Demystifying Life Insurance
Life Insurance
What you need to know
What is Life Insurance?
Life insurance is really pretty simple. You buy a policy. You decide on a “beneficiary.” That’s who will get the money if you die. It might be your spouse, your kids, or your taxidermist…anyone you want.
If you die while the policy is in force, the beneficiary is paid. There are many variations that we’ll get to later, but before we do, let’s ask an important question…
Do I need it?
Most of us need life insurance at some time in our life, but not necessarily all the time.
It totally depends on our circumstances.
For best results, talk to a financial advisor, since the financial planning process is the best way to determine your needs. In the meantime here’s some basics…
I’m single with no dependents. If no one depends on you financially, you probably don’t need any life insurance.
I’m married/partnered with no dependents. Okay, you’ve joined the club and are in a relationship. You may or may not need insurance. If you and your partner both earn money and the loss of one income wouldn’t hurt the other, then it may not matter.
I’m married/partnered with kids. You’ve joined the “I definitely need life insurance” club. Same thing goes if you are caring for parents or other dependents. If you’re gone, your dependents are going to need support.
I own a business. If you own a business, life insurance can serve as a very useful tool, to help the surviving business owner buy out the interest of the person who died. Talk to your financial advisor or accountant for help on this.
I’m retired. Once retired, you may not need life insurance unless you still have dependents. Or if you have a special needs child, you’ll probably always need it.
I’m financially set for the future. People who have been careful savers throughout their lives often have no need for life insurance, since they have accumulated enough wealth on their own to sustain their family.
How much life insurance do I need?
After figuring out if you need life insurance, your second decision is to figure out how much. Most people just pick a number that sounds good. However, unless you’re related to the Amazing Kreskin, that may not work too well.
The insurance industry recommends that you insure for at least 10 times your annual income. Ideally, you should get financial planning done to best estimate your needs.
In the meantime, you can estimate the annual income your dependents would need to maintain their standard of living if you were to die tomorrow. You can figure that out with the help of a calculator. To find one, google life insurance needs estimator and several options should pop up.
Keep in mind these are all estimates. No one can predict the future. If someone is totally incapable of supporting themselves, like a special needs child, you should definitely get the help of a financial advisor to make sure you’re estimating accurately.
Can’t the insurance company just tell me how much I need? Yes, but remember their representatives are paid on commission. It’s best to buy life insurance after doing some financial planning to see how much you need.
What kind should I buy?
Like most products today, you’ll likely have more choices than you want. The key is to only pay for what you need. Paying for bells and whistles is usually a waste of money. Despite all the names, there are really only two kinds of life insurance:
- Term (or “temporary” insurance)
- Whole Life (or “permanent” insurance)
You’ve probably heard of Term, or “Temporary,” insurance. This is actually straightforward, simple insurance. It’s like your car insurance. You buy it to cover one year. If you get in an accident during that year, the car insurance pays for it.
Term /temporary life works similarly. You insure your life for the course of a year. If you die during that year, the insurance company pays. If you don’t, the policy just expires.
With term, you insure your life for a fixed dollar amount (like $250,000). You also agree to a number of years, which gets you a fixed annual (level) premium for those years. If you start the insurance when you’re young, it’s cheap. However, if you start it when you’re older, it’s expensive, since there’s a higher chance you will die. If you die during the year, the face amount of the insurance (i.e. $250,000) is paid to the beneficiaries (whoever you named). If you don’t die during that term, the bad news is the policy expires unused. The good news is… you didn’t die.
Pros: Term insurance is pure insurance. It’s not an investment, it’s not a fancy product, it just does one thing effectively: Insures your life. It’s also very affordable when you’re young.
Cons: Term insurance gets expensive when you’re older. If you no longer need insurance anymore (because your investments can support your dependents if/when you die), that’s fine. But if not, it can get prohibitively expensive. If you MUST have life insurance, such as for a special needs child, term may present some problems later on due to cost if not started early.
This might be important if you know that you’ll need life insurance later in life.
I’d rather put my money into savings.
Along with the key benefit of having affordable premiums when you are older, whole life also forces you to save money. While it’s not the best way to save money, since the insurance company will make money off your investments first, it does force you to save. Similar to a mortgage where your required mortgage payments help you pay down and force savings, these policies do the same.
But the “savings” or investment part comes at a higher cost – high overhead.
Basically, whole life is structured so you pay the same annual premium every year. It doesn’t go up as you age (when you are more likely to die).
So what happens to the extra money I pay?
Because the premium remains the same as you get older, the insurance company charges you more in the early years. This extra amount goes into a reserve fund. Part of this reserve fund is used to pay the agent’s commission as well as the insurance company’s administrative costs. The remainder gets credited to your account, where it begins to earn interest, tax-free. Over time, this reserve creates a cash value that you can access in the future.
If you die with a whole life policy in force, the company pays your beneficiary the face value. There is also a cash value you can use while you’re alive, in a few ways:
(1) You can borrow money against it.
(2) You can purchase additional insurance with it or use it to pay your premiums.
(3) You can cash out: terminate your policy and just take the small amount of money built up.
While the features may sound good, you’re still paying for insurance so the fees and commissions will usually be considerably higher than for other types of investments that are not insurance. You are paying for that insurance feature.
Other types of Whole Life Insurance
Because whole and term are too simple, life insurance companies decided to create some more options, just to mess with all of us. (Okay not really, but sometimes it seems that way!) Two common ones are Universal Life and Variable Life.
What is universal life?
Universal life is a type of whole life policy. With universal, part of your premium pays for insurance, and another part is put into a separate account where it’s invested on your behalf. Universal is very flexible—you can change the amount of insurance you want at any time. And you can usually vary the premium payments. Similar to whole life policies, you will also build up a cash value over time.
What is variable life?
Variable Life is another type of whole life policy. It lets you invest part of the cash value in mutual funds through the insurance company. It really is variable—both the death benefit and the cash value will vary with how well your investments do. There is no guarantee on what you’ll get.
“Too many people spend money they haven’t earned, to buy things they don’t want, to impress people they don’t like.”
–Will Rogers
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