Life insurance can be an essential tool in executing your financial plan. As discussed in a prior post on risk management, it can help create an important safety net. The proper amount of insurance can provide financial support to your family members or others who depend on your income. A death benefit can help with current living expenses. However, it can also assist with other financial goals. Examples include establishing an emergency fund, paying off debt, planning for college, and saving for retirement.
Without it, a premature death can cause immediate financial strain for your dependents. Not to mention the inability to meet existing financial goals. For those with a higher net worth, life insurance can also provide liquidity to your estate for the payment of estate taxes. Having available funds to pay required taxes and debt will allow you to pass property to your heirs in a debt free manner without forced asset sales.
If you own a business with other shareholders or partners, you may also find life insurance useful. It is generally used to fund buy-sell agreements among business partners. A business can also use it to insure a key employee.
But there are different types of life insurance policies. Figuring out which one best fits your needs can be a difficult undertaking. The two major types of life insurance are term and permanent. The permanent type usually includes whole life, universal life, and variable life.
Term Life Insurance
Temporary or term life insurance is the most simple and basic type of life insurance you can acquire. Term insurance has two distinguishing features that permanent life policies do not have.
First, it only pays out a death benefit if you die within the term of the policy. Term policies generally range from 10 to 30 years. So your beneficiaries may never see a death benefit from this type of policy.
Second, it does not build cash value. The premiums strictly go for life insurance protection and the associated insurance company fees and expenses. There is no savings and investment component.
For example, let’s say you buy a 20 year term life policy. After twenty years, your policy expires and you do not purchase additional coverage. If you die after the 20 year policy expires, then your beneficiaries will not receive a payout. But by then, your mortgage may be paid off, the children may be done with college, and your IRA may have sufficient funds for retirement.
Term Life Insurance Has A Low Cost Because It Provides Temporary Protection
Due to its lower probability of a death benefit payout, term life insurance is generally much less expensive than permanent policies which have a guaranteed payout. It’s relative affordability makes it a very attractive option for many.
It is often recommended for those who only want temporary protection for a specific term. The low premiums allow you to potentially save what you’d otherwise pay for a permanent policy. You can therefore build up your own cash value at a potentially lower cost and with more investment choices. But you must have the discipline to save and invest at least some of the difference in premiums.
A term life policy is not ideal for providing estate liquidity or meeting other goals which require a guaranteed death benefit. But if you just want to protect your children and other dependents while they are young and depend on your income, term life is probably the way to go. Once they finish school, get their own jobs, and move out of your home, you may no longer wish to carry life insurance.
Other Considerations Regarding Term Life Insurance
The premiums on term life policies can increase over the term of the policy. This type of policy is called “annual renewable term” or ART. Alternatively, the premiums can be level from the outset. Such policies are called “level term.”
As you would imagine, the level term premiums are usually higher in the beginning, and lower at the end of the term when compared to ART policies . This is so because with level term, the insurance company averages out the lower premiums when you are young, with the higher cost of insurance as you age.
But overall, you will likely pay less over the term of the policy by locking in a level term. Many also prefer the level premiums since they can budget for them more easily. Locking in the premium for the entire life of the policy is more common and is probably your best bet.
You May Be Able To Convert A Term Policy to a Whole Life Policy
Some term life policies may be converted to whole life policies within a specified time frame. This may be beneficial if your need for life insurance changes and becomes permanent. For example, you may accumulate an estate large enough that it will be taxable upon your death. So you may need a policy to pay estate taxes upon your demise.
Converting an existing term policy may be easier and less expensive than purchasing a whole life policy otherwise. Purchasing permanent insurance after twenty or thirty years might not be possible if your health has deteriorated. At the very least, it can be prohibitively expensive. A policy with a conversion feature will result in a higher premium than an otherwise equal policy without it.
