If you worry that your family will fall into dire financial straits if something happens to you, there may be a solution—life insurance.
Life insurance can be an investment in your family’s future and may even improve your investment portfolio. If you worry about the cost of a life insurance policy or see it as an unnecessary expense, you’re not alone. But as long as you pick the right type of policy for your needs, get sufficient coverage, and can afford the premiums, the benefits can outweigh the drawbacks, especially if other people depend on you for support.
What Is Life Insurance?
You purchase home insurance to repair or replace your home if calamity strikes. Life insurance can’t restore or replace your life, but it can ensure that your family doesn’t face a financial disaster if you die.
When you purchase a life insurance policy, you make a contract with the insurance provider. You agree to pay the policy’s premium and the insurer agrees to pay a death benefit to one or more of your chosen beneficiaries should you die during the policy term.
Term life insurance covers you for a specific period of time, while permanent life provides coverage throughout your lifetime. Term life only pays a death benefit, while permanent life insurance also incorporates a savings element, known as the cash value.
Your age and health history are major factors carriers use to determine your rate, or cost of insurance, so it’s best to purchase term life insurance while you’re young and healthy.
General Benefits of Life Insurance
If you have unlimited liquid assets, you might not need life insurance. But most people can benefit from the protection that life insurance provides. The most common reasons people buy life insurance are to:
- Cover estate taxes: If your estate is subject to federal or state estate taxes, your beneficiaries can use the proceeds of your life insurance policy to help pay for them, avoiding the need to sell assets.
- Create an inheritance: People who don’t have a lot of assets can purchase life insurance to create an inheritance for their children or other loved ones.
- Establish a savings fund: Permanent life insurance policies build a cash value over time, which you can borrow against or withdraw from. For instance, you could borrow against your policy’s cash value to make a down payment on a home, pay your child’s college expenses, or take a dream vacation.
- Make a charitable contribution: You can make a posthumous contribution to your favorite charity by naming it as the beneficiary of your life insurance policy.
- Pay final expenses: Life insurance can help pay final expenses such as funeral and burial costs. You can relieve your loved ones of these potentially costly expenses by buying a life insurance policy.
- Pay outstanding debts: The death benefit of a life insurance policy can help your survivors pay off outstanding debts, like credit card bills, a mortgage, or personal loans.
- Replace income: Many couples depend on two incomes to maintain their lifestyle. A life insurance policy can ensure that your partner or spouse can continue their life after you're gone by providing a sum to replace your income.
- Pay for child care: In cases where one parent works and the other rears children, a life insurance policy can replace the expense that would be incurred to care for children if the stay-at-home parent passes.
- Provide for dependents: Life insurance can pay for a college education, or other life goals, for your dependent children or grandchildren if you die before they reach the milestone. If your dependents stand to lose employer- or government-sponsored benefits upon your passing, they can use the life insurance pay out to replace them.
- Enhance inheritance: Utilizing life insurance can greatly increase the amount you're able to transfer to your beneficiaries if wealth transfer is an important goal for you. Cash in the bank or RMDs from an IRA can be used to fund an insurance policy and potentially multiply the inheritance.
Some carriers offer accelerated death benefit endorsements, at an additional cost, which allow you to use part of the death benefit if you become terminally ill. This can help pay medical costs, but reduces the amount your beneficiary receives after you die.
Benefits of Term Life Insurance
Term life insurance has a few main advantages relative to permanent coverage.
It Costs Less
Because term life insurance only pays a death benefit and doesn’t build a cash value, it’s often a more affordable option. For example, we requested term life insurance quotes from Farmers Insurance for two healthy females, ages 20 and 50. The 20-year-old could purchase a 10-year, $250,000 policy for $12.06 per month, while the 50-year-old could get the same policy for $38.93 per month. As we'll see in the Disadvantages of Permanent Life Insurance section below, these amounts are at least 10 times cheaper per month than permanent life policies would cost.
It Provides Temporary Protection
Some insurance needs don’t last a lifetime, and for these, term insurance can be a perfect fit. For example, if you have 15 years left on your mortgage, and still owe $100,000, you could purchase a 15-year, $100,000 term life policy. Or, if you anticipate paying $50,000 to send your child to college, you could buy a $50,000 term life policy that would last until they finish their education.
It Can Be a Tax-Advantaged Employee Benefit
Term life is an affordable way for employers to offer life insurance as a tax-advantaged fringe benefit to employees. Employer-sponsored term life plans vary, but some offer coverage at a lower rate than a personal life insurance policy, and some employers cover all or part of the premiums.
For employees, the IRS excludes the cost of the first $50,000 of group term life coverage from taxation as a fringe benefit. (For coverage in excess of $50,000, the cost of that coverage—as determined by the IRS—is taxable as a fringe benefit to the employee.)
Disadvantages of Term Life Insurance
Term life’s low cost and flexible terms make it an attractive form of coverage for many people, but this type of insurance has a few disadvantages when compared to permanent life insurance policies.
No Lifetime Protection
Once the term ends, so does your coverage. However, some term life policies allow you to renew your coverage at the end of the contract, usually at a higher rate. But you can’t renew a term life policy indefinitely. If you want to be covered once the term expires, you need to apply for a new policy, likely at a much higher rate than the previous one.
