Life insurance is an important part of the financial picture for many investors and savers. And yes, it offers protection, but it can do more in the right circumstances and for the right policyholders. So how can it meet varying needs, and how can it play a role in a well-thought-out financial plan? While of course, there are no one-size-fits-all answers, we raise and answer six key questions here that prospective or current life-insurance policyholders should ask.
1. Do I need life insurance?
Although life insurance can provide benefits in addition to helping protect beneficiaries after the policyholder’s death, the death benefit is usually its reason for being. In general, if you don’t have family members or others who are financially dependent on you, you can probably ignore life insurance and put the money you’d otherwise spend on premiums to better use. (After all, whom would you name as a beneficiary?)
A further note: Couples might consider insuring each other, even if one earns much less or isn’t in the workforce. He or she may provide services to the family that would require a substantial outlay of funds to replace.
2. When is the best time to buy life insurance?
There’s no “right” answer here. You’ll often hear that the earlier you buy insurance the better. For example, a 30-year-old man might buy a 30-year $500,000 term policy (we’ll get to term vs. other life-insurance types in Question # 4 below) for an annual premium in the neighborhood of $375. When he reaches the age of 50, the same policy might cost him $1,500.1
But in either case, the questions he needs to answer are whether he can afford the premiums, whether he has ample funds from other sources to protect his loved ones, and whether he’d be better off investing the funds instead—since the longer his funds are invested, the more time they’ll have to grow.
You should discuss your unique trade-offs with a financial expert. But bear in mind that, absent other assets, you should probably have insurance at least by the time you buy a home (if you do) to cover mortgage payments in the event of your death.
3. If I need life insurance, how much should I buy?
Determining how much life insurance you need depends on a host of factors, including your age, the state of your health, how many dependents you have and how old you are, how much you have in other assets, your debts, and the financial goals that your life insurance will serve.
Let’s say you’re looking simply for protection for your family: replacing the income they’d lose if you were to die. But you don’t want to duplicate protection they will enjoy from other sources. Indeed, if you have substantial financial assets, you may elect to forgo life insurance or they may want it to cover estate tax. Remember though, to include your debts and other liabilities in your reckoning, not just your assets. Further, if you’re working, you may have low- or no-cost life insurance courtesy of your employer. If so, it should be counted when you determine how much protection you need to buy, but employer life insurance is likely to terminate if you leave your job. There’s no dearth of formulas for figuring out the appropriate amount of life insurance. One of the classics is 10 times your annual income, so for example, if you’re earning $100,000 a year, you’d purchase a $1 million policy. However, this equation ignores your debts, and in the view of some insurance experts, is overly simple.
Other rules of thumb include: (a) buying 10 times your annual income plus $100,000 per child for college expenses, and (b) multiplying your annual income by the number of years your family will need support, adding in your debts and your estimated future needs (including your final expenses), and subtracting your liquid assets.2
Whatever number you come up with, you’ll need to monitor your situation at least annually in the years to come: Your income, assets, debts, and family situation may change significantly, suggesting an adjustment—either up or down—in the amount of your life insurance. And, choose the insurance company with a careful eye toward its stability and creditworthiness; you’ll likely be trusting them to make a substantial payout decades later.
4. What type of life insurance is right for me?
Broadly, there are two types of policies: term and permanent life (also called cash-value insurance). Term insurance is so-called “pure protection”: That’s the only benefit it offers. So long as you pay the premiums, it maintains a death benefit for your beneficiaries if the policy is still in force when you die. As its name suggests, term insurance is good for a specified amount of time (perhaps 20 or 30 years, for example). When the time limit arrives, you may be able to extend coverage—almost always for a significantly higher premium, since as you age you become a progressively poorer bet for the insurance company. And after a certain age (often 80), you probably won’t be able to buy term insurance at all.
Premiums on a term policy are often level throughout its term, but they may gradually increase, depending on the policy. If you’re still alive at the end of the term, the policy lapses, and you and your beneficiaries receive nothing. That’s the typical case—but you got what you paid for when the policy was active: security for your beneficiaries. If you find you no longer need the insurance at any point, perhaps because your financial assets have grown enough to support your beneficiaries or the beneficiaries have become able to fend for themselves, you can cancel your policy and avoid paying more premiums. In many cases, you can also convert from your term policy to a permanent-life-insurance policy (see below). You may even be able to sell a permanent policy if you wish.
Permanent life insurance is more complex, and comes in several varieties. In all types, though, the policy will provide a death benefit for as long as you live (if your premiums are paid-up or kept current) and typically also has a cash-value component designed to provide you with additional resources. Because permanent insurance offers more features than term, premiums are higher, especially early on—though they typically stay the same throughout your life. The 30-year-old man from Question #2 buying a $500,000 whole-life policy could expect to pay about $4,750 annually instead of the $375 for term insurance; at age 50, his premium would be about $11,000.3
The cash value of your policy is either guaranteed to grow (often at a relatively slow rate) or designed but not guaranteed to grow, depending on the type of policy. Some of the more popular are whole life; universal life (which allows you to adjust the amount of your policy and the premiums you pay and whose cash value is tied to prevailing interest rates); variable life (whose premiums are fixed and whose cash value depends on the performance of fund-like investments that you choose); and variable universal life (which combines features of both of those two). There are other types of permanent insurance, and each contains sub-types.
You can use accumulated cash value as you see fit. You can withdraw it and either spend the cash or invest it in other accounts, use it as collateral for a low-interest loan on the policy, or in some cases use it to pay policy premiums or even increase the death benefit. Your goal should always be to use up the cash value while you’re alive, because any remaining cash value after your death goes to the insurance company, not your beneficiaries. But keep track of how much money you’re taking out: If you invade the face value of the policy, it will be canceled.4