Life insurance is one of those financial products that can give people the heebie-jeebies. It can sound confusing and complicated, and it involves thinking about a very scary proposition: death.
But life insurance really isn’t as frightening or complex as it seems. It’s actually a fantastically useful and flexible estate-planning tool that can provide income-tax-free security for your loved ones. It can also provide liquidity to pay estate taxes, especially if your estate largely consists of assets such as real estate or a closely held business that you may be reluctant to sell to raise cash. (If the policy is owned by an irrevocable trust, the insurance payout can avoid estate taxes too.)
Here’s a rundown of some of the basics of life insurance:
1. ‘How do I buy insurance?’
You can go directly to an insurance company or use a broker, either in person or online, that compares products from multiple insurance companies and can help you find the best quote.
You also can check if your employer, union or trade association offers a group life-insurance policy. Group life-insurance policies may not offer as much flexibility as some individual policies, but they typically don’t require a medical exam — a boon for those in poorer health seeking to be insured.
When you’re shopping for policies, stick to companies with high financial strength ratings from firms such as A. M. Best, since the last thing you want when spending money for peace of mind is to have to worry about your insurer going bust.
Most individual life-insurance policies require you to get a medical evaluation so that the insurer can assess your health and longevity risks. That’s typically arranged by your insurance broker or the insurer, at no cost to you. In most cases, a medical technician will come to your home or office to get some vital stats and blood and urine samples.
2. ‘Do I need insurance?’
You generally can skip life insurance if you’re single with no dependent kids and don’t expect to have a taxable or debt-ridden estate. Also think twice about forking over for life insurance if your premature death wouldn’t affect the ability of your surviving partner to pay for daily living expenses.
But do consider life insurance if you have dependent children, are a business owner or if your spouse doesn’t work or you have a big income disparity. In these cases, if you die prematurely, a life-insurance policy can help the survivor pay for your family’s day-to-day cost of living, including mortgage payments or help your business remain viable after your death.
There are many variables to factor in when considering how much life insurance to buy. It depends on your current and projected income and assets, your family’s annual living expenses, the length of the policy you are considering and whether you have any specific future economic needs — such as a child’s college tuition, a special-needs child who needs lifelong support, or expected estate taxes to pay off. Your insurance broker or salesperson can help you come up with a coverage amount that’s suitable for your situation.
3. ‘Term or permanent?’
Life insurance, in its most basic form, can be divided into two categories: term and permanent, also called cash-value. Term life, the simplest and cheapest form of life insurance, is when you buy an insurance policy that lasts for a set period, typically 10, 20 or 30 years.
A term policy, which usually costs just a few hundred dollars a year if you’re in good health, is appropriate for people who only want life insurance for a limited number of years — such as until your children are grown or until you reach retirement age.
Permanent or cash-value life insurance, by contrast, lasts for the remainder of your lifetime. These policies are often used for specific estate-planning purposes, such as funding future estate taxes or for ensuring the continuity of a family business.
4. ‘Why the cost difference?’
Permanent insurance is more costly than term life insurance because it lasts longer and because it provides more than just a death benefit: It also has an investment component in which money accumulates tax-free within the policy.
In other words, a portion of your premium is placed in a separate investment account; this money grows tax-free while the policy is in force. (How it’s invested depends on the policy.) As more money builds up inside the policy, you might eventually use this stash of cash to help you pay the policy’s premiums.
Many insurers tout the tax-free investment benefits of cash-value policies. Not only does the money grow inside the policy tax-free, but your beneficiaries don’t have to pay income taxes when they receive the policy’s payout. A cash-value policy might make sense if you have already contributed the maximum amount to other tax-deferred investment accounts, such as 401(k)s and individual retirement accounts.
On the other hand, the higher premiums, commissions, and sometimes limited investment choices might not make a cash-value account worth it.
Some people choose to buy a special kind of permanent policy called a “second-to-die” or “survivorship” policy.
These policies pay out when the second person in a couple — you or your spouse — dies, and the money generally goes to your children or other heirs. They typically cost less than traditional permanent insurance because they are based on the life expectancies of two people, rather than one.
Need to Know: Life Insurance 101
By Rachel Emma Silverman
Wall Street Journal, October 11, 2011