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A good financial road map helps take care of your family's needs, no matter what life has in store. One of the best ways to help protect them is by purchasing a life insurance policy that pays out a benefit upon your passing. Another one of the advantages of life insurance is the policy may enable you to build cash value that you can use for financial needs during your own lifetime.
The need to obtain coverage involves a number of important decisions, including the type of policy and the size of the death benefit. Here's a guide to life insurance basics so you can make the right choice for yourself and the people you love most.
What to Know About Life Insurance
At its most basic level, a life insurance policy is a promise between you and an insurer that the company will provide your beneficiaries with a sum of money upon your death. That death benefit can help them replace any income your household or business may lose because of your passing. It can also help them cover the cost of any final expenses when you die, like a funeral or medical bills.
Most life insurance policies fall into one of two categories: term coverage or permanent coverage. Term policies are only in effect for a certain length of time, usually ranging from 10 to 30 years. They only provide a death benefit to your beneficiaries if you happen to die within that span.
Permanent life insurance, on the other hand, provides a death benefit that doesn't expire. Keep in mind that as long as you pay the monthly premiums and do not terminate your policy for its cash surrender value, it will remain in force. This category of insurance — which includes whole life and universal life policies — also allows you to build cash value that you can access if, for example, you decide to buy a new home or face a job loss. Therefore, permanent coverage provides financial benefits for both you and your beneficiaries.
How Does Life Insurance Work?
Life insurance works by providing a benefit to the beneficiaries you designate for your policy, whether it's a spouse, a business you own or a trust. Typically, the person who owns the policy and pays the premiums is the one who's insured by it. However, the owner and the insured can be different people. Some parents even buy insurance that helps protects the life of their child and helps them grow cash value in their policy at the same time.
You have several different life insurance options depending on your financial needs and budget, including:
- Term life insurance
- Whole life insurance
- Universal life insurance
- Variable life insurance
When you buy a permanent policy like whole life or variable life, part of your premium covers the death benefit guarantee. But another portion of your payment goes toward the cash balance in your policy. In addition to the contributions from your premium, the insurer credits your account based on prevailing interest rates or — in the case of a variable policy — based on the performance of investment subaccounts.
Before you can get an insurance policy, you typically have to go through an underwriting process. Essentially, the insurer reviews your health and financial status to assess the risk it's assuming by extending coverage to you. Underwriting may require you to submit a blood and urine sample for testing, receive a physical exam and allow the insurer to check your medical records. You also likely need to answer questions about your occupation and hobbies.
The premium you pay is generally more expensive for someone with health issues. And if the company sees you as too risky, it may even deny you coverage altogether.
Ensuring you make timely premium payments is key to avoiding a life insurance policy lapse and loss of coverage.
How Does Life Insurance Help Protect Loved Ones?
Your passing has the potential to take more than just an emotional toll on your family — it could also result in financial hardship if you don't have a sound plan in place. By providing a life insurance policy that pays a benefit when you die, you can have the confidence that they can move forward without having to worry about money.
The larger the death benefit you choose for your policy, the higher the premiums may be. However, it's still important to have a policy large enough to:
- Replace your income
- Pay down any mortgages or other large debts
- Cover your burial expenses
- Transfer wealth to children or grandchildren
If you're starting a family or taking care of older or disabled relatives who depend on your income, having a financial safety net can be vital. You may want to connect with a representative who can talk to you about life insurance basics, including the different policy types available and potential riders you can add to a standard policy.
What Does Life Insurance Cover?
Life insurance is designed to provide a financial safety net for family members, or even business partners, should you pass away while the policy is in force. While it typically covers such costs like funeral expenses and debt, the insurer may not provide a death benefit in certain scenarios. These include cases when the death is caused by:
- Suicide
- Dangerous or risky activities
- Illegal activity
- Drug or alcohol abuse
In the case of high-risk hobbies or jobs, the insurer may decide to cover claims in exchange for a higher premium. It is important to disclose activities when filling out application.
How Much Life Insurance Do You Need?
You may come across certain guidelines that suggest how much life insurance you need. But the fact is, the amount of protection your family may need depends on several factors that are unique to your household.
The first step you may want to take is identifying how long your spouse, kids or other dependents may require financial support should you pass away. Consider what their estimated annual expenses might be during those years as well as how much income they can count on from other sources like spousal wages or Social Security. Your life insurance policy generally should fill in the gaps for every year in which their income would otherwise fall short.
If you're a key person at a small business that depends on your relationships and expertise to generate income, you may also want a policy where the company becomes the beneficiary. This typically involves an analysis of how much money the company may need until it can find a replacement.
Determining the size of your policy can be one of the trickiest aspects of buying life insurance. Using our life insurance calculator can help ensure that you're accounting for all the potential expenses and sources of income that those closest to you can expect in your absence.
When Should You Get Life Insurance?
