Life Insurance Basics
Life Insurance should be simple. If I die, I would like my loved ones to have money to pay for funeral expenses and help them replace my lost income. Yet, like many financial products, it has grown into an ugly, complicated mess of a product that confuses everyone. I won’t use this post to explain the details of every life insurance policy that is available on the market. Instead, I want to focus on who needs life insurance and the main differences between a term policy and whole life policy.
Do you need life insurance? Here is what you should consider. Do you have enough to cover the cost of your funeral when you die? Funeral costs usually start around $5,000 and go up from there. More importantly, does anyone in this world depend on your income? This could be a spouse, children, or someone else that you provide for. You should have enough coverage to help them maintain their current lifestyle without having to worry about paying the bills. A good rule of thumb is a policy that would be able to match your income for at least 10 years. That equates to a $1 Million policy if you earn $100,000. Finally, how much money do you have? Let’s say your spouse works, you have $1,000,000 in assets, and all your children have graduated from college. There probably isn’t a need for you to have life insurance at this point. You may still want some coverage for other financial goals, but it isn’t a necessity at that point.
Now let’s go over the two types of life insurance.
Term Life – This is the simple type of policy to understand. You buy a policy for a set amount (premium) per year that you can keep it for a defined number of years (term). The policy will pay out if you die. If you live longer than the defined term, you would have to purchase a new policy. It’s simple and straight-forward. For example, I buy a 20-year policy with $1,000,000 coverage. I would pay an annual premium until the 20 years are up. If I die during that time, my beneficiaries would receive $1,000,000.
Whole Life – The main difference with whole life is right in the name. It lasts your whole life. The premiums are significantly higher, but the policies are more than just insurance. Whole life policies are set up to build up a savings/investment account within the policy. The earnings within the policy grow tax-free similar to a traditional retirement account. They are also permanent if you choose to keep it. The main downfall of these policies is the fees and cost that go along with it compared to purchasing a term policy. Also, if you build up $200,000 cash value within the policy, you can’t withdraw it unless you take it as a loan and pay interest or surrender the policy. The beneficiaries receive the policy amount when you die. That means that if you pay in for a long enough period, you have essentially paid extra fees to create a savings account for yourself. These are very complicated so make sure to do your research before buying a plan.
Another thing to consider before you run out to start shopping for insurance policies, check with your benefits at work. Most employers offer small life insurance policies to their employees that would be enough to cover funeral costs for you and any dependents. You can usually add additional coverage for a minimal cost as well. It probably won’t cover all your needs, but it is a good start.
Make sure to analyze your family situation before buying a policy. They can be extremely beneficial in case of a death, but they can also eat up a large portion of your cash flow if you buy something unnecessary. Stick to what you need for your loved ones and also allows you to accomplish all of your other financial goals.
-Mike Zeiter, CPA