Life Insurance: The Basics
When it comes to protecting yourself and loved ones, life insurance is a must-have conversation. Once we added children to our family, there was no question that we needed to add life insurance to our financial plan. So let’s take a look and see what we can do to protect our families, have peace of mind, and check this off our to-do list!
WHY LIFE INSURANCE?
First, we need to understand the purpose of life insurance.
Simply put, life insurance exists in order to pay a death benefit to your beneficiary/beneficiaries upon the event of your death. So if you have any dependents and your death would have a financial impact on your family (this goes for both wage earners and spouses who stay at home), then life insurance is for you. This means that nearly anyone with dependents should have life insurance.
There are two main types of life insurance: term and permanent. Let’s look at each of these in a little more detail:
TERM LIFE INSURANCE
A term life policy pays a death benefit upon the death of the policy holder within a specific term period (commonly 10, 20, or 30 years). Premiums are typically level. Once you reach the end of the term, you stop paying your premiums and you lose the death benefit. The policy itself has no value other than the death benefit.
When you’re trying to figure out how much coverage you need, multiply your income by 10. This is a very basic rule of thumb for calculating your number.
A more accurate number would take into account your debt, your future wages, future expenses, and your current assets.
(Current debt + Salary replacement + Future expenses for dependents)- Current Assets= Death Benefit
(Note: Since federal student loans are forgivable upon death, you would not need to include these in the calculation. Private loans still count.)
Term life is straightforward and affordable, and for these reasons, it’s the type of life insurance that is recommended for most people.
PERMANENT LIFE INSURANCE
As the name suggests, this type of life insurance policy is built to stay with you until your death, so there are no term limits here.
There is also an added savings component, which is referred to as the policy’s cash value. This is where things can get complicated, so it is in your best interest to understand these differences BEFORE you commit to a life insurance product!
Here are some common types of permanent life insurance:
This is the most well known type of permanent life insurance. Typically, the premium and death benefit are fixed. Each insurance company determines how the cash value will accumulate in the policy.
Universal life insurance is very similar to whole life insurance, but the premium and death benefit are more flexible.
VARIABLE UNIVERSAL LIFE
This type of insurance invests the cash value portion of your policy, so it is tied to the performance of the stock market. There is usually a minimum guaranteed rate of return so that you don’t lose money when the investments are down, but there is also a cap so that even when the markets are up, you aren’t getting the full benefit of that increase in value.
There are many other types of life insurance products that you will see out there. They are all variations of the above. Here are some examples:
- Single Premium
As you can see, a permanent life insurance policy is a completely different beast from a term life insurance policy. The complexity level goes up significantly, and it’s important to understand why you would choose one type over the other.
Here’s a summary of pros and cons of term and permanent life insurance:
TERM LIFE INSURANCE: PROS
- Fixed premiums (usually)
- Guaranteed death benefit within a set term
- Insurance only product
TERM LIFE INSURANCE: CONS
- No value if you outlive your term policy
PERMANENT LIFE INSURANCE: PROS
- Savings component by building up cash value
- Ability to borrow/withdraw from your policy
- Can be used for estate planning and tax strategy purposes
PERMANENT LIFE INSURANCE: CONS
- Very expensive premiums- can be 10x or more expensive than a term policy for the same death benefit
- Less cash flow, so potential for lost opportunity cost to save and invest
- Historically low rates of return on savings/investments
- Historically high rates of these policies being surrendered (canceled)
- Don’t “break even” on your policy until you hold this policy for many years (could be a decade or more). This means that if you cancel early on in the policy, there will be penalties, surrender charges, and you will likely end up losing money when it’s all said and done.
- Conflict of interest: Large commissions for agents who sell these policies
Let’s say that Abby, who is 30 years old, purchases a 30 term life policy with a death benefit of $1 million. She makes the same monthly payment every month, and she pays around $500 annually for this policy ($41.67/month). If she were to pass away unexpectedly within the next 30 years, her beneficiaries will get $1 million. If she makes it to the end of the term, it will expire, she will no longer make monthly payments, and there is no inherent value to the policy. Her death after the end of the term will result in no insurance being paid out.
