Buy enough life insurance to make up for the difference between what your dependents would have if you died and what they would need
The death of a loved one can cause surviving family members or dependents financial loss and hardship. Life insurance can cut or even eliminate such difficulties. It is a legal agreement between the insured individual and the insurer that guarantees payment of a death benefit to the selected beneficiaries. In exchange, the insured individual pays a premium during his or her lifetime.
Identify Your Needs
When buying life insurance, you select the amount the insurer will pay your beneficiary or beneficiaries if you die during the policy period. You get to choose whether the benefit is paid in installments or as a lump sum. The amount of coverage depends on what you want the insurance amount to do for your beneficiary. The majority of people buy life insurance to provide financial security for their family upon their death. If this is why you want insurance, your first step should be to determine your dependents’ likely financial needs in the future.
Married people should make sure the coverage is enough to provide for their partner after their death. If you have children who depend on you, you must consider the costs of college or other related expenses.
If your annual living expenses include car loans, mortgage and/or credit card debt you should buy more insurance than an individual who has no loans. You should also have enough coverage to pay for your final costs, such as hospital and burial costs.
Next, make a list of your sources of income and the assets the family would have if you were not alive at that moment. Your list can include the cash in savings and checking accounts, the value of bonds or stocks you own, home equity, and any benefits from Social Security.
The final step requires you to compare the total of your income and value of your assets with the total expected expenses of your dependents after your death. In ideal circumstances, buy enough life insurance to make up for the difference between what your dependents would have if you died and what they would need.
Types of Life Insurance
Term Life: Term life insurance provides coverage for a set period, known as the policy term, which starts and ends on particular dates. For instance, a 10-year policy term provides insurance coverage for ten years. Benefits are paid if the individual dies within that policy term. If you live past the end of the term without renewing the policy, the policy would expire, giving you no benefits or cash value.
Term insurance provides life insurance protection at the lowest cost. Yet, because the risk of dying increases with age, the premium will increase each time you renew your policy, until a point when it becomes unaffordable.
Pros
- Typically provides the highest death benefit for the least amount of premium.
- Policy period is flexible (you can buy for 1-, 10-, or 20-year term periods).
- You can convert it to whole life or another type of permanent insurance.
- Death benefit is not taxed.
Cons
- Gets more expensive to buy as you get older.
- You must renew it once the term ends to prevent losing insurance. Premiums are higher at each renewal.
- Does not pay interest and has no cash value.
Whole Life: Whole life insurance is a type of permanent insurance. It remains in force throughout your entire life as long as you pay the premiums. This type of insurance includes a death benefit with cash savings. Part of the premium pays for the death benefit; one part pays for the insurer’s profit and expenses, and another part goes into an account that generates interest with time. The latter part is called the policy’s cash value.
Once your policy’s cash value reaches a certain amount, you can borrow against the cash value by taking a policy loan. If you die before paying it back, the owed amount would automatically deduct from the death benefits that would go to your beneficiaries.
If you surrender this policy, the insurance company will pay back the cash value accumulated until that point — after deducting any unpaid loans or interest.
Premiums for whole life remain the same as long as the policy is in force. In the early years, that means your premiums will be higher than for a term policy with similar benefits because of the added savings feature. However, as you continue into middle age and beyond, whole life insurance costs less than a similar term policy.
Pros
- Normally, premiums do not increase with age.
- The policy protects individuals for their entire life.
- Death benefit is not taxed.
- Cash value grows on tax-deferred basis.
Cons
- Initial costs are higher than for term life insurance.
- You must make a long-term commitment.
- Dividends may decrease due to lowering interest rates.
- Cash value adds up slowly during the first couple of years. You can lose most of your money if you surrender the policy within the first three to five years of buying it.
Universal Life: Universal life insurance is similar to whole life insurance. It is a type of permanent insurance that contains a cash value element. In universal life, the premium goes into an investment fund managed by the insurance company. Every month, the insurer will deduct the costs of term insurance coverage and its administrative costs from this fund. Unlike whole life insurance, where rate of return on the cash value depends on the insurance company’s long-term investment portfolio, the interest earned on a universal life value depends on current market rates. As a result, when the market interest rate increases, the policy’s cash value increases too. This allows you to pay lower premiums, or perhaps even skip some premium payments entirely. However, if the current interest rates decline, you may have to pay a higher premium to ensure the policy remains in place.
Pros
- Provides greatest flexibility; policyholders can vary the timing and the amount of premium payments as well as the amount of coverage.
- Your investment component grows free of income taxes.
- Death benefit is not taxed.
Cons
- Premiums rise as you grow older.
- Cash value of policy and size of premiums are closely linked to market interest rates and can fluctuate depending on the general financial climate.
- Administrative costs are front-loaded, which means that the insurer deducts its administrative expenses from your premiums in the policy’s early years. This causes the cash values to build slowly through the initial years. You can lose most of your money if you surrender the policy during the first three to five years after buying it.
Variable Life Insurance:Variable life insurance addresses adverse effects of inflation on cash values and death benefits. In this type of permanent insurance, cash values and death benefits depend on the performance of assets in which the premiums are invested.
You will normally have many investment options to choose from, including money market funds, stock funds and bond funds. If the fund earns a profit, the amount of death benefit will increase. If the fund loses money, the death benefit will decline.
If you cancel the policy, you will get the insurance policy’s cash value.
Pros
- Provides various options for investment.
- Earnings are not taxed until you surrender the policy.
- Death benefit is not taxed.
Cons
- Death benefit might decline if investments lose money.
- Administrative costs are high and can reduce the overall return.
- While policy can be surrendered, the ability to borrow against the policy’s cash value might be limited.
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