Many people recognize the importance of purchasing life insurance in order to provide financial protection for surviving family members if a family’s primary earner dies unexpectedly. But choosing the right type of life insurance for your family’s needs can be both challenging and confusing.
There are several different kinds of life insurance, and some kinds are more appropriate for certain situations than others. The following description of the main types of life insurance may help you choose the right insurance for your family.
Term vs. Whole Life Insurance
All types of life insurance fall into one of two broad categories: term insurance and whole life, also called permanent, insurance. Term insurance is fairly easy to understand: You would buy a certain amount of coverage for a specific period of time at a certain price. If the insured dies during this period of time and other conditions are met, your designated beneficiaries will receive the coverage amount, or death benefit.
Term insurance premiums can usually be paid in a single lump sum or annually, semi-annually or monthly. The premiums remain the same for the entire term of the policy, thus providing cost certainty for a period of time. When the policy’s term is up, you may be able to renew it for another term, although it’s likely that the premium will rise since you’ll be older.
The premium amounts for term insurance are based on a variety of different factors such as the insured’s age, health status, state of residence, tobacco usage and other factors. In general, the older you are and the poorer your health, the more expensive a term policy will be because you would present a higher risk to the insurance company.
People often have two main questions about term insurance. The first is how much coverage should they buy, and the second is what is the appropriate term? There is no one-size-fits-all answer to their of these questions — it depends on your particular situation. However, one common strategy is to purchase enough coverage to replace the insured’s income for a certain period of time.
For example, suppose John is the sole earner in his family and he makes $150,000 a year. John wants to ensure income replacement for his family if he dies until his 12-year-old daughter graduates college. In this scenario, he might consider buying a term policy with a death benefit of $1.5 million (10 years until college graduation x $150,000 = $1,500,000).
Permanent Coverage Plus Cash Value
Some people aren’t comfortable with the idea that if they don’t die during the term of their life insurance policy, they will have received no benefit. If you feel this way, you might consider purchasing whole life instead of term insurance.
Whole life adds a savings or investment component to the insurance policy. A portion of premiums paid is contributed into a savings or investment account, with the rest of the premium paying for insurance protection. This results in the accumulation of cash value, which can be withdrawn, borrowed or used to buy more coverage (which is referred to as paid-up additions).
There are several different types of whole life policies, such as universal life, variable life and variable-universal life (or VUL). These allow cash value to saved or invested in different ways. You should discuss the pros and cons of these types of policies with a life insurance expert before buying one.
In addition to offering a savings or investment option, the other big benefit of whole life insurance is that the premium amount stays the same for the rest of the insured’s life — hence, the name permanent insurance. This makes whole life insurance an attractive option if you want to lock in coverage permanently at a fixed price for the rest of the insured’s life.
Because of these benefits, whole life insurance typically costs more than term insurance. To determine whether or not this extra cost is justified, ask yourself a few questions, starting with how much can you afford to pay in premiums? If whole life insurance is cost-prohibitive, you should probably opt for a term insurance policy.
Also, how important is it to lock in a fixed premium amount for the rest of your life? If John in our example above only needs to lock in coverage until his daughter graduates from college, he might be better off buying a term instead of a whole life policy. And do you have other savings and investment accounts, like a 401(k) plan at work or an IRA? If so, you might not need a whole life policy for saving and investing purposes.
A Critical Financial Decision
Deciding which type of life insurance to buy could be one of the most important financial decisions you make for your family. If you have more questions about life insurance, please give us a call.