With many options available, figuring out how to choose life insurance can be overwhelming. However, ensuring you’re appropriately covered can make a significant difference for your loved ones. 42% of Americans say that if their household’s primary wage earner died prematurely, they would face financial hardship within six months. Another 25% said this would impact them within a month, making life insurance an important consideration.
A life insurance policy can help protect your loved ones when you pass away. While each policy may be a bit different, the basics are generally the same: The policy owner pays premiums to the insurer, and in return, the insurer agrees to pay a death benefit to the named beneficiaries if the policyholder dies during the covered period. The policyholder determines the coverage period when they purchase the term life insurance.
In contrast, for permanent life insurance, the covered period lasts the entirety of the policyholder’s life as long as they pay the premiums to keep coverage active.
Beneficiaries can use the funds received for various purposes, including paying for funeral and burial costs, paying off debts, and covering ongoing living expenses. Some life insurance policies also include a living benefit, which builds cash value throughout your lifetime. While a death benefit is only available after you pass away, you can access the cash value while alive.
To pick the best life insurance policy for your needs, consider the type, amount, and costs of your available options.
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What Kind of Life Insurance Do You Need?
Understanding your options is one of the first steps in choosing a life insurance policy. There are two primary types of life insurance policies: permanent and term. Term policies may only protect you for a specified number of years. Permanent life insurance can provide coverage for your entire lifetime as long as you keep up with the premium payments.
Each type of policy has unique advantages and disadvantages, and some individuals find that a combination of coverage is needed to meet their needs. Here’s a closer look at the details.
Permanent Life Insurance
Term Life Insurance
Yes, tends to be higher
Yes, tends to be lower
Permanent and Whole Life Policies
Whole life insurance policies are the most common type of permanent life insurance. It combines a life insurance policy with a cash value account. When you own a whole-life policy, a portion of your premiums accumulate in your cash value account. This contribution grows tax deferred until it’s withdrawn. Then, the policyholder can access it through either a policy loan or a withdrawal. In contrast, term life insurance policies do not have a cash value component.
There are many different types of whole life insurance. Some common examples include:
- Non-participating: fixed death benefit, fixed premiums, fixed cash value, no dividends
- Participating: fixed death benefit, fixed payments, pays dividends
- Indeterminate premium: premiums adjust based on company performance
- Single premium: one large upfront premium payment, a tax-free death benefit
- Limited payment: higher premiums for a set number of years, then continued coverage with no premiums
Advantages of Permanent Life Insurance
- Lifetime coverage: When you have permanent life insurance, you can retain coverage over your entire lifetime as long as you continue to pay your premiums. Unlike most term insurance policies, in which only the provider pays out if you die during the set policy period, permanent life policies guarantee that a beneficiary will eventually receive your death benefit as long as the policy is still in force at the time of death.
- Cash value: Since it builds cash value over time, permanent life insurance is also considered an asset. Depending on the type of policy you have, this could grow to a significant amount. It also doesn’t decline with the market. You can access your cash value while you’re still alive so that it can become a crucial part of your retirement plan. Some permanent life policies also pay dividends, which you can use to pay your premiums, reinvest in your policy, or take as cash.
- Tax benefits: A death benefit on a permanent life policy is tax-free, allowing your beneficiaries to receive the total amount without worrying about tax liability. A permanent life policy’s cash value growth is typically tax-deferred, meaning no tax payments are due until you access the funds.
Disadvantages of Permanent Life Insurance
- Higher costs: Permanent life policies are typically more expensive than term life policies with a comparable death benefit. While these policies offer lifetime coverage and the ability to build cash value, you also pay more for these features. In some cases, the higher premiums may prevent you from being able to afford the death benefit you need.
- Complexity: Variables like cash value growth rates and dividend payouts can sometimes be confusing. The complexity of these policies may require you to consult with a qualified professional to ensure you choose the right policy for your needs.
- Lack of flexibility: As you get older and your family dynamics change, you may need more or less life insurance coverage. In this case, a permanent life policy could lock you into a fixed benefit that’s too small or too large for your current circumstances.
Term Life Policies
A distinguishing feature of term life insurance is that it has a set ending date, typically 10 to 30 years from the issue date. Many term policies are known as level term, meaning that the death benefit remains the same for the entire time the policy is active. Another option is a decreasing term policy, which has a death value that shrinks over time. People use these to cover costs such as a mortgage loan, which decreases over time as one pays it off.
Once the initial term is up, your policy may have a provision to renew your coverage. Most do this on a year-by-year basis with premiums that are higher than the initial amount. Some policies also allow converting it into a whole or universal life insurance policy without a medical exam. However, these types of policies are typically more expensive.
Advantages of Term Life Insurance
- Simpler and more affordable: Term life insurance is simpler and easier to understand than permanent life insurance plans. It’s also a less expensive option when compared to whole life insurance. You may find that a term policy offers extensive coverage at a budget-friendly rate. In addition, since there are no additional features like dividends or cash value, purchasing a term policy allows you to get a maximum death benefit at a minimum cost. For this reason, consumers sometimes buy an inexpensive term policy and use the money they save on premiums to fund a separate savings account.