If you develop a serious health issue while you have a term policy in force, you’ll be covered for the duration of that policy, but may not be able to get another policy once the term ends.
Not Available After a Certain Age
Typically, providers don’t offer term life coverage after a certain age, usually around 80, according to the Insurance Information Institute. So, if your 20-year term life policy ends when you’re 73, you won’t be able to renew it. At this age, buying a permanent life insurance policy is not a practical option for most people.
No Cash Value
Since it isn’t designed to last a lifetime, term policies don’t build a cash value, or have an internal savings component: Once you pay premiums, in most cases, they’re entirely gone. Some policies include a return of premium feature, which pays back a portion of your premiums, unless you die during the term. However, these types of term life policies usually cost significantly more than regular term coverage.
Benefits of Permanent Life Insurance
Permanent life policies, like term policies, pay a death benefit to your beneficiaries upon your death. They have additional features and benefits not available in term policies.
Unlike term life insurance, permanent life policies don’t limit your protection to a certain number of years. As long as you pay sufficient premiums, your policy can last a lifetime. This can be especially beneficial if you develop a health issue while insured that would prevent you from qualifying for another policy.
Builds Cash Value
Any gain or interest earned on your policy’s cash value grows tax deferred. The cash value is used to offset the cost of insurance as you and your policy age and insurance costs increase, but it can also be accessed.
After you accumulate a cash value, you can borrow against it or withdraw from it, though doing so could have a negative effect on the policy. Always talk to your insurer before making a withdrawal from cash value or taking a loan against it.
A permanent policy incorporates both a savings element (cash value) and an insurance element (death benefit). These amounts are subject to requirements from Section 7702 of the Internal Revenue Code.
Premiums and Death Benefit May Be Flexible
Some permanent life policies give you the option to alter your premium payments, increase your death benefit, or both. However, you may be required to provide evidence of insurability if increasing the death benefit, or face value.
Different Policy Types
Traditional whole life, universal life, indexed universal life, and variable life policies are types of permanent policies that are structured differently. One of the most apparent differences between them is how the cash value is treated. Some policies allow you to invest the cash value in mutual funds (variable life), while others credit interest according to the performance of a market benchmark like the S&P 500 (equity-indexed life), while others may credit a money market rate of interest (universal life).
Disadvantages of Permanent Life Insurance
Permanent life insurance policies have disadvantages (relative to term policies) to be aware of as well.
Permanent life insurance costs more than term life, especially in the early years of coverage (relative to comparable term policies). The same healthy 20-year-old and 50-year-old discussed above would pay $129.13 per month and $456.60 per month, respectively, for a $250,000 whole life policy.
Since permanent life insurance builds a cash value, a portion of premium payments goes into the cash value.
This is roughly $122 and $418 more, respectively, than what they’d each pay for a 10-year term policy with the same amount of coverage. Although the quotes we received don’t necessarily reflect what you’ll pay for a policy, the comparison does illustrate the sizable price difference between term life and whole life insurance.
Poor Returns Can Reduce Death Benefit or Cause Policy Lapse
The cash value earnings of any universal life insurance depend on how well cash-value investments perform, or the rate of return the cash value receives. For example, variable universal life insurance enables you to invest in bonds, money market mutual funds, and stocks. But if your investments perform poorly, you run the risk of decreasing your cash value, your death benefit, and the policy lapsing.
Permanent policies frequently have a “surrender period” during which time any surrender of the policy (cancellation) or withdrawal from the cash value will result in a charge—usually a percentage of the amount withdrawn, according to a pre-set fee schedule in the policy documents.
Surrender periods typically last anywhere from one to 15 years, with the percentage charged reducing each consecutive year. For example, a policy with a five-year surrender period might charge 5% for withdrawals during the first year of policy ownership, 4% during the second, and decrease to 1% during the fifth year until 0%, or no fee, would be charged from the sixth year onward for policy withdrawals or cancellation.
Insurance companies are required to honor a “free look” period after you buy a policy during which you can “return” it for a full refund of any premiums paid. The period differs by state, but may be no less than 10 days and no longer than 30.
Can Become an MEC
Although permanent life insurance policies can build a tax-deferred cash value, they may convert to a taxable modified endowment contract (MEC) if you don’t follow IRS guidelines. In an MEC, cash value distributions are taxed as income first, as opposed to basis first, and may be subject to an additional 10% tax if you’re under 59 ½. To avoid this, you must stay within the guideline premium limitation established by the IRS for your policy’s level of coverage.
In other words, if you increase your premium payments in a universal life policy to accelerate the accumulation of cash value, but pay more than the IRS threshold for your policy’s coverage level, you may inadvertently convert it to an MEC.
When we say that distributions are taxed as income first, rather than basis first, that means that any amount you access from the cash value will be taxed as income up to the amount of gain in the policy. For a policy that isn’t considered an MEC, you can avoid taxation on distributions.
The Bottom Line
Term and permanent life insurance can work in combination or individually to satisfy specific insurance needs throughout your life. Permanent life policies provide a lifetime of protection, build a cash value, and can create an inheritance for the people you most love. Term life costs less than permanent life insurance and can add an important layer of financial protection during periods in your life when you need it most. Term life is adequate for the vast majority of people.
Assuming you have dependents or don't have enough savings to cover your funeral costs, it may make good financial sense to protect your loved ones’ future with an appropriate life insurance policy.