Life Insurance

Life Insurance Basics

• What it is: A contract with an insurance company that provides your beneficiaries with a certain amount of money when you die.
• Pros: Beneficiaries are safeguarded from the financial impact of your passing; death benefits pass to beneficiaries income tax–free and may be estate tax–free; cash values grow tax deferred.
• Cons: Confusing products; high fees; agents may push products you don’t need.
• How to buy: From a local life insurance agent or online firm (check the company’s ratings with A.M. Best or other rating agency)
• Tip: In most cases, a term life policy (see below) is the way to go. As a general rule, policies should be worth seven to 10 times your annual income, or enough for your family to live off 4% interest earned on the lump-sum payout.

A life insurance policy, as noted above, is a contract with an insurance company. You pay premiums, and in exchange, the insurance company makes payments to your beneficiaries. These payments are known as death benefits, and they are generally income tax-free and may be estate tax-free. There are two primary categories of life insurance:

• Term life insurance: These policies offer protection for a specified period of time, typically between one and 20 years. Proceeds from term life policies are generally used to replace lost potential income during working years, providing a safety net for your beneficiaries. Premiums, which are based on your health and life expectancy at the time you apply for coverage, are guaranteed during the term. You may be able to continue coverage beyond the term – but you’ll pay a much higher premium. If, at any time, you stop paying the premium, the insurance stops. Term life policies pay a lump-sum benefit if you pass away during the policy period, but they don’t build any cash value. They are usually less expensive than permanent life insurance.
• Permanent life insurance: This type of life insurance combines a death benefit with a savings or investment account. These policies are intended to protect your beneficiaries as long as you are living, providing you pay the premiums. The premiums may be fixed or not, depending on your policy, and, like term life, they are based on your health and life expectancy. These policies accumulate some cash value through a savings or investment component, but they are generally much more expensive than term life policies.

Buying Life Insurance

Life insurance is a good choice if you have dependents to protect, who wouldn’t have enough savings to cover items like the mortgage, college tuition (either now or looming) and other bills if you were no longer around. When you purchase life insurance, you have to answer a couple of questions: What kind of insurance should I get, and how much insurance do I need?

Permanent life insurance policies (such as whole life or universal life) are often used by wealthy individuals as estate-planning tools to help preserve the wealth they plan on passing to their beneficiaries. These policies are substantially more expensive than term life, and, in most cases, are not the policy of choice unless your income is more than $250,000 a year or you have over $1 million in assets.

Term life insurance, on the other hand, is the way to go if your main goal is to protect your family against the loss of your income. These policies last a certain amount of time – such as 20 years – and after that, the need for the insurance is typically gone (i.e., the mortgage is paid off and the kids are through college).

So how much? One rule of thumb is that your policy’s death benefit should be seven to 10 times your annual salary. This is not very precise, but it does provide a good starting point. Another option is to calculate how much is needed for a lump-sum payout to create income for your family indefinitely. In this case, your family would live off the interest from your payout: The rule of thumb assumes 4% interest a year. So if you make $50,000 a year, for example, you would need $1.25 million in insurance for your family to maintain your “salary” ($50,000 ÷ 0.04). If you make $100,000 a year, you’d need a $2.5 million policy ($100,000 ÷ 0.04).

One other option is to calculate how much money your family would need to cover normal monthly expenses and pay off debts (for example, the mortgage and credit card debt), plus money to pay for your funeral and your children’s future education. See Is Life Insurance a Smart Investment? for more on this topic.