Life Insurance

For people with a partner, dependents, or a mortgage, life insurance is often part of financial planning conversations.

There are many types of life insurance policies, and we can only cover those relevant to most people here. For many, choosing a type of life insurance is simple - term life insurance, described below, is one of the more commonly purchased types of coverage. But for those with more complex needs, particularly regarding estate planning and tax management, we encourage you to contact a financial planner to better understand all policy options.

What is Life Insurance?

Life insurance is a contract between the policy owner and the insurance company. The person whose life is covered is the insured, who is often - but not always - the owner. When the insured dies, the insurance company agrees to pay a certain amount of money to the policy's beneficiary - the person or people you specify to receive the benefit. In exchange for this arrangement, the policy owner must pay a periodic fee, known as the premium, to maintain coverage. For example, in a hypothetical illustration, a policyholder might pay a premium of $50 per month for a $500,000 benefit paid to their designated beneficiary upon death. Actual premiums vary widely by person and insurer.

Most people consider two main types of life insurance: term and whole life. A term policy is temporary and generally provides coverage at a level premium for a set period - often between 5 and 30 years - as long as premiums are paid and the policy terms are met. At the end of the policy term, the insured stops paying premiums and is no longer covered. Term policies generally cost less than other types, especially for younger applicants. Actual premiums depend on factors such as age, health, coverage amount, and the length of the term, so quotes can vary widely from one person or insurer to the next. But a common approach is to buy a long-term policy when younger, if possible.

A whole-life policy is a type of policy that offers a death benefit similar to term policies but also builds tax-deferred cash value over time. It's typically possible to withdraw money from the policy or take out loans against the policy's cash value if needed. A related option is variable life insurance. Like whole life, it builds cash value - but that value is tied to investments in stocks and bonds, so it can go up or down based on market performance. Whole-life policies cost considerably more than term insurance policies, and the implications of withdrawing cash value can be complex in terms of tax liability and the policy's benefit value.

Some financial advisors argue that for many people, purchasing term insurance and investing the difference in tax-advantaged accounts like an IRA or 401(k) may produce better long-term results, though investing involves risk and returns are not guaranteed. Others point to specific situations - such as estate planning or certain tax strategies - where whole life policies may offer advantages. A financial advisor can help you weigh the tradeoffs for your situation.

How Much Coverage?

Determining how much coverage is appropriate is a decision you - and anyone who depends on your income - are best positioned to make. If you have no dependents or partner to support, your life insurance amount could be enough to repay any loans and funeral expenses.

The picture gets more complex if you have children, a partner, or a mortgage. Many people feel that a policy equal to ten times their annual salary is sufficient. In contrast, others will project specific education costs, home payoff, and long-term savings for a partner or other household members. Another strategy is to choose the life insurance amount based on your net worth at the time of policy expiration. This approach may fit better with a 20 to 30-year time horizon, if major expenses like a home or education costs are largely behind you by then and the need to replace your income has decreased. Whether that holds true depends on your own timeline and finances.

It can help to remember that an insurance policy's purpose is not to make your dependents wealthy - it's to replace lost income. Nor is life insurance a substitute for a retirement plan. Life insurance is generally designed to replace income during working years - separate retirement savings strategies are typically needed to support long-term financial security. That said, another important consideration is that term policies are not indexed for inflation. For example, at a hypothetical 3% annual inflation rate, a $500,000 policy's purchasing power in 30 years may be only $200,000 or so in today's dollars.

Finally, death benefits are generally not treated as taxable income to beneficiaries, though exceptions can apply depending on how the policy is structured and on estate tax rules. A tax professional can explain how this may apply to your situation.

Shopping for a Policy

There are several ways to purchase an insurance policy. Two common paths are working with an individual insurance agent or using a policy comparison service. Some insurers also sell directly to consumers, and coverage is sometimes available through an employer or group plan. The advantage of working with an individual agent is that they can provide more personal assistance in navigating the options, particularly for more complex or unusual policy situations. The downside of an individual agent is that they may have fewer options than comparison services.

Many life insurance policies require a medical exam, and final pricing is usually set after that exam is complete. Most companies can, however, offer a reasonably accurate estimate based on your answers to a list of medical questions. Pricing will vary depending on your age, health, personal decisions such as smoking or riding motorcycles, and family history. Insurers may consider additional factors depending on the policy type and applicable state regulations.

No matter who you buy a policy from, it can help to look at the insurance company's rating before purchasing. Companies such as S&P Global Ratings and A.M. Best publish opinions on insurers' financial strength. Many buyers weigh these financial strength ratings when comparing insurers, since the rating reflects an assessment of the company's ability to pay claims over time.

Finally, timing can matter. Premiums are often based partly on age and health, so waiting may mean higher costs later or fewer options if health changes. If you have decided coverage makes sense for your situation, comparing quotes sooner rather than later may be worth considering.

If you need clarification on how much coverage is appropriate for your situation, please consult a qualified professional.