Deciding whether you need life insurance or what type best fits your needs can be a challenge, especially with so much information online and so many agents and insurers vying for your business. The first, and perhaps most difficult decision is whether to purchase term life insurance or a whole-life or universal policy (both often also referred to as cash-value policies).
Several factors may influence your decision, including current premium cost, predictability of premium increases, how long you want to have coverage in place, and whether you want to be able to borrow against the value of the policy down the line. This guide focuses on term life insurance but identifies some noteworthy differences between term policies and other options.
What Is Term Life Insurance, What Does It Cover, and How Does It Work?
Term life insurance is so named because the policy is in place for a defined period of time, or term. The insured pays a premium for coverage for a specific term, then the policy terminates unless it is renewed for additional coverage periods by paying the applicable premium for those periods.
At the end of each policy period, the premium may change unless there is a predefined rate structure regarding increases. Such increases are often keyed to age brackets and can rise sharply from one bracket to the next.
The basic operation of a term life insurance policy is straightforward: If the insured dies during the policy period, the insurer pays the death benefit to the beneficiaries identified by the insured.
The beneficiaries are often a spouse and/or children but may be a friend, other family member, trust, or charity. The death benefit is usually a lump sum but might be structured as an annuity, which pays over time.
A life insurance policy may contain exclusions to coverage, or circumstances when the policy will not pay the death benefit. The exclusion most commonly known is for death by suicide.
Some policies deny a death benefit in any case of suicide, while others may simply have a six-month or one-year exclusion period to discourage someone from taking out a life insurance policy with the intention of taking his life shortly thereafter to help his family out of a financial crisis.
Other possible exclusions to coverage include high-risk or dangerous activities such as skydiving or rock climbing, death in the crash of a private plane, death during commission of a crime, and death by drug or alcohol overdose.
Exclusions are not standard and may vary widely from one insurer to another, so this is to read the fine print. If you engage in activities that are deemed high-risk and excluded from coverage, you may be able to have the exclusion removed from the policy by paying a higher premium to compensate for the increased risk.
Keep in mind that the insurer can cancel a term life insurance policy for certain reasons, primarily nonpayment of a premium, misrepresentations in the insurance application, if you cease to be eligible for the policy (for example, when coverage is through an employer, a professional organization, or an affinity group), and at the predefined end of the policy period.
Be sure to read the fine print regarding when the insurer may cancel coverage.
Who Needs Life Insurance?
You might think that someone engaging in high-risk activities needs life insurance more than the average Joe, but it may be quite the opposite. Whether you need life insurance, and how much you need, does not relate to how risky a life you lead but rather to the needs of those you will leave behind.
Married couples are at the top of the list of people, with several reasons for buying life insurance, including the merging of their finances and financial responsibilities and possibly having children to provide for.
Although having life insurance to help take care of a spouse you leave behind is an act of love and caring, the death of a spouse is a difficult and delicate issue that not every couple is prepared to consider.
I introduced an insurance agent to two coworkers of mine who had recently married. The husband felt strongly about making sure his wife was well taken care of in the unfortunate event of his death.
However, when the insurance agent sat down at the kitchen table with the couple to discuss their life insurance needs, it became clear that the wife was not comfortable discussing the possibility of losing her husband, much less reducing it to dollars and cents with a stranger.
Cultural issues may have been at play, and perhaps the husband should have simply purchased a policy for her protection and never even mentioned it, but he wanted her to be an equal partner in their financial decisions.
The couple did not end up purchasing a policy, fought repeatedly about the issue, and ultimately divorced. That may seem like an extreme example, but the point is that life insurance involves discussing two very sensitive and sometimes taboo subjects: death and money.
If you have loved ones who depend on your income, life insurance naturally comes to mind as a way to protect them financially in the event of your death.
However, the loss of a family member who is not the primary breadwinner can still be costly.
We might not immediately think of the loss of a family member’s services as being a major financial blow to a household, but it absolutely can be. If Mom is working full-time and is the primary breadwinner while dad stays home raising the children and managing the household, the loss of either parent will have a dramatic financial impact on the family.
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Dad’s services — raising the children, cleaning the house, taking care of the yard, running errands, managing bills — must be taken on by someone else, probably day care staff, a nanny, a housekeeper, landscapers, and others. All those services have a financial value that is as equally important to replace as Mom’s salary and benefits were she to die.
