Life Insurance Basics

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Life insurance is one of those necessary expenses that we, ourselves, will never enjoy, outside of the peace of mind we will get knowing that our loved ones will be taken care of once we're gone. Here is some basic information about life insurance and how much you'll need.

Do You Need Life Insurance?

The main purpose of life insurance is to help ensure that your family and loved ones are protected against financial difficulties in the event of a premature death. The money your dependents will receive, the death benefit, is an important financial resource. It can help pay the mortgage, cover household expenses, and ensure that your dependents are not burdened with debt. The proceeds from a life insurance policy could mean that they would not have to sell assets to pay outstanding bills or taxes. Importantly, there is no federal income tax on life insurance benefits.

How Much Insurance Will I Need?

One rule of thumb is to buy life insurance equal to five to seven times your annual gross income. However, the following are a few steps you can take to determine how much insurance you will ultimately need:

  • Add up all of your debts, such as credit cards, mortgages, and student loans.
  • Add in final expenses, such as medical bills, burial costs, estate taxes, and attorney fees that may be owed.
  • Educate yourself about the basics of college tuition and calculate future education expenses for your children. It can be tricky to figure out how much these expenses will be, especially if your children are young.
  • Include everyday expenses, such as childcare, medical care, food, and clothing. Figure out what a year's worth of expenses are, and then determine how many years of expenses you would like to have covered.
  • Take an inventory of financial assets, such as retirement plans, stocks, bonds, mutual funds, and Social Security benefits. Do not include things like your home, automobile, or real estate holdings unless you have decided to sell them in the event of a premature death.

Types of Life Insurance

Term Life Insurance

Term insurance provides protection for a specific period of time. It pays a benefit only if you die during the term. Some term insurance policies can be renewed when you reach the end of the term which can be from 1 to 30 years. The premium rates increase at each renewal date.

Advantages of Term Life Insurance

  • Initial premiums are generally lower than those for permanent insurance, allowing you to buy higher levels of coverage at a younger age when the need for protection is often greatest.
  • It is good for covering needs that will disappear in time, such as mortgages or car loans.

Disadvantages of Term Life Insurance

  • Premiums increase as you grow older.
  • The policy does not generally offer cash value or paid-up insurance.

Permanent Insurance

Permanent insurance provides lifelong protection. As long as you pay the premiums, the death benefit will be paid. These policies are designed and priced for you to keep over a long period of time.

Permanent policies are known by a variety of names: whole, ordinary, universal, adjustable, and variable life. Most have a feature known as "cash value" or "cash surrender value." This feature, not found in most term insurance policies, provides you with some options. You can cancel or "surrender" the policy, in total or in part, and receive the cash value as a lump sum. If you surrender your policy in the early years, there may be little or no cash value.

Whole Life or Ordinary Life

This is the most common type of permanent insurance. The premiums generally remain constant over the life of the policy and must be paid periodically in the amount indicated in the policy.

Universal Life or Adjustable Life

This policy allows you, after your initial payment, to pay premiums at any time, in virtually any amount, subject to certain minimums or maximums. You can also reduce or increase the death benefit more easily than under a traditional whole life policy.

Variable Life

This policy provides death benefits and cash values that vary with the performance of a portfolio of investments. You can allocate your premiums among a variety of investments offering different degrees of risk and reward: stocks, bonds, combinations of both, or accounts that guarantee interest and principal. Learn more about the basics of savings and investing in this article.

The cash value of a variable life policy is not guaranteed and the policyholder bears the risk. However, by choosing among the available fund options, you can allocate assets to meet your objectives and risk tolerance. Good investment performance will lead to higher cash values and death benefits. If the specified investments perform poorly, cash values and benefits will drop.

Some policies guarantee that death benefits cannot fall below a minimum level. There are both universal life and whole life versions of variable life.

With all types of permanent policies, the cash value of a policy is different from the policy's face amount. The face amount is the money that will be paid at death or policy maturity. Cash value is the amount available if you surrender a policy before its maturity or your death.

Advantages of Permanent Insurance

  • As long as the premiums are paid, protection is guaranteed for life.
  • Premium costs can be fixed or flexible to meet personal financial needs.
  • The policy accumulates a cash value against which you can borrow; loans must be paid back with interest or your beneficiaries will receive a reduced death benefit. You can borrow against the policy's cash value to pay premiums or use the cash value to provide paid-up insurance.
  • The policy's cash value can be surrendered, in total or in part, for cash or converted into an annuity.
  • A Provision or "rider" can be added to a policy that gives you the option to purchase additional insurance without taking a medical exam or having to furnish evidence of insurability.

Disadvantages of Permanent Insurance

  • Required premium levels may make it hard to buy enough protection.
  • It may be more costly than term insurance if you do not keep it long enough.