There are many financial instruments that can provide the peace of mind that comes with knowing your loved ones will be financially supported after you pass on, but it can be confusing to figure out which is most appropriate for your situation.
Few people enjoy thinking about what will happen after they die. In reality, it is something that is very important to plan for, especially if you have a family. Before you choose a life insurance policy, you should ask yourself a few questions.
- How much coverage do you need?
- How long do you want/need coverage?
- How much can you afford each month?
- Do you want access to the funds before you die?
Knowing the answers to these questions will help you make an informed decision about which of the most common types of life insurance is best suited for your situation.
Term Life Insurance
As the name suggests, term life insurance lasts for a specific term. For example, if you buy a 20-year policy and you are still alive at the end of the 20 years, the policy ends. Term life insurance is just a death benefit meant to provide for your family, and typically has no long-term value beyond the coverage term. It is most commonly used to cover the prime working years of a person’s life to provide a financial safety net in the event of an untimely death. You name beneficiaries for your policy. In the event of your death during the covered term, those named beneficiaries receive the payout. Term life insurance is typically the most affordable.
Pros:
- Simple to understand and buy
- Low premiums
Cons
- Expires at the end of the term with no cash value
- You’ll need to apply for new insurance at the end of the term with higher premiums due to your older age
Best For:
- Young adults with new debt
- Young families just starting out
- Anyone that needs coverage with a low premium
Permanent Life Insurance
Term life insurance has a specific term. Permanent life insurance, on the other hand, lasts for your lifetime, as long as you make your payments. Underneath the permanent life insurance category is several options. Check them out below.
Whole Life Insurance
Whole life insurance, as the name suggests, lasts for your ‘whole life.’ There isn’t an expiration date as long as you pay your premiums. A portion of each premium is invested, typically in a tax-deferred savings account. This amount earns interest over time and you get a guaranteed cash value. The other portion of your premium pays the death benefit, which again, doesn’t expire or change.
When you consider whole vs term life insurance, you’ll want to focus on the cost. Whole life is much more complicated because you have to figure in the cash value. Your premiums remain the same for the duration of the policy, as does your death benefit, but they’ll be higher than term life insurance premiums.
The cash value of your whole life insurance will increase over time, with a guaranteed interest rate. You can use the cash value as an emergency fund, should you need it. You may be able to withdraw funds or take out a loan against the balance. It may also be possible to contribute additional funds beyond the annual premium which will grow and can be used as a retirement savings account. The exact rules vary by company.
Pros:
- Guaranteed cash value
- Premiums remain the same
- You may earn dividends
- Can be used to save for retirement
Cons:
Premiums are much higher than term life insurance Harder to understand than term life insurance
Best For:
- Anyone that wants the ‘extra’ savings
- Anyone that maxes out their retirement account benefits and has more money to invest
Indexed Universal Life Insurance
Like whole life, universal life insurance offers a savings component. A part of every premium you pay goes toward your death benefit. This is the amount paid to your beneficiaries should you die. The other part of your premium goes towards your cash value. The interest rates earned on universal life policies change with the chosen index. If the index decreases, you don’t earn any interest that month. If it increases, you earn interest based on your participation rate, which varies between 25% and 100%, which varies by company.
Universal life insurance also allows the option to increase or decrease your death benefit. If you decrease the benefit, which is common after paying off your mortgage or saving enough in external accounts, your premiums decrease. If you increase your coverage, you may be subject to a medical exam and higher premiums.
Once the cash value of your account is high enough, you may set it up so that your cash value covers the premiums each month. Just make sure you have enough money accumulated to always cover the premiums. If you stop making payments, you lose your policy.
Pros:
- Your cash value grows tax-deferred
- You can invest a portion of your cash account in a fixed interest rate environment, lowering the risk
- The premiums tend to be lower since you bear the risk
Cons:
- Each insurance company sets its own participation rates which affect your returns
- You may have long periods where you don’t earn any interest
Best For:
Anyone that can take risks based on the market index Anyone looking or an ‘extra’ way to invest for retirement after exhausting all other tax-advantaged options
Variable Life Insurance
Variable life insurance is another permanent life insurance policy. It provides coverage for your lifetime. However, rather than a savings component, it has an investment component. The cash value of your policy is invested in sub-accounts. Typically, the sub-accounts are invested in mutual funds, but the exact investments vary by company.
The main difference between variable life insurance and universal or whole life is the riskiness. Just as you could lose money when investing in stocks or mutual funds, the same is true for the cash value of your policy. If the mutual fund market goes up, your cash value increases. If the mutual fund market goes down, you lose money.
Variable life insurance earnings have a tax benefit, though. You don’t pay taxes on your earnings until you withdraw the funds (if you do). You can use the cash value in one of the following ways: withdraw the cash, use it as loan collateral, or use it to increase your death benefit.
Variable life insurance policies offer the potential for higher earnings, but also the chance of greater loss. You must be hands-on with your investments, monitoring its performance and making changes accordingly in order to preserve your account's cash value.
Pros:
- Always have a ‘guaranteed’ death benefit
- Greater chance of maximizing your earnings
- You are in control of where your money is invested
Cons:
- Greater chance of loss
- The most difficult policy to understand and manage
Best For:
- Anyone that wants another investment option for retirement after exhausting all other retirement options
- Anyone that can afford the higher premiums
Choose your life insurance policy carefully. Think about what you can afford now and into the future. Do you want coverage that includes cash value or do you just need something to protect you while you need funds to pay a mortgage or fund a college education? Permanent options offer lifetime coverage, while term options cover you during the ‘term’ you find yourself in debt.
