses that could otherwise undo the financial stability of a beneficiary. Understanding the components of both term and permanent insurance, the cost, and the guarantees alongside the specific circumstances individuals face is the best strategy for determining which type of coverage is necessary.
Guaranteed Acceptance Life Insurance
One final type of life insurance that may be of interest to some individuals is guaranteed acceptance life insurance, more commonly referred to as final expense or senior life insurance. Because life insurance coverage is the most affordable for individuals who are in good health, older individuals may not be able to qualify for a policy that falls within their budget. Guaranteed acceptance life insurance is a form of permanent insurance that typically ranges from $2,000 up to $25,000 that does not require a medical exam or proof of insurability by the insured. Instead, the insurance company guarantees coverage in exchange for a set premium each month. Guaranteed acceptance life insurance can be expensive as it is based on the policyholder’s age, but it can be beneficial for those concerned about covering final expenses, such as funeral costs, outstanding debts, or small payments to heirs.
Group Life Insurance vs. Individual Life Insurance Coverage
Each of the policy types listed above is considered an individual life insurance policy, meaning the coverage is not tied to a specific employer or association. Individual life insurance policies require a proof of insurability that typically includes a medical history questionnaire, an abbreviated exam that measures height and weight, and lab work which involves drawing blood and a urinalysis. The insurance company offering the policy needs to ensure the individual is relatively healthy before entering into a guaranteed contract, and the underwriting process allows the company to assess the person’s health easily. Individual life insurance policies are sold through licensed insurance agents, financial advisors, and in some cases, online brokers who help the policyholder select the amount and type of coverage, as well as manage the underwriting process behind the scenes.
Group life insurance coverage is also an option for individuals who have access to this benefit through an employer. Life insurance under a group contract does not typically require full underwriting since the insurance company is spreading out its risk over a significant number of policyholders. Although there is no medical exam or lab work required, group life insurance coverage has a few caveats. First, group policies have limits on how much coverage can be purchased without proving insurability, and the premiums for coverage may increase as the employee gets older. Also, group life insurance policies are not portable, which means individuals do not often have the option to continue coverage once they have left the specific employer offering coverage. Finally, group life insurance policies are term policies, and they do not extend into retirement years. For individuals who cannot qualify for an individual life insurance policy based on health, a group policy may be the only viable way to receive the coverage needed. It is important to understand the cost, underwriting requirements, and duration of coverage before selecting a group or an individual life insurance policy.
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