Life Insurance 101

Despite life insurance being widely used, many misconceptions remain. Most people do not know what type of policy is right for them or when in their lives they will need coverage. This article explains everything you need to know about the basics of life insurance.

There are a few terms associated with life insurance that we should define:

  • the insured– the person on whom the policy is written
  • death benefit– the amount of money paid if the insured dies
  • premium- the cost of the policy. Premiums can be paid monthly, yearly, as an ongoing expense, or for a limited period
  • owner- the person who owns the policy. This can be the same person as the insured, another person, a trust, or a business
  • beneficiary– the person(s), trust, or business who will receive the death benefit

There are two broad types of life insurance: term and whole life. Term insurance is purchased for a specific number of years, such as 10, 20 or 30 years. The monthly cost typically stays the same for the duration of the term (“level term”). If the policy is in force when the insured dies, the beneficiary will receive the amount of the death benefit. Term life insurance is generally inexpensive for healthy young people- thus, the earlier you purchase a term policy the better. Most people are looking for a relatively inexpensive way to replace potential lost income for a limited number of years- therefore term life is the most common type of life insurance we recommend.

Term Life Insurance

The main difference between whole life and term insurance is that whole life does not expire. If the owner continues to pay the premium, the policy will stay in force throughout their lifespan and the death benefit will be paid when the insured dies. Whole life is more expensive than term and there are many different options or “riders” that you can add for additional benefits or provide different features- for an increased premium. While these riders increase the cost of whole life insurance, there are special situations that can make whole life with one or more riders an attractive option. The strongest example of this has come to light in recent years with the near disappearance of standalone long-term care insurance. Now available almost exclusively as a whole life rider, someone with a family history indicating a need for long term care insurance may look to whole life for the long-term care option.

Whole life is often marketed as a combination of an insurance policy and an investment. This is because there are whole life policies that offer a “cash value.” Think of the cash value as a savings account. The cash value is funded through “over payments” of the premium. That is- the owner of the policy pays more to the insurance company than the insurance costs. The excess amount accrues to the separate cash value account. The cash value will grow over time. The amount of growth you will receive varies according to the policy. Some policies pay a fixed rate of interest while others (“indexed” or “variable”) are tied to the performance of the stock market. It is important to remember that while these types of policies offer higher rates of growth while the stock market is doing well, the insurance company receives significant fees along the way, meaning that the returns received by policy owners are substantially less than the returns on comparable stock market index funds.

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Similar to annuities, gains in cash value life insurance policies are tax deferred, meaning you won’t need to pay taxes on gains on a yearly basis. However, if the policy owner decides to let the policy lapse and take out the cash value, the entire gain (the cash value in excess of the basis) will be taxed as ordinary income. Gains from insurance are not eligible for the preferential tax rates given to capital gains or qualified dividends. While the cash value element of whole life can be enticing, especially for those who have difficulty saving regularly on their own, it is important to remember that in most cases the cash value will not be paid to the beneficiaries in the event of the insured’s death.

The tax code usually allows beneficiaries to receive the death benefit tax-free. This is a major benefit for family members who have recently lost a loved one.  As is nearly always the case when it comes to taxes, there is an exception to this rule. Life insurance policies that are sold (also known as “transferred for value”) from one owner to another lose the income tax exclusion. This applies whenever the ownership of the policy is changed in exchange for something of value- typically cash. There are three exceptions to the transfer for value rule: 1) When the policy is transferred to the insured 2) When the policy is transferred to a partner of the insured (in a partnership) and 3) When the policy is transferred to a corporation of which the insured is an officer or a shareholder. Policies that are gifted (as opposed to sold) do not run afoul of transfer for value rules.

Major life events often trigger life insurance purchases: getting married, having a baby or buying a house. These are all great reasons to get a life insurance policy, but a mistake that is often made is that life insurance is frequently purchased only on the spouse that earns income or the spouse that earns the most income. Life insurance being used as an income replacement tool leads many people to only cover the working spouse or the spouse that provides that majority of the income. Although this will save you money on premiums, it might not be the best decision for your family.

Life insurance is a tool that can help you cover additional expenses that may arise after the death of a spouse. The greatest and most expensive example of this is childcare. If one spouse stays home and takes care of the children, it’s important to quantify the amount that the stay-at-home spouse contributes. According to www.care.com a family in the Lowcountry with two young children can expect to pay a $713 a week for a full-time nanny. This adds up to $37,000+ per year! That’s not a small expense to cover unexpectedly.

Surviving spouses also have increased expenses for other things like meal prep, house cleaning, yard work, laundry, etc. While the income might not change, expenses will likely go up. The potential for a big increase in expenses is an excellent reason to purchase life insurance and should be considered when deciding how much to purchase. If these additional expenses are your sole reason for life insurance, consider a term policy that will expire when these additional expenses will no longer be needed.

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Often, life insurance is also used to pay for burial, estate and funeral expenses. The average cost for a funeral is between $7,000-9,000 and although it may not be a reason to have a million-dollar life insurance policy, it is something to consider. Potential end-of-life medical expenses that may have arisen from an unexpected death can be covered with life insurance proceeds. The spouse that is left behind may find themselves with large medical bills and the death benefit from a life insurance policy could make a huge difference financially as the family tries to move forward.

During the transition, the surviving spouse may also need to take a prolonged period off from work. Life insurance can facilitate this, allowing them to take unpaid time off from work if they need to. A life insurance proceeds can provide a bridge that will allow the family to take their time before making big financial decisions and moving on.

It is not just about money.  Life insurance gives a family flexibility and stress reduction after losing a loved one. It can be used to help replace income, pay off debts, and cover unexpected or new expenses. Most importantly a life insurance death benefit can give people time. Time to grieve, time to figure out their options, time to adjust and make changes. Partner with your CERTIFIED FINANCIAL PLANNER™ to get advice on your personal situation. They will be able to recommend the type and amount of life insurance you should have in place for your family.