Many financial experts consider life insurance to be the cornerstone of sound financial planning. It is generally a cost-effective way to provide for your loved ones after you are gone. It can be an important tool in the following ways…
- Income replacement – For most people, their key economic asset is their ability to earn a living. If you have dependents, then you need to consider what would happen to them if they no longer have your income to rely on. Proceeds from a life insurance policy can help supplement retirement income. This can be especially useful if the benefits of your surviving spouse or domestic partner will be reduced after your death.
- Pay outstanding debts and long-term obligations – Consider life insurance so that your loved ones have the money to offset burial costs, credit card debts and medical expenses not covered by health insurance. In addition, life insurance can be used to pay off the mortgage, supplement retirement savings and help pay college tuition.
- Estate planning – The proceeds of a life insurance policy can be structured to pay estate taxes so that your heirs will not have to liquidate other assets.
- Charitable contributions – If you have a favorite charity, you can designate some of the proceeds from your life insurance to go to this organization.
How much life insurance do I need?
To decide how much life insurance to buy, you need to first figure out what your goals are in purchasing this coverage. Ask yourself the following:
- Do I want to spare my loved ones funeral costs and outstanding debts?
- Am I concerned that my spouse or domestic partner will not be able to continue to pay off the mortgage if I die suddenly?
- Do I have dependents who count on my income?
- Am I concerned about college savings for my children or retirement savings for my spouse if I die suddenly?
While all situations are different, here are two scenarios to help you think through the questions you should pose to your insurance professional:
If you have children, a spouse who does not work outside the home or aging parents who you financially support, you have dependents. Alternatively, you may simply have a spouse or domestic partner who would be unable to pay the mortgage without your financial contribution. In either case, your loved ones will no longer have your income to help them pay the bills and maintain their lifestyle after you are gone. You will have to purchase enough insurance to provide for their future, while considering how much of your budget should be devoted to life insurance.
Some insurance experts suggest that you purchase five to eight times your current income. While this may be a good way to begin estimating your family’s needs, you will also need to figure how much your dependents will need to pay for some or all of the following:
- Cost of owning a home (mortgage, maintenance, insurance, taxes and utilities)
- College savings
- Food, clothing
- Child care
- Nursing home or elder care
- Retirement savings
- Funeral expenses and estate taxes
Your family may also need extra money to make some changes after you die. They may want to relocate or your spouse may need to go back to school to be in a better position to help support the family.
If you are young and plan to have a family in the future, you may also want to consider purchasing life insurance now so that you can lock in a good rate.
Just because you don’t have dependents, does not mean you don’t have responsibilities. For instance, you may be concerned with not being an economic burden to others if you die unexpectedly. You may also want to leave some money behind to close family, friends or a special charity as a remembrance. In this case, you should purchase enough coverage for funeral and burial expenses, outstanding debts and tax liabilities, so that the bulk of your estate goes to your family, friends or charities.
Your insurance needs will vary greatly according to your financial assets and liabilities, income potential and level of expenses.
What is a beneficiary?
A beneficiary is the person or financial institution, (i.e. a trust fund) you name in a life insurance policy to receive the proceeds. In addition to naming a specific beneficiary, you should name a second or “contingent” beneficiary, in case you outlive the first beneficiary.
If there is no living beneficiary, the proceeds will go to your estate. If there are probate proceedings this could possibly delay your loved ones receiving the money. The proceeds may also be subject to estate taxes.
Picking a beneficiary, and keeping that choice up-to-date, are important parts of purchasing life insurance. The birth or adoption of a child, marriage or divorce can affect your initial choice of who will receive the death benefit when you die. Review your beneficiary designation as new situations arise to make sure your choice is still appropriate.
Pay special attention to the wording of your beneficiary designations to ensure that the right person receives the proceeds of your estate. If you write “wife/husband of the insured” without using a specific name, an ex-spouse could receive the proceeds. On the other hand, if you have named specific children, any later-born or adopted children will not receive the proceeds – unless the beneficiary designation is changed.
What types of life insurance are available?
While there are many different types of life insurance policies, they generally fall into two categories: term and permanent.
Term insurance is the simplest form of life insurance. It provides financial protection for a specified time, usually from one to 30 years. These policies are relatively inexpensive and are well suited for goals, such as insurance protection during the child-raising years or while paying off a mortgage. They provide a death benefit, but do not offer cash savings.