The most obvious time to buy life insurance is when a loved one becomes dependent on your income to sustain their lifestyle. That could be the birth of a child or when aging parents begin to need your financial support to stay afloat.
You may also want to think about coverage if you're the key person in a small business that may not be able to pay the bills if you were to pass away. The payout from your policy may help the business navigate the difficult period immediately following your death.
However, the death benefit isn't the only reason you might want to think about purchasing life insurance. Permanent policies like whole life provide a cash value component that can give you greater flexibility whenever a financial need arises. Many parents buy policies that insure their minor children, knowing that their child can access that cash balance later in life.
What About Life Insurance Through an Employer?
Many employers offer life insurance coverage at no extra cost for their workers. While the prospect of a no-cost policy may sound great, it's important to understand the limitations of these policies. For one, your coverage may end when you separate from the organization, as most group insurance plans only provide temporary coverage You may need medical underwriting to get a policy on your own.
In addition, employer-provided policies may not provide the amount of coverage you need — especially if you have young children or other dependents. A typical group life insurance plan provides a death benefit worth one to two times your salary. If your family needs additional protection, you may want to consider buying a separate policy on the individual market to supplement what you're getting through work.
What Are the Advantages of Life Insurance?
By purchasing a life insurance policy, you can help your family replace your income and eliminate the worry of how they're going to pay the bills when you're gone. When bought with the guidance of a financial professional, these policies can potentially also provide a tax-efficient way to transfer wealth to younger generations.
Aside from the death benefit that life insurance provides to your beneficiaries, permanent life insurance allows you to build wealth over longer periods of time through the cash value feature. Part of each premium payment is credited to the cash balance of your policy. On top of that, the insurer credits your cash balance based on current interest rates or, in the case of a variable life insurance policy, based on the performance of investment subaccounts.
When Should I Purchase Life Insurance?
Typically, it's a good idea to buy life insurance when you get married, have a child or take on other financial dependents — including aging parents. It may also be a good idea for your business to buy a policy against your life. If you pass away while the policy is active, your partners or employees can pay any outstanding bills and keep the entity afloat while looking for your replacement.
However, these aren't the only circumstances when purchasing a policy might make sense. For example, many parents buy permanent life insurance policies that insure their young children, when premiums tend to be the most affordable. The policy can help them cover funeral or other expenses if their child were to pass away. Plus, the cash value associated with these insurance products allows the child to grow their wealth over a period of years or decades. They can access that balance whenever they face a financial challenge or a major expense like a wedding or a new home.
How Much Does a Funeral Typically Cost?
There are three components of a funeral to think about: preparing the body, the service and the internment. All of these come at a cost, which can present a financial challenge for families that aren't prepared.
According to the National Funeral Directors Association, the national median cost for a funeral with burial was nearly $8,000.1 For a funeral with cremation, the total cost was slightly less: approximately $7,000.
To make sure your family is financially ready to take care of your final expenses, you may decide to set aside money in a separate account or even prepay for your services. If saving that much is out of your budget, consider buying a life insurance policy that's at least large enough to handle funeral expenses.
You may also have the option to add a child rider to your policy, which provides a modest death benefit if one or more of your children under the age of 18 passes away. That money can help you cover the cost of their funeral or pay outstanding healthcare bills.
When Should I Replace My Policy With a New One?
In general, life insurance rates go up the older you get. That fact alone provides a powerful incentive to hang onto your current policy, rather than seeking out a new one.
However, there may be cases when you want to shop for a replacement. If, for example, your health or credit score has substantially improved since you took out your policy, it can be a good idea to shop around for quotes. If you decide to get a new policy, don't let the existing one expire until the new one is in place. At that point, you can contact the previous insurer and let it know you intend for the policy to lapse.
If you own a permanent life insurance policy, there are additional factors to consider before letting your old policy expire. For example, if you've only owned the policy for a few years, some insurers assess a surrender charge that reduces the cash value you receive. It may also take years for a new permanent policy to grow to the same cash value you have in your current policy.
Life Insurance Terms to Know
Shopping for life insurance means running into a series of phrases that aren't exactly part of everyday conversation. Are you curious to learn what, exactly, a "double indemnity" is or an "irrevocable beneficiary"? Our glossary of insurance terms is a convenient resource, so you know exactly what you're getting from your policy.
Bottom Line
Ultimately, a life insurance policy could help provide economic security for your loved ones and put your mind at ease. If you want to explore the available options further, consider contacting a financial professional who can take a personalized look at your situation and suggest potential solutions.
Additional Resources
Sources
- 2021 NFDA general price list study shows funeral costs not rising as fast as rate of inflation. National Funeral Directors Association. https://nfda.org/news/media-center/nfda-news-releases/id/6182/2021-nfda-general-price-list-study-shows-funeral-costs-not-rising-as-fast-as-rate-of-inflation.
