Life insurance can play many roles in financial planning, which is part of the reason that there are so many types of life insurance. Not all life insurance types are created equal, however, and depending on your needs, one type may be more appropriate than another for your goals. In many cases, life insurance provides income replacement to benefit surviving family members or other beneficiaries, but life insurance can also be an effective way to transfer wealth from one generation to the next, or a way to provide final expenses, including funeral costs and any lingering medical bills.
In most cases, life insurance policies purchased with after-tax money provides the proceeds of your policy tax-free to your beneficiaries. Below we cover some of the most common choices for life insurance coverage.
It’s also important to note that you can’t purchase more life insurance than your potential loss. A person who earns $25,000 per year and who has an expected working life of another 10 years might find themselves limited to a $250,000 policy or less, an amount equal to or less than to their expected earnings .
As its name suggests, term life insurance provides a fixed benefit amount and charges a fixed premium for a set amount of time, a term, after which the policy either terminates or becomes an annually renewable term policy — but without a guaranteed premium. Term life insurance is often most useful when you need coverage for a specific amount of time. In some cases, a term policy can be converted to a permanent policy.
Many families and individuals purchase term life insurance based around a time goal. For example, if you just bought a house and started a 30-year mortgage, a term life policy with a 30-year term might seem like a sensible choice. If an insured income earner passes away unexpectedly before the mortgage is paid off, the term life insurance policy can provide replacement income, which can either be used to pay off debt such as the house or cars or can be used as consistent income spread out over time while the surviving family members continue to make payments and pay for life’s other expenses.
Another time consideration often revolves around children. For example, if you just started a family, a 20-year term life insurance policy can provide financial protection for your family until your kids reach an age when they are either on their own or can contribute to household earnings and expenses.
Starting a business or taking out a sizable loan are also common reasons for purchasing term life insurance. In many cases, surviving family members can’t take the reins of the business, which can create financial risk for your family if you pass away unexpectedly. Loans, whether business-related or personal loans, are another common reason the purchase term life insurance. Many business loans for small businesses have a personal guarantee attached to the loan, which can put your savings or assets at risk. A term life insurance policy closely matched with the term of the loan can remove some of the financial risk associated with the loan.
Because term life insurance doesn’t provide a guaranteed premium forever, the premiums for term life insurance are generally much less expensive than for other types of life insurance for the same amount of coverage. At the end of the coverage term, the policy either terminates or becomes an annually renewable policy, the latter of which is often cost prohibitive. It’s best to think of a term life insurance policy as being coverage only for the term you purchased. If you develop a health condition that would prevent purchasing another life insurance policy, it may be wise to keep your term life insurance policy in place even after the rates increase when the guaranteed term expires. In most other scenarios, the cost of term life insurance can be too high to justify after the guaranteed term expires.
One frequent criticism of term life insurance is that if you don’t make a claim during the policy’s coverage term, the insurance company keeps all your premiums, which can make you feel like you’ve paid for nothing. In truth, you’ve paid for coverage that may have been valuable to your family. The fact that your policy never paid out on a claim is good news because it means you’re still alive.
To provide lasting value in a term life insurance policy, many insurers now offer a return of premium term life insurance policy. As its name suggests, a return of premium term life insurance policy returns your premiums to you at the end of the policy term. This may seem too good to be true but there is a cost. A return of premium term life insurance policy has higher premiums than a standard term life insurance policy. However, depending on your ability to pay the higher premium, a return of premium term life insurance policy can often represent a better value and can be a way to create a forced savings for yourself.
Let’s say you purchased a 20-year return of premium term life insurance policy to provide protection during the early years of your mortgage when your mortgage balance is at its highest. If you never need to make a claim on your policy, at the end of 20 years, your insurer will refund the premiums you paid on the policy, which can then be used to pay off your remaining mortgage or for any other purpose you choose. Term options for return of premium term life insurance policies are often limited, with many companies only offering 20 or 30-year policies.
If you have a life insurance policy through your employer, it’s likely that this policy is a group term life insurance policy. A group term life insurance policy can be useful as additional coverage — and if it’s included as a free benefit, the price is certainly right. The potential downsides to group term life insurance policies are that you do not control the policy and you often do not control the coverage amount. Many group term life insurance policies provide a coverage amount equal to one- or two-years’ worth of earnings, which probably isn’t enough coverage to protect your family or beneficiaries. Additionally, your policy is at risk if you change employers. It’s best to think of group term life insurance as extra insurance instead of primary insurance.
While term life insurance is intended to provide coverage for a set amount of time, permanent life insurance is designed to provide coverage for your entire lifetime. There are several types of policies that can help you reach this goal. Expect most permanent life insurance types to have higher premiums than term life insurance policies.