Whole Life Insurance
Whole life is the traditional type of permanent life insurance coverage. The key feature of whole life insurance is that your beneficiaries are guaranteed a death benefit regardless of when you die. That is as long as you keep the policy in force by paying your premiums. So you can die at 95 years of age, for example, and the policy will still pay out its face amount.
Another key feature of whole life insurance is that it builds up a cash value over time via a savings element built into the premium. A portion of each premium is allocated to the savings portion of the policy, and accumulates interest on a tax-deferred basis. However, there is no flexibility in how the cash value is invested.
The main downside of whole life policies is that they are much more expensive than term life. They can run anywhere from three to over ten times the cost of a similar face value term policy. Their main advantage, a guaranteed death benefit is the reason they are more expensive.
Participating vs Non-Participating Whole Life Insurance Policies
Whole life policies can also be participating or non-participating. Mutual insurance companies are owned by the policyholders of the company. Whole-life policies may have a participation feature wherein they receive dividends from excess earnings of the insurer. Participating policies were typically offered by mutual insurance companies.
However, many publicly traded stock insurance companies also offer participating policies as well. The dividends can be received in cash, added to the cash value of your policy, or they can be used to pay premiums. They can even be used to purchase incrementally more “paid-up” insurance, which increases your death benefit.
Cash Value Uses of Whole Life Insurance
The cash value accumulated within a policy can be used to reduce or eliminate the premiums you have to pay out of pocket. But you can also borrow against your life insurance cash value or use it to deal with a financial emergency. Finally, you can turn your cash value into a retirement annuity.
Keep in mind though, that your beneficiaries will not receive the cash value in addition to the death benefit. Upon your death, any cash value goes to the insurance company. Further, any cash value you withdraw or use for premium payments, and do not pay back will be subtracted from the ultimate death benefit. The only way you get to take the cash value and keep it is if the policy is terminated.
Universal Life Insurance
Universal life is another type of permanent insurance. Such policies also have a savings component. However, the interest rate on the savings (cash value) is not fixed. You may earn more than the minimum guaranteed rate.
The universal life policy is also very transparent. You can see how much of your premium is going towards the policy and how much is going towards cash value savings. You can even see what portion is going towards fees and expenses paid to the insurer.
Universal life policies provide more flexibility with regard to arranging insurance premiums. The premiums paid must fall within a minimum and maximum range set by the policy. You can choose what you want to pay within the range.
But this flexibility can work against you if you are not careful. With a whole life policy, the premiums are fixed and the cash surrender value is guaranteed. So as long as you pay your premiums, your policy will not lapse. But this is not the case with universal life.
Paying Too Little Can Cause a Universal Life Insurance Policy To Lapse
Paying less early on, when the insurance protection portion of your policy is cheaper, may seem attractive. But later, as the cost of protection increases, you may run into problems. If you do not accumulate enough of a cash value over time, you will have to make some tough decisions. You may have to increase your premium payments, decrease the death benefit, or allow the policy to lapse.
Besides underpaying premiums, cash value can decrease due to lower interest rates. The insurance company may also charge higher fees and expenses over the life of the policy, which can reduce cash value.
Two General Options for the Death Benefit of a Universal Life Insurance Policy
Universal life policy death benefits are generally set up one of two ways. You have option 1 or A and option 2 or B. With the first option, the death benefit is the face value of the policy. With option 2 or B, the death benefit is equal to the face value of the policy plus any accumulated cash value.
Total premiums paid will be greater under option 2/B since the cash value does not offset the higher cost of insurance in the later years as you age. Many policies allow you to switch from one option to the other.
Variable Life Insurance
Like whole and universal policies, variable life insurance policies also provide permanent protection. But the distinguishing characteristic with these policies is that you can choose investments in which to allocate your cash value. The insurance company usually will provide a list of offerings from which you can choose.
Whole and universal life policies generally invest in bonds and other fixed income types of investments. But with variable life policies, you can add investments such as equity based mutual funds. This can be a plus if the investments outperform.
