What Type of Life Insurance is Right for you?
Life Happens. Be prepared and consider buying life insurance.
But what kind? How does one navigate through the many types and attributes of life insurance products? To make things more complicated, high commissions create an unavoidable conflict of interest for life insurance agents, which can muddy the waters and lead to further consumer uncertainty.
To provide clarity, we will explore what life insurance is and provide a broad overview of the different policies that can be purchased. Someone’s lack of understanding should not get in the way of life insurance being a part of their financial plan.
WHAT IS LIFE INSURANCE?
Life insurance is an important tool to protect loved ones and/or business relationships. Most people should have some form of life insurance to provide cash flow in case of the inevitable.
A life insurance policy is a contract between a policyholder and an insurance company. In exchange for payment of premiums, the insurance company will pay a death benefit upon the death of the insured. The death benefit is a tax-free* sum of money paid to the beneficiaries of the policy, which are often family members.
If you have someone who relies on you for financial support, and you cannot self-insure, you need life insurance.
TYPES OF LIFE INSURANCE?
There are numerous different types of life insurance policies. Policies will vary in coverage, premium cost, cash value, investment risk, and flexibility. Of these differences, policies can be divided into two key groups: Term life and Permanent life.
Term — Term life insurance allows the policy owner to pay for coverage for a predetermined number of years, typically 5, 10, 20, or 30 years. For most, a term policy is the least expensive way to purchase a death benefit. The death benefit can be level or decreasing. Some will purchase a decreasing death benefit to match their decreasing mortgage debt.
Permanent — Permanent life insurance is just as it sounds. The policy owner may decide to have their life insurance policy last a lifetime (up to age 120), often requiring a lifetime of premiums payments. There are several types of permanent policies. Popular policies include Whole, Variable (VL), Universal (UL), Variable Universal (VUL), and Indexed Universal Life (IUL).
Key differences between a term policy and a permeant policy include price, length of policy, and a component called cash value. Permanent policies are traditionally more expensive. The higher premiums cover the cost of the death benefit (including administrative fees), and the remainder is added to a cash value.
Traditionally, the death benefit is used at death while the cash value can be used during the policyholder’s life. The cash value of a permanent life policy can be a tax-advantaged savings vehicle for the policy owner. Permanent policies are typically most advantageous once other tax-advantaged savings vehicles like your 401(k), Roth IRA, etc. have been exhausted. The cash value may be available to the policy owner to withdraw or borrow against. The cash value can accumulate in a variety of ways and is often distinguished by the type of permanent policy. See below for differences between common permanent policies and their cash value accumulation.
Whole Life — The insurance company takes on the responsibility to pay out a dividend which is based on the performance of an investment portfolio managed by the insurance company and their ability to keep their business expenses low.
Variable policies (VL & VUL) — The policyholder may invest the cash value in a selection of mutual fund-like sub-accounts. Variable policies provide a “variable” growth (& potential loss) of cash value as sub-accounts are connected to underlying investments.
Index Universal Life (IUL) — The policyholder may earn interest based on the performance of an equity index, think the S&P 500. While there is no actual money invested in the index, interest is credited to the cash value based on the performance of the selected index. IUL’s provide variable growth with a cap on maximum returns (cap rate). There’s also a guaranteed minimum annual return (floor rate often never less than 0). For example, an IUL has a cap rate of 8% and a floor rate of 0%. If the selected index grows by 20%, the cash value is credited a growth of 8% (cap rate), if the index loses value by -5% the cash value does not decrease due to the index (floor rate).
WHAT TYPE LIFE INSURANCE IS RIGHT FOR YOU?
This is our opinion, some life insurance agents and brokers with a conflict of interest may disagree.
You are young — Do you have plans for a family? This may be a great opportunity to purchase a term life policy. The younger you are, the less expensive premium payments will be.
You are the breadwinner — Term life insurance can replace lost income during working years. Life insurance prevents your surviving spouse (and children) to forgo their standard of living and helps meet the family’s financial obligations.
You are a stay-at-home parent — While there is no income number attached to a stay-at-home parent, there is a value associated with the services they provide a family. Term life insurance covering the years when kids are young can help cover the cost of child-care, housekeeping, and other responsibilities taken on by a stay-at-home parent.
You own a home — For many Americans, a home is one of their largest assets and debts. Purchasing a term life insurance policy with coverage lasting the length of a mortgage can cover the remaining mortgage balance.
You are a business owner — A life insurance policy is a multifaced tool for a business owner. A policy can help pay off business debts, pay estate taxes, and fund a succession plan like a buy-sell agreement. There are many variables to consider when choosing between term and permanent policies.
You have maxed out your retirement accounts — If you have maxed out tax-deferred retirement savings vehicles, a permanent life insurance policy can provide another avenue of retirement savings. Permanent policies build a cash value that can be accessed tax-free**. We do not typically recommend this to our clients because permanent policies are often very costly. The larger price tag can include investment costs (we commonly see 1-1.5%), administrative fees, as well as surrender penalties.
You want to leave an inheritance — Do you plan to spend all your retirement dollars, yet you would like to leave heirs with an inheritance? A permanent life insurance policy will provide a lump-sum benefit to your beneficiaries no matter when you pass away (can be up to 120 years).
You have a high net-worth — Permanent life insurance is best for those who are concerned about estate taxes. A lump-sum benefit at death is distributed to heirs to pay estate taxes, rather than selling-off inheritance.
Life is complex. As such, your situation may require multiple life insurance policies for you and your family.
WE ARE HERE IF YOU HAVE QUESTIONS
There are many options for life insurance. While Human Investing does not sell life insurance policies, we do help clients find the best policy within their financial plan. Having someone to help you navigate life insurance without incentive to sell you a product has immense value. If you have questions about what type of life insurance may be best for you, or how it fits into your financial plan, please contact us at Human Investing.
*Death benefit will be tax-free if it does not violate the “transfer-for-value” rule.
**Tax-Free-withdrawals up to basis then gain taken as loan. Also, is not a modified endowment contract.