Do I need life insurance? What is the best kind? How do I know the right amount to purchase? Life insurance can play an important part of your financial plan because it reduces risk, like the risk that your family wouldn’t have enough money if something were to happen to you. It can also serve to enhance estate planning and charitable strategies.
Do I need life insurance?
If you are young and don’t have any dependents, it’s unlikely you need life insurance. However, if you and your spouse own a home, have kids or other dependents, have a taxable estate or you have charitable aspirations, then life insurance might be an effective tool to protect your loved ones and the legacy you care about.
In the case of a taxable estate, insurance is put in place to offset the tax burden. For instance, death can trigger a sizable estate tax. However, if there is insurance, death also triggers the payout of a policy to cover that tax. When it comes to charity there are a variety of strategies involving insurance. It could be as simple as naming a charity as the beneficiary of the policy. Or, depending on your tax situation and other goals, you might consider putting a charitable remainder trust in place and augmenting your estate with life insurance.
What kind of insurance is right for me?
1. Term – Important factors to consider are the length of the insurance (a.k.a. the term), the face amount (the amount paid upon death) and the premium amount (how much you pay for the policy). It is a “pure” form of life insurance. You pay the premium and if the insured person dies the insurance company pays the beneficiary the amount of the policy.
The next two types of policies have a few more features. First of all, as long as the premiums are paid, the policy will stay in place. Coverage doesn’t stop after a certain number of years like a term policy. Additionally, there is a pool of money in the policy (known as the cash value). That money can be invested, borrowed against or withdrawn if you give up the policy (a.k.a. surrender the policy).
2. Whole Life – With a whole life policy premiums are generally kept the same for as long as the policy is in place. That means that when the person is younger premiums are relatively high (particularly in comparison to term policies). It’s also important to understand that the cash value is not in addition to the death benefit. If you borrow against the cash value and haven’t paid that back at the time of death, the amount that would have been paid out will first go toward paying off the loan then the remainder would go to the beneficiary. Over the life of the policy one concern is that the cash value won’t keep up with inflation or other savings options. One of the disadvantages of a whole life policy is they tend to be inflexible.
3. Universal Life – This is where an investment component comes in. With a universal life policy the cash value can be invested in insurance company sub accounts. Therefore, the cash value can fluctuate (either up or down) more than in a whole life policy. Unlike whole life insurance, the premiums and death benefit of universal life insurance are flexible. However, depending on the performance of the sub accounts, you might have to pay higher premiums than you initially anticipated to keep coverage in place. You could also lower the death benefit, but that can also be problematic.
I view the cash value and investment component of whole and universal life as types of planning strategies that are best addressed outside of an insurance policy given the cost benefit tradeoffs. Of course, there are exceptions but this generally applies, which is why I recommend term insurance to the majority of clients. What I’ve outlined above are the basics. There are other bells and whistles (a.k.a. riders) that can be added to a policy to tailor it to your needs.
What is the right amount of insurance to purchase?
Although I don’t sell insurance, I often create an insurance analysis for clients to answer this very question. The types of things I consider are the following; How much money will survivors need to maintain their current living expenses? Do you have a mortgage? How much paid help would a spouse need to raise children? Do you want college tuition to be covered by the policy? We also have to factor in rising costs and inflation when making this calculation. I like to add a “buffer” (about 10%), but too much coverage isn’t an effective use of funds either.
I recommend purchasing insurance from a broker (vs. a captive agent who only sells one company’s products) so that you receive competitive quotes from various insurers. Another important item to note is that if you think you can’t get life insurance because of a medical condition or chronic disease, you might still have options. This article mentions insurers who specialize in specific areas of coverage.
Be sure to consider life insurance as part of your overall financial plan. It is a useful risk management tool and can give you and your loved ones peace of mind.
This post was written by SaveUp’s personal finance contributing writer, Catherine Hawley, CFP®.