However, investments may very well underperform. If they do, your cash value may decrease along with your death benefit. There is usually a guaranteed minimum death benefit stated in variable insurance policies. This, along with more involved and complex administration usually results in higher premiums as compared to a whole life policy.
There are also policies which combine the features of universal life insurance with variable life. Such policies are called variable universal life (VUL) insurance. They combine the flexibility of universal policies with the investment options of variable life policies.
How Much Life Insurance Do You Need?
There are many rules of thumb as to how much term life insurance you should purchase. They range widely from 5 to over 20 times your annual salary. However, rules of thumb can lead you astray.
First of all, they do not consider savings you may already have accumulated. You may already have put aside enough money to fund college for the kids. Or your investments might generate enough investment income to supplement living expenses to a certain extent.
Financial Analysis is Preferable to Rules of Thumb
So a more accurate way to determine the amount needed is to do an analysis specific to your current finances. An income and expense analysis and a budget can help in this regard. You first need to figure the amount of income your family will be earning after your death. You must factor in such things as social security survivor benefits, and whether or not a stay-at-home spouse might be willing and/or able to return to work.
Then calculate your estimated final expenses. These can include funeral and burial costs, medical bills, and accounting and legal services. After this, you must calculate your projected ongoing expenses. This will include living expenses such as food, rent, property taxes, utilities, etc. Next, figure out how much you need to pay off any debts such as a mortgage or car loans.
If debts are expected to be paid off immediately with insurance funds, don’t forget to adjust your ongoing expenses for the principal and interest currently being paid. Finally, estimate any amounts necessary to fund existing financial goals, such as saving for college, or funding a retirement account. Be sure to factor in an estimate for inflation and an expected rate of return on invested funds.
Once you have these numbers you can estimate the approximate amount of life insurance required. Calculating the above items can be a complicated and time consuming process. It may require estimates and the help of software or a financial advisor. There are some online tools which can also help with the process. For example, Edward Jones offers a simple online life insurance needs calculator.
The amounts needed business purposes such as buy-sell agreements, key employees, or to pay estate taxes are beyond the scope of this article.
Different Ways to Purchase Life Insurance
You can purchase life insurance in different ways. You can buy it from an agent, a broker, or directly from an insurance company. Working with an agent can help you to understand what type and how much insurance you need. An agent can also answer other questions you may have.
A captive agent usually only represents one insurance company. Therefore, they may be biased in their recommendations. However, if you’ve done your homework and compared policies and insurance companies already, this may be an option for you. Not to mention that some companies sell exclusively through their own captive agents. So if you wish to go with their product, you might not have a choice.
Alternatively, you may want to work with an independent agent or broker. They usually work with several companies, and may be able to do a lot of the research and comparisons for you. However, such agents may also have some bias. They may need to sell a specific amount for a particular company to maintain their appointment with that insurer. So make sure you do some of your own comparison shopping as well.
If you purchase directly from an insurance company, you can get “no-load” or “low-load” life insurance. This generally means that the agent or broker commission otherwise built into the premium is eliminated or reduced. The overall cost may therefore be lower. On the downside, the service you may get from a representative of the company may not be as in-depth as when working with an agent or broker.
If you want pure protection for a specified term, go with term life. It is much less expensive. If you need a guaranteed death benefit and level premiums with a guaranteed cash value, look at whole life. But if its a permanent policy with flexibility you are looking for, universal life may be for you. Finally, if you want to invest your cash value in riskier investments, a variable policy may a fit.
Also make sure you name the right beneficiaries to your policy and update them as necessary. The beneficiaries may be your spouse, a trust, or your estate. Putting an insurance policy into a trust can help to avoid potential estate taxes. This is only an issue if your estate large enough to be subject to federal or state estate taxes. Minor children should not be named beneficiaries.
Purchasing from a financially stable insurance company is also essential. But financial stability is only the first step in your research. You must also choose the appropriate policy which meets your own needs. Shop around to find a good deal. Click here for an example of one of the many sources for online life insurance quotes.