Easily the most common type of permanent life insurance is whole life insurance, which combines a savings element with a life insurance death benefit. Because part of your premiums go toward a savings component that generates interest, your whole life insurance policy can build cash value. Your policy then gains characteristics that a term life insurance policy does not have. You can borrow against your policy and your policy can be sold. The cash value in your whole life insurance policy can also be used to pay premiums. It’s important to understand, however, that borrowing from your whole life insurance policy or using the cash balance to pay premiums can ultimately put your life insurance policy in jeopardy or reduce its value to your beneficiaries.
Another type of permanent life insurance is universal life insurance, which has some variants of its own. A universal life insurance policy has an investment element that can help build the value of the policy significantly when compared with other types of life insurance.
There are some risks and caveats with universal life insurance, however. It’s essential to keep the policy well-funded during its early years to be sure the policy stays healthy later in life. A universal life insurance policy contains both an investment element and an annually renewable term life insurance policy. Because an annually renewable term life insurance policy can become expensive as we get older, it’s important to fund the policy well so that the term life insurance within the policy can be paid through investment growth.
For most households, a simpler term life insurance policy combined with a whole life policy or final expense policy may be an easier-to-manage choice.
If you don’t need your life insurance policy to provide income replacement or if you want a life insurance policy to complement a term policy without reducing the benefit payout available for your family, a final expense life insurance policy can be a sound choice.
Typically, final expense insurance policies are only available for people 50 years or older, with some insurers having higher age requirements. Often, a final expense life insurance policy is easy to get when compared with other types of life insurance because the death benefit is designed to pay for final expenses and therefore is a lower coverage amount. You can find final expense life insurance policies with coverage amounts starting at $10,000 to as high as $50,000.
There are several rules of thumb for determining how much life insurance you need. The problem with rules of thumb is that they are arbitrary and may or may not apply in your individual situation. One such rule of thumb suggests that you should buy 10 times your annual salary in life insurance coverage. However, depending on your spouse’s income, the number of dependents you have, the age of your dependents, the amount of outstanding debt you have, and the age at which you might pass away unexpectedly – which can’t be predicted, 10 times your income might not be enough coverage – or it may be more coverage than you need.
A detailed approach that analyzes your own financial situation is a better way to choose a life insurance coverage amount. Often, it’s best to think of life insurance as providing for two distinct goals. Let’s assume that you plan to purchase a term life insurance policy. You’ll need to provide for your final expenses as well. A funeral combined with lingering medical bills can easily cost tens of thousands of dollars, which can diminish the value of your term life insurance policy as income replacement for your family. A final expense insurance policy or a small whole life insurance policy can accomplish the goal of planning for final expenses, which can also be particularly useful if you die after your term policy has expired.
Consider how long your family or beneficiaries will require replacement income and budget to replace about 80% of your income with your life insurance policy. The lower amount accounts for one less person in the household, which reduces some living expenses.
If you make $50,000 a year now and you think your family will need your income for the next 20 years, a policy that can provide $40,000 of income for the next 20 years seems like a sensible starting point. With just this consideration, you’ll need an $800,000 life insurance policy. Because the death benefit can be invested, it may be possible to choose a smaller coverage amount.
However, you might also want to budget for outstanding debt. Many households still have mortgages, car loans, credit card debt, or other types of debt, which you may not want your family to be burdened with if you pass unexpectedly. If you choose your coverage amount based on income replacement, be sure to factor debt service into the income needs for your family or beneficiaries. Alternatively, you can add debt amounts to your life insurance coverage amount as a lump-sum. Using the example above, your $800,000 policy might become a million-dollar policy.
For some households, the primary goal of life insurance is to secure the house and other assets so that surviving spouses or beneficiaries don’t have to struggle or sell assets if you pass unexpectedly. If this is the case or if choosing a higher coverage amount is price prohibitive, a smaller coverage amount that is enough to retire your debt is a better option than not buying life insurance at all.
Life insurance rates are closely associated with age because the older we get the more risk there is of death and the more likely it is that the policy will pay a benefit in the short term. Therefore, life insurance rates go up each year if you don’t yet have a policy in place. Waiting until after your next birthday will typically be a more expensive decision regarding monthly premiums than purchasing a policy now.
Health considerations also play a large role in life insurance rates. It pays to take care of your health not just regarding your own longevity; your life insurance rates will usually be lower as well. Smokers can expect to pay more, as well as those with pre-existing health conditions or those who are overweight.
Of course, the coverage amount that you choose for your life insurance policy also plays a role in the premiums for your policy. A higher coverage amount typically results in higher premiums.
Believe it or not, credit can also play a role in life insurance rates. In most states, your credit history can significantly affect your insurance rates for auto, home, and even life insurance. Using credit responsibly can save you money not just in interest expense, but also on your insurance premiums.