Even if you don’t have a spouse or children who are financially dependent on you, life insurance may still make sense for myriad reasons. Insurance proceeds can cover the cost of funeral and burial expenses that your family may not be prepared to take on.
You may own a home with a large loan outstanding and want to leave the property to someone without the burden of debt that she may not be able to refinance or afford.
Perhaps you have pets and want to ensure they will be taken care of and not simply dumped in a shelter. You may have personal or student loans with a cosigner who you do not want to saddle with the debt. Maybe you want to leave a charitable donation to a cause that is important to you but do not have a large estate or the cash flow to donate during your lifetime.
How Is Term Life Insurance Different From Cash Value or Whole-Life Insurance?
The most important difference between term life insurance and whole-life, universal, or cash value policies is that when a term life policy expires, there is no cash value to the policy and generally no refund of premiums. You cannot “cash in” or get your money back at the end of a term life policy. You also cannot borrow against a term life policy while it is in force.
However, for the average person the premiums for term life are usually much lower and more affordable.
Because insureds often feel they did not get the benefit of their insurance if they outlive the policy term, there are policies or policy riders that provide a “return of premium” benefit if the insured does not die during the policy term.
The truth is, while you didn’t die during the policy period, you did receive the benefit of the policy, which is not the death benefit itself but rather the hedge against the financial loss of the insured’s income and services, along with peace of mind.
Nonetheless, insurers are happy to sell consumers the additional reassurance that they will have their premiums reimbursed if they don’t “die early.” However, the premiums required to secure such a policy or policy rider will be much higher and the insurance company will happily invest all that extra money and reap the interest on it during the policy period.
From a net present value perspective, you would be better off investing the difference in the additional premium you would have paid for a “return of premium” policy and accepting that the premiums are the price of peace of mind.
Return of premium policies are much like “vanishing deductible” auto insurance policies—the increased monthly insurance premium you would pay for a vanishing deductible is more than if you simply set aside the difference in a savings account (on which you, not the insurance company, would earn interest) to pay a deductible if necessary.
Whole-life, universal, or cash value policies have an investment component in which a portion of the premiums paid build up the “value” of the policy over time. It does so very slowly in early years, so such policies are thought of as a long-term investment vehicle as well as a means of providing the safety net of a death benefit.
One may elect to cancel the policy, stop paying premiums, and take whatever cash value has accrued.
Whole-life locks in coverage but tends to be expensive and have certain tax benefits that will most likely be reaped by the very wealthy. High-net-worth individuals may invest heavily in whole-life policies, then borrow against their value to draw cash out later in life; if not repaid before the policyholder dies, the loans will be repaid from the death benefit when the borrowers die.
Some insurers and agents take polar positions for or against term or whole-life policies. You may purchase term life at a much lower premium, take the difference from what you would have paid for a whole-life policy, and invest that money in building a nest egg to purchase additional term coverage later in life.
Depending on the market and your investment strategy, you may end up in a better financial position than if you bought the more expensive whole-life policy.
The risk, however, is that the investments do not grow enough to keep pace with higher premiums as you get older or that you develop significant health problems that make getting affordable coverage extremely difficult. There is no right answer or one-size-fits-all solution, so you need to weigh the pros and cons and consult with financial professionals to find the best fit for your situation.
Although term life does not have a “cash value” component with the insurer, both term life and whole-life or universal life policies may be sold under certain circumstances.
For example, if you are diagnosed with terminal cancer, you may wish to sell the policy to an investor who will get the proceeds upon your death; you then take a discounted amount of cash now to help pay medical and/or living expenses or go on a round-the-world cruise before you die.
Such “viatical settlements” are controversial and regulated as securities investments but do offer a service that may make sense for some policyholders. Some insurers restrict or do not allow such sales. Therefore, if that feature is important to you, you will want to inquire specifically about the ability to transfer or assign the policy.
How Much Life Insurance Coverage Do I Need?
When purchasing term life insurance, the key goal is to replace income and services provided to dependents so they are taken care of and may maintain their lifestyle after one’s death.
You will want to consider how large a benefit is necessary to pay immediate bills and funeral expenses, to replace lost income on a net-present-value basis for the remainder of your significant other’s life or for some number of years, how much is needed to provide for children’s college education, to purchase health insurance and cover medical expenses, and how much is needed for the family to remain in the home and not be rushed to sell.
The benefit amount needed very much depends on one’s financial situation and goals and any specific purposes for the death benefit.