Purchasing term insurance is like renting a home. It is a short-term solution. Monthly costs are usually lower, but you will not be building equity. Just as many people rent (while saving to buy a home), individuals who need insurance protection now, but have limited resources, may purchase term coverage and then switch to permanent protection. Others may view term insurance as a cost-effective way to protect their family and still have money to put into other investments.
Term insurance can be a useful financial tool for:
- Those who need a large amount of life insurance, but have a limited budget, such as a young couple, with children.
- Covering debts that will disappear in time, such as a mortgage or car loan.
- Business owners who want to cover the life of a key employee for a specific number of years.
Keep in mind that premiums are lowest when you are young and increase upon renewal as you age. Some term insurance policies can be renewed when the policy ends, but the premium will generally increase. Many policies require a medical examination at renewal to qualify for the lowest rates. Before deciding on a policy, find out what the requirements are. Also, see if you would be able to convert the term policy to a permanent policy later on.
Permanent insurance (such as universal life, variable universal life and whole life) provides long-term financial protection. These policies include both a death benefit and, in some cases, cash savings. This type of insurance is good for long-range financial goals.
Purchasing permanent insurance is like buying a home instead of renting. You are taking care of long-term housing needs with a long-term solution. Your monthly costs may be higher than if you rent, but your payments will build equity over time. If you purchase permanent insurance, your premiums will pay a death benefit and may also build cash value that can be accessed in the future.
A permanent life policy provides lifelong insurance protection. The policy pays a death benefit whether you die tomorrow or you live to be a hundred. There is also a savings element that will grow on a tax-deferred basis and may become substantial over time. Because of the savings element, premiums are generally higher for permanent than for term insurance. However, the premium in a permanent policy remains the same; while term can go up substantially ever time you renew it.
In a permanent policy, the cash value is different from the face value amount. The face amount is the money that will be paid at death. Cash value is the amount of money that is available to you. There are a number of ways you can use this cash savings. For instance, you can take a loan against it or you can surrender the policy before you die to collect the accumulated savings.
There are unique features to a permanent policy such as:
- You can lock in premiums when you purchase the policy. By purchasing a permanent policy, the premium will not increase as you age or if your health status changes.
- The policy will accumulate cash savings. Depending on the policy you may be able to withdraw some of the money. You may also have these options:
- Use the cash value to pay premiums. If unexpected expenses occur, you can stop or reduce your premiums. The cash value in the policy can be used toward the premium payment to continue your current insurance protection – providing there is enough money accumulated.
- Borrow from the insurance company using the cash value in your life insurance as collateral. Like all loans, you will ultimately need to repay the insurer with interest. Otherwise, the policy may lapse or your beneficiaries will receive a reduced death benefit. However, unlike loans from most financial institutions, the loan is not dependent on credit checks or other restrictions.
- is that you lock in a certain rate for the period of the policy. The disadvantage is that rates will jump considerably if you want to renew with another level policy.
What types of permanent insurance policies are available?
- Whole or ordinary life – This is the most common type of permanent insurance policy. It offers a death benefit along with a savings account. If you pick this type of life insurance policy, you are agreeing to pay a certain amount in premiums on a regular basis for a specific death benefit. The savings element would grow based on dividends the company pays to you.
- Universal or adjustable life – This type of policy offers you more flexibility than whole life insurance. You may be able to increase the death benefit, if you pass a medial examination. The savings vehicle (called a cash value account) generally earns a money market rate of interest. After money has accumulated in your account, you will also have the option of altering your premium payments – providing there is enough money in your account to cover the costs. This can be a useful feature if your economic situation has suddenly changed. However, you would need to keep in mind that if you stop or reduce your premiums and the saving accumulation gets used up, the policy might lapse and your life insurance coverage will end. You should check with your agent before deciding not to make premium payments for extended periods because you might not have enough cash value to pay the monthly charges to prevent a policy lapse.
- Variable life – This policy combines death protection with a savings account that you can invest in stocks, bonds and money market mutual funds. The value of your policy may grow more quickly, but you also have more risk. If your investments do not perform well, your cash value and death benefit may decrease. Some policies, however, guarantee that your death benefit will not fall below a minimum level.
- Variable-universal life – If you purchase this type of policy, you get the features of variable and universal life policies. You have the investment risks and rewards characteristic of variable life insurance, coupled with the ability to adjust your premiums and death benefit that is characteristic of universal life insurance.