However, if Abby went with a permanent life policy, she would be expected to pay $5,000+ annually towards her premium for the same death benefit of $1 million. The cash value will build over time. If she cannot make these payments for various reasons, she will need to work with her insurance company to figure out what she can do with the policy. She can choose to surrender the policy, cash it out (if it has any cash value at all), or roll it over into another life insurance product.
If she keeps the policy, she will need to make decisions regarding the cash value (use it to pay premiums, withdraw or borrow from it) and how to use it towards estate planning and tax planning purposes. This would require the help of financial professionals.
SO WHAT’S RIGHT FOR ME?
Remember, these are insurance products that have the same basic offering: a death benefit to your beneficiaries upon your death.
As to whether you want to keep this as a “pure” insurance product (term life insurance) or add cash value to it (permanent life insurance) will be up to you and your financial goals. If you don’t know your financial goals, then do not rely on an insurance agent to make this decision for you.
Remember that insurance brokers have been trained extensively on how to sell these products, and they are NOT trained to be financial planners or advisors who can look at this in the context of your whole financial picture. I firmly believe that most brokers are not intentionally giving bad financial advice, but you have to be aware that this is a product that they are incentivized to sell, so you can see the conflict of interest here.
Most people would benefit from a simple term life insurance product. It is easy, straightforward, and affordable.
Permanent life insurance tends to make sense for those who are at a stage where they are thinking about estate planning and diversifying their investment portfolio.
If the biggest benefit of a permanent life insurance policy is that it provides a “forced savings,” then remember that you have other ways to save and invest for the future (retirement accounts, high yield savings accounts, taxable accounts, real estate, your own business). You would have to be very comfortable about making those premium payments and having a long term strategy when it comes to permanent life insurance products.
Life insurance isn’t fun, but it’s so vital as a part of a sound financial plan. We only want the best for our loved ones, and this is an easy way to ensure that they will be well cared for if the unexpected should happen.
Remember not to put this off for too long. We’re not getting any younger, and rates increase as we get older. Lock in those rates while you’re still young and healthy.
Term insurance is recommended for the vast majority of the population. If someone is strongly encouraging a permanent life insurance product, make sure you understand how that works in the grand scheme of your finances and if that’s the best use of your money now and in the long term. If they are making this recommendation without any consideration for the rest of your finances, that’s a big red flag.
Even if you’re single and/or have no children, you may very well still want a policy to care for loved ones.
Do you have any other tips or stories when it comes to life insurance? Comment below!
Good info, as always! I have always only had life insurance through my university employer. They offer a basic amount ($10k I believe) for everyone, then you can get up to 5x your salary at an additional cost. What would you call this? It isn’t term, since it isn’t for a set amount of time- it’s just while I’m employed. It’s not permanent. I’ve always been confused why my situation is never discussed when life insurance comes up. I never saw it discussed on the WCI blog, either. But there are plenty of vets employed by universities! Thanks!
I believe this is supplemental life insurance. I believe that most workplace life insurance policies don’t offer enough coverage for a typical family that needs term life insurance. If they’re offering a max of 5x your salary and the rule of thumb is at least 10x your salary, then you need to cover that gap with another policy outside of work. In that case, it may make more sense to forgo the workplace policy and go with an individual policy that is portable and not tied to your workplace- of course you’ll need to run your numbers and see what makes sense!
That is very helpful, thank you! This makes more sense now. We never really needed life insurance- DINK, so if one of us died, the other could absolutely handle life expenses. The only reason we used to have it is because I thought, “Well, if one of us dies, we may need a 6 month sabbatical or something.” Now that we are close to FI, we are dropping all our insurance except liability and housing. It may be worth mentioning to readers that, once they reach FI, they can drop their life insurance! Thanks again!
Yes, it makes more sense for those with children/dependents, and even a working spouse could still benefit from being a beneficiary. You’re right that if you’re financially independent, you wouldn’t really *need* life insurance at that point- hopefully everyone can get a ballpark number for life insurance coverage by doing some quick calculations.