In my own situation, I am single with no children, so I could likely go without coverage. However, I would not want to burden my family with unexpected funeral and burial expenses. I also have several pets whom I want to know will be kept together, have a roof over their heads and food in their bowls, and receive any needed veterinary care.
Prior to my father’s death, I was concerned about leaving him with the burden of some $200,000 in student loans he had cosigned for me. After his death, I opted to keep the coverage, designated a close friend as the beneficiary with the understanding that she would take in my pets, and that money would more than cover their care and feeding and compensate her for any inconvenience it all caused.
Is a Medical Exam Required to Get Term Life Insurance?
Not all life insurance requires a medical exam so if time is of the essence in putting a policy in place, you are concerned about what a medical exam may reveal, or you know that major health issues will impact getting a policy, you may opt for one with no medical exam requirement.
The downside to avoiding a medical exam is that insurers are not likely to give you the benefit of the doubt that you’re in optimal health; your premium will most likely be higher than if you chose a policy that requires a medical exam.
The likelihood of finding no-exam policies will also decrease with age, and your premiums will increase with age. You may be able to get inexpensive term coverage while young but find that obtaining affordable coverage later in life or with health problems becomes challenging.
If you do have the ability to afford a whole life policy, getting one when young and healthy will get the best rates and lock in permanent coverage that will not change based on your health later in life. It will be a bigger cash outlay up front, but less sticker-shock on the back end. As long as you pay your premiums, a whole life policy remains in place regardless of your health.
Medical issues can have a significant impact on life insurance premiums. When my former husband and I were shopping for life insurance, his premium for the same amount of coverage was four times mine, even though he was only five years older.
Why? Because he was a smoker and I had quit at least 15 years earlier. Fifteen years was the magic number at which my lungs were suddenly treated as if I had never smoked a cigarette.
Misrepresentations on an insurance application may be grounds for the insurer to nullify your policy, so it is unwise to lie, hide, or misrepresent your health conditions and family medical history.
At the same time, you do not need to answer questions that haven’t been asked or offer additional information. An insurance agent may seem as if he is working for you, but he isn’t; as friendly as the agent may be, anything you share with him may end up in your file and affect the underwriting, so it’s advisable to be honest but not to over-share.
How Much Does Term Life Insurance Cost?
Term life insurance premiums vary widely and depend on term, coverage amount, demographic information such as your age and sex, and health and medical conditions. One person may pay $20 a month for the same coverage that costs another $150.
Insurers have voluminous data on life expectancies, as well as armies of actuaries who can give a frighteningly accurate estimate of when you are going to die. Insurance companies are not in the business of paying claims early and losing money.
There is a saying that the only way to beat the life insurance company is to die early. That isn’t exactly worth it.
However, term life insurance is widely considered more affordable than other types of life insurance. Therefore, if your goal is to get the most coverage right now for your premium dollars, term life is most likely your best bet.
Premiums can vary widely from one insurer to another, and if you are a member of a group with longer life expectancy (say, an accountant versus a race car driver), you may find significant savings through group policies offered by professional organizations.
You may also be able to obtain better rates or save overall by having multiple policies with the same insurer (whether multiple life insurance policies or those for a home, an auto, or a boat) or by getting a larger benefit amount.
You can also stack multiple smaller policies with different terms to match the timeframe of the need for purposes. For example, one does not need as lengthy a policy to insure against the need to pay for children’s college education as to provide for a surviving spouse for the remainder of his or her lifetime. These considerations may or may not achieve a lower premium but are worth looking in to.
Term life rates rise significantly as you age. My $200,000 in coverage through AAA Life Insurance increased by 38 percent when I moved from one five-year age bracket to the next. I’m worried about what it will be when I hit the next bracket in a few years.
I’m probably long overdue to reevaluate my life insurance needs and to do some shopping around, particularly before any additional medical conditions arise.
In decreasing term insurance, you may lock in a flat premium amount for the life of the policy — most likely in long policy terms such as 20 or 30 years — with a decreasing death benefit. While this provides certainty regarding the premium amount, it also relies on the not entirely accurate idea that one’s financial obligations decrease with age and less coverage is needed later in life.
Such coverage may make sense for some specific situations, but because term insurance is far more affordable than permanent life insurance, it is unlikely to be a sound financial investment.
One should compare the costs and benefits of various policy types in net present value dollars to understand the true cost of a policy.
It may make more sense to have multiple policies for varying terms and simply eliminate policies as they become superfluous — for example, having a policy that coincides with the time frame and dollar amount needed to pay children’s college tuition, then cancelling that policy once the children are done with school.
