When we think about financial planning for our future, saving and investing are typically the two words that come to mind. However, to create genuine security for your loved ones, you must manage risk and mitigate worst-case scenarios. Life insurance prepares you for the event of a breadwinner’s untimely death and ensures that surviving family members have immediate and long-term resources for day-to-day living.
While most people understand the benefits of life insurance, it remains one of the least understood aspects of long-term financial planning. The number of Americans who believe they don’t have enough life insurance has more than doubled since 2010, with women twice as likely as men to lack life insurance. In this article, we’ll talk about what life insurance is, what it covers, the types of life insurance, and how much you need.
What is life insurance?
Life insurance is a contract you sign with a life insurance company, which states that in exchange for premium payments made by you either monthly or annually, the insurance company will pay a lump sum to a named beneficiary in the event of your death. The life insurance policy is the document that the insured signs and the policy’s death benefit refers to the lump sum.
A life insurance policy provides security and peace of mind. Suppose you’re the family breadwinner and die without taking out a life insurance policy. In that case, you leave your family in the difficult position of figuring out how to continue paying bills and dealing with their grief. A life insurance policy gives out a lump sum to the beneficiary, not subject to federal tax. It allows them to use the money for whatever purpose they see fit, including paying bills, putting money towards a mortgage, settling existing debt, or paying funeral expenses.
Research from the Insurance Information Institute shows that 68% of people with life insurance feel financially secure, with that financial security number rising to 78% when they have both employer-based and individual life insurance policies.
The terms of a life insurance policy
The terms of a life insurance policy differ by company, and state laws regulate insurance policies differently. Working with a life insurance professional or legal advisor may be a good idea when putting together your policy.
Some of the terminology you’ll encounter when taking out life insurance include:
- Insurer: This is the company that provides life insurance.
- Policyholder: The person or entity (such as a business or trust) who has taken out the policy.
- The Insured: The person whose life is insured.
- Death benefit: The amount of the lump sum that is paid upon the death of the insured person.
- Beneficiaries: The person, people, or entities that receive the death benefit.
- Premium: The annual or monthly payment for the policy to remain in place.
- Cash value: Some life insurance policies, such as whole life policies, include a cash value component that grows on a tax-deferred basis.
Why you need life insurance
If you’re making an income and have dependents who rely on that income, you need life insurance. 42% of American households would encounter significant financial difficulties within half a year if they lost the primary wage earner in the family, and 28% would reach this point in only a month. A life insurance policy can be helpful for other reasons as well. Let’s talk about a few.
Financial support: If you have a family, such as a spouse or kids, it’s imperative that you take out life insurance to cover expenses and cash flow upon your passing. While this is particularly important if you’re the sole breadwinner, life insurance can be beneficial even if you’re not. If two spouses contribute to a household, one partner’s death can put additional financial pressure on the family, making it difficult to manage.
- Pay for taxes and final expenses
Upon death, individuals may incur taxes such as death duties, estate taxes, and inheritance taxes. Plus, funeral costs, debts, long-term care expenses, medical expenses, and other end-of-life bills can quickly add up. The lump sum from life insurance can help pay for all of these.
- A source of savings
Some life insurance policies come with a cash value against which you can withdraw. If you already have a whole-life policy, your premiums contribute towards savings you can cash out later, even though there are better ways to invest your money.
What does life insurance cover?
Life insurance covers all causes of death, with certain conditions. The policy may also not pay out if there’s misrepresentation by the policyholder, such as withholding health information. The limitations you’ll find in a life insurance policy include:
- Lapsed term or payments: Term life policies cover the policyholder for a certain number of years, after which the life insurance coverage ends. For all policies, if you fail to pay your premiums on time, your policy will lapse.
- Withheld information: There is a two-year contestability period with life insurance policies, which means that if you die within two years of taking out a policy and the insurer finds that you’ve intentionally misrepresented vital information, they can deny the death benefit payout.
- Suicide: Many life insurance policies will not cover death by suicide for the first two or three years of the policy.
Types of life insurance
There are two different types of life insurance policies.
Term life insurance
The term life insurance policy is the most popular type, partly because of its affordability and partly due to the simplicity of the contract. You can take out term life insurance for 10, 20, or 30 years, and after the term of the policy ends, your coverage will also end. With term life, you have a few insurance products to choose from.
- Decreasing term life: This is renewable term life insurance in which the death benefit decreases over the policy’s life. These policies can cover financial needs that decrease over a period of time, for example, a mortgage.
- Convertible term life: This policy starts as a term life policy with the option to convert to a permanent insurance policy with a cash value in later years.
- Renewable term life: With renewable term life insurance, you can renew the policy at the end of the contract without additional documentation.
Permanent life insurance
Permanent life insurance remains in effect for the insured person’s entire life. Permanent life insurance policies come with a cash value; they have an investment portion that grows at a guaranteed rate. The types of policies in permanent life insurance include:
- Whole life insurance: In addition to a fixed lump sum paid out on the insured’s death, the entire life insurance policy also has a cash value component, which grows at a guaranteed rate of return and pays out tax-free dividends. You can use the dividends to reduce premium payments or add them to the cash value to receive additional interest.
- Universal life insurance: The universal life insurance policy is a type of permanent life insurance that allows you to change your premium payments and death benefit under certain conditions.
- Indexed universal life insurance: These are the same as universal life policies. The critical difference is that the policy’s cash value portion is based on an index like the S&P 500.
- Variable universal life: Again, the variable life insurance is similar to how the universal life insurance works. The main difference is that the cash value has investment accounts you can choose and manage.
How to buy life insurance
To ensure sufficient coverage for your family in a worst-case scenario, you must understand the policy terms and your needs and requirements when looking at life insurance options. Keep the following in mind:
Step 1: Determine how much you need
How much life insurance you need will depend on several factors, including how much you still owe on your house, what your monthly expenses add up to, and whether you need to cover your children’s college tuition. You may not need as much insurance if you already have sizeable assets. However, if your family depends on your income to pay the bills, you want to cover those through your policy.
Step 2: Understand what determines your coverage amount
Your insurance rates and premiums will depend on various factors, such as your age and health. It’s important to factor these in when determining your coverage because if you’re in good health, for example, you can get more coverage for the same amount than someone with recurring health problems. Before finalizing the policy, you may be required to undergo a medical exam. Some factors that influence your coverage include:
- Overall health
- Family medical history
- Driving record
Step 3: Get quotes and compare policies
It may surprise you to note that, according to a study by LIMRA and Life Happens, 8 out of 10 consumers overestimate the cost of life insurance. If that’s you, get life insurance quotes from several insurers so you can get an accurate figure for what it will take to protect your family. Choose the best life insurance by considering premiums and death benefits.
The bottom line
If you want to secure your financial future, you need three pillars to keep you stable. The first is earnings. The second is investment. And the third is insurance. By taking out insurance, you ensure that the earning and assets you’re working so hard to set up can continue to benefit your family in the eventuality of your death.
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