Life Insurance 101
If you have dependents who rely on your financial support, life insurance may be worth considering to ensure they are protected if you unexpectedly pass away. This article will take a deep dive into what life insurance is, if you need it, and how to calculate the right amount of coverage for your needs.
What Is Life Insurance?
Life insurance is designed to provide financial support to your loved ones after you die. When you buy a life insurance policy, you enter into a contract with the insurance company stating that in exchange for premium payments, the insurer will pay out a lump sum, also known as a death benefit, to the beneficiaries of your choice upon the insured person’s passing. Once the beneficiaries receive the death benefit, they can decide the best way to use it.
Who Needs Life Insurance?
The decision to buy a life insurance policy is a personal one, and not everyone wants or needs to be covered. Some of the most common reasons why people may want to buy life insurance include:
To replace income. Over half of households rely on a dual income to maintain their lifestyle, according to LIMRA’s 2021 Life Insurance Barometer Study. Of these respondents, 42% say they would struggle financially within six months after losing an income. Twenty-five percent would only last one month before experiencing financial hardship.
To pay for end-of-life costs. The average funeral and burial cost $7,848, while a funeral and cremation is about $6,971, according to the National Funeral Directions Association. Many insurers sell a form of permanent coverage called funeral or burial insurance that is designed to pay for such end-of-life expenses.
To provide an inheritance or a gift to charity. If you want to leave your loved ones a financial legacy, a life insurance policy death benefit could provide an inheritance. You may also be able to designate a favorite nonprofit or charitable organization as the beneficiary of your policy.
To protect your business. A life insurance policy’s death benefit may be used to cover your small business’ payroll and other operational expenses should your death disrupt operations.
To diversify your investments. Permanent life insurance policies have a cash value component that grows tax-free. Usually, this is at a fixed or money-market rate, which offers a very conservative return. However, some policies allow you to invest the cash value in stocks, bonds, and other financial vehicles that may offer a greater return.
To cover estate taxes. If you anticipate leaving substantial assets to your heirs, they could face a large estate tax burden. Beneficiaries of your life insurance policy can use the death benefits they receive – which are not taxable in most instances – to pay any estate taxes.
What Kinds of Life Insurance Are There?
Term life insurance and permanent (whole, universal, and variable) life insurance are the two primary types of life insurance. As the name implies, term life insurance provides coverage for a specific term or amount of time, usually one to 30 years or longer. By contrast, permanent or whole life insurance provides coverage for your entire life. Because term life only lasts for a specific period and carries no cash value, it is usually more affordable than a permanent life insurance policy.
What Is Term Life Insurance?
Term life insurance offers coverage for a particular time frame, such as 5, 10, or 20 years. When you buy a term policy, you lock in your premium rate and death benefit for the term you select. If you die during the term, your beneficiaries will receive the death benefit, provided that regular premium payments have been made. If you die after the term expires, the insurer will not pay out the death benefit.
Generally speaking, the longer your policy term is the more expensive your premium will be. Premiums also become more expensive the older you get. On average, a 20-year-old will pay less than a 40-year-old for the same term life insurance policy, according to our data.
In some cases, term life policies are convertible. In other words, your insurance company may allow you to convert your term policy to a permanent one within a specific time frame after you’ve acquired the original policy. When you convert your policy, you are not required to take a medical exam or answer questions about your health. You may also have the option to renew your term life insurance policy once it expires, although your premium almost certainly will increase.
What Is Whole Life Insurance?
Whole life insurance, also known as ordinary life insurance, provides coverage for your entire lifetime. This type of permanent life insurance policy comes with a cash value component that can accumulate value on a tax-deferred basis. However, the actual value of the account may differ depending on the insurance company. For example, some companies may base the accumulation on premium payments (minus expenses), but others may not.
As the policyholder, you can access the policy's cash value while you're alive by either taking out a loan or withdrawing funds to pay for expenses such as college costs or home renovations. However, if you withdraw funds from the account, it could reduce your death benefit, which leaves less money for your beneficiaries.
When you borrow money from the cash value, the loan amount will accrue interest until you repay the debt. If you choose not to repay the loan, the outstanding loan balance will be taken out of your total death benefit when you pass away.
With a whole life policy, your death benefit and premium amounts will usually remain the same. However, like with other life insurance policies, the older you are when you purchase insurance, the more coverage will cost.
What Is Universal Life Insurance?
Also referred to as adjustable life insurance, universal life is another form of permanent life insurance. This type of policy also offers a death benefit and cash value component. However, policyholders can adjust the premiums and death benefits as their financial situation changes. It’s also possible to use a portion of the cash value to offset your premium cost, although this will affect the death benefit amount. Like whole life insurance, you can access the policy’s cash value through a withdrawal or loan, although doing so will diminish the death benefit if the funds aren’t repaid.
What Is Variable Life Insurance?
Variable life insurance is another type of a permanent life insurance, the primary difference being that policyholders can invest the cash element into stocks, bonds, or other investment vehicles. While there is a potential upside for growth if the market performs well, that isn’t guaranteed. Also, these types of policies frequently carry investment-management fees and related expenses.
How Much Life Insurance Do I Need?
There is no one-size-fits-all solution, but there are several ways you can estimate the amount of coverage you need. Below are three common methods for estimating your life insurance needs.
Multiply Your Salary
This method is pretty straightforward, although it also provides the least detailed picture of your future needs. Some insurers recommend multiplying your current salary by 10 to 15 times to arrive at a quick estimate. For example, if you make $50,000 per year and multiply that by 10, you’d estimate needing $500,000 worth of coverage. If you have children, you may also want to include the cost of college in your tally by adding $100,000 to $150,000 to your estimate.
Use the DIME Method
DIME is an acronym that stands for debt, income, mortgage, and education. It’s a more detailed means for estimating your future financial needs. To determine an adequate level of insurance coverage, add up all of the following:
Debt such as car payments, credit cards, and student loans
Income for the total amount of years you need coverage
Outstanding mortgage or home equity loan balance
Education costs if you have children