What Kind of Life Insurance Do You Need?

  • By Karen Carr, CFP, Society of Grownups
  • October 28, 2015

Most people avoid thinking about life insurance for as long as possible. But to make the question of whether you need it a little less daunting, set your emotions aside for a moment and answer this simple question: Would anyone suffer financially if you weren’t around to provide for them?

life insurance
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If the answer is yes, then you should consider buying some type of life insurance, which would provide your family or other dependents with cash (known as a "death benefit") if you were to pass away. This could help replace your income, cover funeral costs, pay off debt, or fund college for your kids. There is also no federal income tax on life insurance benefits, unlike other types of assets that your loved ones might inherit upon your death.

Simply put: Life insurance is a smart way to ensure that they are well taken care of if something were to happen to you. Read on for information to help you figure out which type of insurance makes the most sense for you.

Term Life Insurance
Term life insurance provides coverage for a specified amount of time, often in increments of five years. Term is ideal if you need coverage for a certain amount of time (e.g., until your child graduates from college or until your mortgage is paid off). There aren’t any bells or whistles — if you die during the term, your designated beneficiary will collect the death benefit. If not, the policy will end once the term is over.

Term life insurance is usually the most inexpensive form of life insurance (outside of a group policy offered by an employer — more on that below). The cost varies based on factors like health, age, location, and size of death benefit. An online calculator can you help you estimate your costs.

Employer-Sponsored Life Insurance
Many of us carry some basic term life insurance coverage through our employers without even realizing it. (Check with your HR department to understand what’s available to you or your spouse.) The downside: This type of insurance isn’t usually portable, meaning that when you leave your job, you’ll lose the coverage.

Accidental death and dismemberment insurance (also known as AD&D) is another common form of employer-sponsored life insurance. While it’s not a bad safety net to have, it won’t pay out a death benefit if you pass away from illness or other non-accidental causes, unlike term insurance. If this is all your employer offers, seek out additional insurance.

The cost depends on your employer. Some workplaces offer a basic benefit for free, while others have a monthly or yearly cost. While these policies can be limited, they’re typically the most cost-effective option (if available), since you’re benefiting from group rates.

Permanent Life Insurance
Permanent life insurance provides coverage for life, as long as the premiums are paid. But it doesn’t just have to cover your family in the event of a tragedy — it can also accumulate cash value. A portion of your premium will go to building cash value, which can then grow tax-deferred from policy dividends, interest, or investment earnings. In short: A portion of the money you pay for your insurance policy will also be earning money. And you can borrow (usually tax free) or withdraw the cash value if you need it. But remember, any loans or withdrawals that aren’t paid back can reduce the death benefit, possibly leaving your loved ones with less. (You’ll often have to pay a cancellation charge if you no longer want the policy.)  

If you’re thinking about permanent life insurance as a way to build cash reserves, weigh the risks and costs with the potential for growth. Talk to a pro, who will explain the return you can expect to see if you buy this type of policy. Permanent insurance is more expensive than term, so the potential return on your cash value will need to outweigh this extra cost. If not, you may want to consider buying a term policy and investing the difference in your 401(k) or IRA.

Ultimately, to determine whether permanent life insurance is right for you, ask yourself this: Do you see yourself needing life insurance when you are 70, 80, or older? If your kids are self-sufficient and your spouse will be just fine between savings, inheritance, and Social Security, then you may not need permanent insurance.

But there are some cases where permanent insurance makes sense even if there’s not an immediate financial need. It’s worth considering if:

  • You're in a very high tax bracket.
  • You've maxed out all available retirement accounts.
  • You want insurance to cover estate taxes when you die.

If you decide that permanent insurance is right for you, there are three major types: whole, variable, and universal.

  1. Whole life insurance (sometimes also called “straight life” or “ordinary life”) remains in effect for a person’s whole lifetime as long as they pay all required premiums. With whole life insurance, you’re guaranteed a certain death benefit and rate of return on your cash value, which comes from the premiums you’ve paid and the interest they’ve accrued. It’s a good solution for people looking for insurance for life without any surprises.
  2. Variable life insurance provides a death benefit and cash value that rises and falls with the performance of underlying investments. You choose how to invest your premiums and you (not the insurance company) assume the risk. It’s ideal if you are willing to take on some risk to see the cash value grow.
  3. Universal life insurance is the most flexible permanent life insurance option. It has adjustable premiums, meaning you’ll have the option to pay more or less as long as you’re maintaining the cost of the insurance. This way, you can put more money into it if you want to grow its cash value. You can also adjust how much of your premium goes toward the cash value (versus paying the premiums) and then choose how it’s invested. Finally, you also have the option to pay your premiums with the cash value that has built up. So instead of writing a check to your insurance company every year, you can draw down the cash value to pay the premiums and maintain your policy. The policy is self-sustaining unless the cash value runs out.

The major difference between whole or variable life insurance and universal life insurance is that premiums are no longer fixed. Universal life insurance is a good choice if you want permanent life insurance but also want as much flexibility as possible, since you decide how much you pay, how the money is invested, and whether you pay the premiums using the cash value of the account or out of pocket.

You Might Also Like:
6 Estate Planning Steps Even Broke People Need to Take
What Insurance Do You Really Need?
7 Essential Questions to Ask Before You Open a 401(k)

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