Are Life Insurance Premiums Tax Deductible?
Life insurance premiums are generally not a deductible expense for personal income tax purposes. IRS Publication 502, regarding deductible medical expenses, states that you cannot include premiums paid for life insurance policies.
Life insurance premiums for “key man” life insurance policies for a business are often deductible business expenses. So if you have a small business in the family, it may be worth conferring with your accountant and insurance agent to determine whether such a policy makes sense and could be deductible.
Are Life Insurance Proceeds Taxable for the Beneficiary?
Life insurance proceeds are usually not taxable income to the beneficiary. Interest, however, is taxable. Interest is less likely to be involved in the payout on a term policy than a whole life one, which has a built-in investment component, but it is conceivable that interest on the death benefit may accrue while the insurer evaluates the claim or is looking for the beneficiaries.
Because the proceeds are typically not taxable to the beneficiary, life insurance can be a useful means of transferring wealth between generations without estate taxes or probate.
As with anything tax-related, every situation is unique, and you should consult your tax professional regarding your specific situation.
Where Can I Buy Term Life Insurance?
In the internet age, there are more options than ever when shopping for insurance.
Life insurance may be offered through your employer, entities such as AAA or AARP, professional organizations, directly from the insurer through its website or call centers, through an agent who represents one or many insurers, or through online marketplaces. If you are a veteran, you may qualify for life insurance through the Veterans Administration.
In many cases you’ll be trying to compare apples and oranges, because each policy will be slightly different. Nevertheless, it is still worth doing your homework and shopping around to compare all those options.
I had long stuck with my local insurance agent and bundled multiple policies (for instance, home, auto, boat) for discounts, but then I decided to see what my Florida Bar member discount could get me elsewhere. It saved me 30 percent on my car insurance with a different insurer.
An important consideration is that insurance is regulated primarily at the state level. Laws and regulations governing policy terms can vary widely from one state to another, so it is important to research your specific state and not assume that consumer rights (for instance, canceling a contract within a certain number of days) apply in every state.
Insurers and their agents are licensed at the state level so a quote you see online may not be a product you may even purchase if that insurer isn’t licensed where you live.
The National Association of Insurance Commissioners, the professional organization of state insurance regulators, offers a wealth of unbiased information for consumers to find their state’s chief insurance regulator, learn about insurance and applicable laws, and search for complaint and financial information about insurers before you buy.
What Should I Look for in an Insurer?
An insurance policy isn’t worth much if the insurer never pays its claims. Research, research, research. Ask friends, family, and coworkers about their experiences with different insurers. Read online reviews. Check complaints with the Better Business Bureau and especially with state insurance regulators.
Price and value are certainly important considerations, but a seemingly inexpensive premium may be too good to be true if the company stalls payments, disputes every claim, engages in shady behavior, and has unresponsive customer service.
Ask yourself and others: Is the insurer reputable? Is customer service responsive, or do phones get answered only by the sales team? Is the insurer financially sound? Having a big name does not necessarily translate to being a good company as far as customer service or financial wherewithal to pay claims is concerned.
Battling with an insurance company while grieving the loss of a loved one is an especially unpleasant experience that you don’t want to leave your loved ones with.
The Bottom Line
Key Dos and Don’ts of Shopping for Life Insurance
- Do shop around, both for types of coverage and insurers.
- Do think of the range of income and services you provide your family in determining what coverage amount you need.
- Do check the financial solvency and complaint history of a potential insurer before buying.
- Don’t commit to a premium you can’t really afford and run the risk of losing your coverage.
- Don’t be pushed into a policy by an agent who may be getting a big commission to steer you to a product or a company.
- Don’t be swayed by polar positions in the industry that term insurance is always best or whole-life is always best; individual circumstances vary and change over time.
- “Buyer’s Guide to Term Life Insurance”
- “7 Kinds of Insurance Policies Everybody Should Consider”
- “What to Consider Before Buying Life Insurance”
Term vs. Permanent Life Insurance
|Lower premiums for same death benefit amount||✓|
|Wide range of policy-term length options||✓|
|Longer policy terms||✓|
|Can borrow against policy value once it’s built up||✓|
|Has “cash value” at end of policy period||✓|
|Lower premiums for same death benefit amount|
|Wide range of policy-term length options|
|Longer policy terms|
|Can borrow against policy value once it’s built up|
|Has “cash value” at end of policy period|