Life insurance is designed to protect your beneficiaries in the event of your death. The death benefit can help compensate a family for your lifetime income. It can also provide cash to pay any debts or business expenses you leave behind.
The basics of life insurance are easy to understand, but it can be difficult to know whether or when you need a policy of your own. It can also be hard to know how much coverage you might need. Here’s what you need to know so you can decide for yourself.
How Does Life Insurance Work?
Life insurance policies have three main characters:
- An owner or policyholder.
- The person whose life is insured. This is often the policyholder, but it doesn’t have to be.
- The beneficiaries who receive the death benefit. It can be one or more than one.
Life insurance provides a death benefit to the beneficiaries when the insured person dies; this is done in exchange for premium payments from the policyholder. Because your risk of death increases as you age, life insurance tends to be cheaper if you purchase it when you’re younger.
There are two main types of life insurance: term and permanent.
Term life insurance is in effect for a certain term. This is most often between one and 30 years. It will only pay out the death benefit if you pass away during that term. If you outlive the term, your beneficiaries will receive nothing from this kind of policy. Term life tends to be the least expensive type of life insurance.
Permanent life insurance covers you for your entire life. The insurer charges more in premiums compared with term life, but premiums can remain level, even though your risk of death increases over time. This is because a portion of the “additional” money you’ve paid to the insurer (relative to premiums you’d pay for a comparable term policy) builds up as a cash value. You can access it during the life of the policy.
That means this kind of life insurance can be used as a type of savings account. It could give you a source of income for later in life.
Why Buy Life Insurance?
There are several common reasons for buying life insurance, including:
- To replace your income for any dependents who rely on that income.
- To pay for funeral expenses and other final expenses.
- To provide a financial legacy for heirs.
- To pay estate or inheritance taxes.
- To provide a donation to a charity.
- To create a savings vehicle if there is, or may be, a life insurance need.
Who Needs Life Insurance?
Not everyone needs life insurance, but it’s important to figure out whether you do. You may need life insurance if:
You Have Dependents
The most common reason for buying life insurance is to protect your dependents from the loss of your income. If you have a spouse, children, or other dependents, the payout can help your family survive the financial impact of your death.
You Own a Business
If you're a business owner, you may need life insurance to help keep your business alive. It could also provide your heirs with the cash needed to disband or sell the business, or it could insure another employee who is key to the success of the business.
If you co-own a business with another person, each partner may need a policy that will allow them to buy out the other’s half of the business after their death.
You Carry a Great Deal of Debt
Most debts owed solely in your name must be paid off by your estate after you die. Co-signed loans become the co-signer’s responsibility if they pass away before paying the debts off. Dying while carrying debts could mean your estate goes entirely toward paying off your creditors. That could leave any loan co-signers on the hook for debts you agreed to pay. Life insurance can help pay off your debts so they won’t affect your heirs.
Federal and some private student loans are discharged upon the death of the borrower or the student who took them out.
You Want to Cover Your Burial Expenses
The median cost of a funeral with a viewing and burial was $7,640 in 2019. Life insurance can help cover the cost of your burial. That can help you feel secure knowing that your death will not be an added financial burden to your family, especially if you have any concerns about their ability to afford a funeral.
Final expense insurance tends to be affordable. This is a specific type of life insurance for burial expenses. The death benefit is fairly low; it's often in the $10,000 range.
How Much Life Insurance Do You Need?
The amount of life insurance you need depends on why you need the insurance. Be sure to keep these factors in mind when thinking about how much you need.
Enough to Support Your Family
People with dependents are often advised to purchase a life insurance policy equal to a multiple of their salary. This rule of thumb is a quick way to come up with an amount that will provide a few years of replacement income, but it’s smart to use this rough number just as a starting point. Then, be sure to take a deeper look into how much your dependents will need.
Think about how much other income they will be able to count on. How much non-salary income from your employer will be lost when you die? That could include things such as health insurance subsidies or retirement contribution matches.
What Your Heirs Need for Your Business
If you’re buying insurance to protect your business, you should think about these questions: How much money will your heirs need to take over or sell it? How much would you need to replace a key person upon their death? How much would any co-owners need to buy out your share?
Enough to Clear Your Debts
Life insurance shoppers who are concerned about leaving debts behind can calculate their death benefit based on the amount it would take to clear their debts after death. Those who wish to leave money to pay for their burial and other final expenses can fill out a funeral pricing checklist to estimate their needs.
In some cases, though, the amount of coverage you require will be greater than what you can afford. You may wish to address this by buying a combination of term and permanent insurance, or you may buy only term insurance. And another option is buying a term policy that you can convert to a permanent policy later.
Less Common Life Insurance Needs
On top of the most common reasons for buying life insurance, it can help cover some less common needs. These could include:
Buying a policy on a child can ensure that the family will financially survive the loss of the child, but keep in mind that such a loss is fairly unlikely. It can also ensure the child’s ability to qualify for life insurance in the future. That could be helpful in the case of a health diagnosis that might make it harder to pass the underwriting process.
Replacing Retirement Benefits
Life insurance is often marketed as income replacement for an insured person during their working years, but some retirees may choose to keep theirs after leaving work. It can be used to replace the loss of any retirement income for their spouse or any dependents.
Permanent life insurance can provide you with a potential income source. You can access your cash value once it has built up to a certain level. Some policies also allow for an accelerated death benefit, which allows you to access the death benefit while you're still alive in case of a triggering event. That could include being diagnosed with a terminal illness, needing extreme medical intervention, or needing nursing home care.
Is Life Insurance Worth It?
The decision to buy life insurance is personal. So many of the insurance calculations depend on your circumstances, financial situation, and future plans.
Even individuals who don’t currently have dependents, a business, or significant debt may want to look into getting life insurance. That’s because the cost will go up as you age, which means that right now is likely the cheapest time for you to buy a policy.
Even the best planners can’t predict the financial fallout of your demise. Carrying some life insurance can provide a layer of financial protection for your beneficiaries.
Thinking through the potential financial issues that could arise after your death can help you answer the big questions: when, and how much life insurance you should buy, if any.