The Basics of Life Insurance
When you buy a life insurance policy, you are making an agreement with an insurance company to pay a monthly premium in exchange for a payment (or “death benefit”) to your beneficiaries at the time of your death.
You can purchase a life insurance policy that lasts for just a few years or for your entire life, with death benefits ranging anywhere from several hundred dollars to several million dollars.
Why Do I Need Life Insurance?
If you were to die unexpectedly, would anyone in your life be financially impacted? If the answer is yes, you might want to consider a life insurance policy.
Life insurance helps protect the people in your life who need you the most. Legally, your beneficiaries can use a death benefit payout any way they wish. A life insurance death benefit is meant to replace the income of the policyholder, so beneficiaries can use the payout on whatever expenses they have after the death of the policyholder.
Final expenses, including the cost of a burial or cremation, can cost a family upwards of $10,000.1 Many people dedicate a portion of a life insurance payout to covering these costs. Some other common uses for a life insurance payout include:
- Paying off debts
- Making mortgage payments
- Paying funeral costs
- Setting up an inheritance
- Paying estate taxes
- Paying medical bills
- Maintaining a certain standard of living
Types of Life Insurance Policies
Life insurance comes in many forms, but it helps to first understand the two major types: term life insurance and permanent life insurance.
Term Life Insurance
Term life insurance covers the policyholder only for a predetermined amount of time (known as the policy’s “term”). Terms typically last from 5 years up to 40 years, and insurance companies will only pay a death benefit if the policyholder dies within the limits of the term.
These types of policies are designed to help cover your loved ones’ financial needs when they are the greatest. For example, a term life insurance policy can help ensure that, in the event of your death, your kids can pay for college or your spouse can continue paying the mortgage. Once your family grows up and your need for insurance decreases, you can choose to let the policy expire or you may be able to renew it for a higher premium.
On average, term policies are the most affordable type of life insurance on the market.
Permanent Life Insurance
Permanent life insurance stays in force for your entire life as long as your premiums are paid on time and in full. Unlike term life insurance, it builds tax-deferred cash value over time.
A portion of the premium payments is designated for the cash value component. Value can build over time and at different rates, depending on the type of permanent policy you have.
While you are still alive, you may be able to access the cash value of the policy. This can be used to pay premiums, or may be accessed via loans or withdrawals. Policy loans and withdrawals will reduce cash values and death benefits, and may cause the policy to lapse. Additional premium payments may be required to keep the policy in force. Withdrawals may be subject to a surrender charge. Withdrawals and any unpaid loans are subject to ordinary income tax and, if taken prior to 59 1/2, a 10% federal additional tax.
Permanent life insurance policies typically cost more than term life insurance policies.
How Much Coverage Do I Need?
You can purchase a life insurance policy with a payout as small as a few hundred dollars and as large as a few million dollars. How much life insurance you should buy depends on what financial burdens your loved ones will have once you’re gone, as well as how much you can afford in monthly premiums.
Financial professionals will often recommend purchasing a policy for eight to 10 times your annual income,2 but the exact amount you need depends on several different factors, including your current savings and total outstanding debts.
Your age will also play a factor in what kind of policy you can buy and how much you should apply for.
You can keep learning about how age will affect your search for life insurance with the next article in this series: Life Insurance For Every Age.