- Flexibility – Term insurance is an effective option for covering needs that eventually decrease or disappear. For example, a young couple may need a higher death benefit to cover the costs of raising children and putting them through college. However, once the kids grow up and move out of the house, there would be little need to continue paying for a significant death benefit. A term life insurance policy set for 20 to 30 years can help provide extra coverage for parents when their children need more protection.
- Fee-free cancellation: If you find that your term policy no longer meets your needs, you can often cancel it without any fees or penalties. This may not be the case when dealing with whole-life policies because of the cash value aspect.
Disadvantages of Term Life Insurance
- Temporary coverage: If you have permanent coverage needs, a term policy may not be the best long-term solution. For example, you may need to ensure that your child with special needs is cared for throughout adulthood. In this instance, a permanent policy makes more sense. It can also be difficult to predict how long you need your term policy accurately. If you underestimate this, you could find yourself without the necessary coverage.
- No payout guarantee: If you don’t pass away during the covered term or cancel your policy, you won’t receive any of your premium payments back unless you have a return of premium feature, which adds an extra expense. In contrast, if you cancel a permanent insurance policy, there is typically a surrender value based on the policy’s current cash value.
- Age limits: Many term policies have an upper age limit. Once you reach your 50s and 60s, you may find that you’re limited to buying a 10-year or 20-year term policy. This could be a disadvantage if you need coverage for a more extended period later in life.
Term to Permanent Policies, or Convertible Policies
Convertible life insurance policies begin with term coverage, then allow you to convert your policy to whole life or universal life policy without having to go through the health qualification process again. Doing so also converts the policy from a set coverage period to continuing indefinitely as long as you continue paying your premiums.
Some policies allow you to covert any time, while others have a set conversion period. Your policy may also have a maximum age limit for conversions. If you meet the requirements and decide to convert, completing paperwork and paying the new policy premiums is typically just a matter of completing paperwork. You may also choose not to convert your policy. In this case, your current coverage continues with no change and terminates at the end of the original term or renews at a higher rate.
Purchasing a term-to-permanent policy may allow you to keep premiums low when you’re younger and still give you the option to choose permanent coverage later in life. However, you can typically expect higher premiums if you decide to convert. It’s also important to pay attention to the conversion deadlines, so you don’t miss the window.
Combining Permanent and Term Policies
Since term and permanent life policies each have unique benefits and drawbacks, purchasing both types of policies can help you obtain well-rounded coverage. For example, you may want a more comprehensive term policy to cover your needs while your children are young and a minor permanent policy to pay a death benefit to your beneficiaries in your later years.
If you’ve taken on debt, such as a mortgage or business loan, you may consider a term policy that would pay off the remainder of the debt if you pass away. This would allow you to choose a term that coordinates with your loan, meaning you only pay for the extra coverage while you need it.
How Much Life Insurance Do You Need?
Choosing the proper amount of life insurance requires taking the time to evaluate your needs. While financial professionals sometimes suggest purchasing 10 to 15 times your annual income, your ideal coverage may be more or less, depending on your circumstances.
Some of the factors to consider include:
- Debt: You may want enough insurance to pay off outstanding debts, including your mortgages, student loans, vehicle loans, credit cards, and personal loans.
- Income replacement: It’s common to purchase a death benefit that replaces your income for a set period and some extra to guard against inflation.
- Dependent needs: If you have dependents, you may want to factor in money for expenses like college tuition or future weddings, which may increase your death benefit needs.
- Cost of other services: Make sure to factor in the cost of paying for services the insured individual currently provides, such as childcare or home maintenance.
Do You Need Special Coverages or Riders?
When applying for life insurance coverage, the company typically evaluates certain risk factors, such as age, medical history, gender, and lifestyle. These factors combine to determine your eligibility and your premiums.
Sometimes, the insurance company may determine that you are a high-risk individual. This could be due to medical conditions, health issues like being overweight or smoking, or lifestyle choices like engaging in risky hobbies such as skydiving or scuba diving.
The insurer may only offer a guaranteed-issue policy if you fall into a high-risk category. This type of policy doesn’t require a medical exam but does come with higher premiums. Other companies may issue a standard policy but charge higher premiums to offset the additional risk.
While insurance riders add an extra cost, they can also allow you to amend your policy and protect yourself against certain circumstances. For example, a guarantee insurability rider allows you to purchase additional coverage during a stated period without additional medical examinations. A waiver of premium rider allows you to retain coverage without paying additional premiums if you have a severe injury or illness before a specified age.
You may also consider other options like a return of premium rider for term life policies, which allows you to recuperate some of your premium payments if you don’t die during the covered period. Another option is a long-term care (LTC) rider, which offers monthly payments if you end up in a nursing home or need home care while you’re covered. Yet another standard rider is the accelerated death benefit rider, which pays a higher death benefit if you’re diagnosed with a terminal illness that is likely to shorten your life expectancy.
Life Insurance Costs to Consider
Choosing the least expensive life insurance policy you can find is tempting, but there are other important factors to consider. When you look closer, a policy with low premiums may not be as affordable as you think. In addition to policy premiums, make sure to consider:
- Term length: how long the coverage lasts (for term policies only)
- Cash value: guaranteed accumulation rate
- Death benefit amount: the amount the policy pays to your beneficiary upon your death
Carefully evaluating each factor can help you compare your policy options and choose the one that’s right for your needs.