Most adults will buy life insurance at some stage. But figuring out how much to buy, and what kind, can be hard. We hope to make it easier.
Life insurance: what it is and why you buy it
The concept is simple. Life insurance is a contract between the buyer and an insurance company. The insurer pays a pre-agreed amount in the event of the insured’s death.
You usually buy insurance to protect against the loss of future income. There are other reasons as well. A couple examples:
- Case 1: Jan is the main wage earner for a family of four. Her salary covers expenses, and she also contributes to a retirement plan she and her spouse will need in retirement. She should purchase insurance on her life.
- Case 1 (cont’d): Jan’s husband, Bill, is a stay-at-home dad. Their kids are young. The couple should also purchase insurance on Bill’s life, because without him, Jan will have to pay for child care.
- Case 2: Mary and Tom are a dual-income couple. They could each cover most of their own expenses without the other, but they could not pay the mortgage. They should own a policy on each of their lives sufficient to pay off the mortgage.
How much should you buy?
The examples above should lead you to an answer.
- In Case 1, Jan should have enough insurance to cover her cumulative after-tax earnings until retirement, plus whatever she expects to save for retirement. If she is 20 years from retirement, makes $90,000 after-tax and contributes $10,000 annually to her retirement plan, she should have as much as $2 mm of insurance on her life.
- Also in Case 1, if Jan would have to pay for day care and / or a nanny, costing $20,000 annually for four years until their twins were of school age and another $10,000 for eight years before they could be home alone after school, they should own as much as $160,000.
- In Case 2, if Mary and Tom’s mortgage is for $350,000, that’s the amount of insurance they should own on each of their lives.
The calculations become more complicated, for several reasons.
- If anyone has insurance through an employer’s group plan, they should reduce the insurance need dollar-for-dollar.
- If the deceased spouse was building up a Social Security benefit, the surviving spouse would be entitled to a survivor’s benefit, usually as early as age 60, or immediately if survivors include children below age 16. That reduces the insurance need.
- You should expect to earn money, over time, by investing the insurance proceeds. As long as those investments earn a higher rate than inflation, you need somewhat less insurance.
If you need help making these calculations, or if your situation is complicated, ask your financial advisor.
What kind of insurance should you buy?
There are two basic kinds of life insurance: term and permanent.
Term is almost always the best option. It is the least expensive, it directly addresses the insurance need and it’s not overly complicated.
Term life provides insurance for a specific number of years – usually 10 or 20. It pays a pre-agreed amount if the insured passes away during that period. If the inured survives, the policy ends. The cost of insurance can be very low, especially for young people in good health.
Permanent life insurance is a combination of life insurance and a tax-deferred investment. It is designed to last for the insured’s entire life – hence the name “permanent”.
There are several types of permanent life insurance.
Whole life is the traditional form of permanent insurance. You usually pay the same premium every year, and the death benefit is fixed up-front. Some of your payments in the early years are used to invest at the insurance company’s discretion, and if those investments do well, you will build up a “cash value” you can take out if you wish to cancel. The cash value may also reduce or eliminate premiums in later years.
Universal, variable and variable universal
Universal life allows the policy owner to change the premium payments or the death benefit. This flexibility can help in years when the owner cannot afford to make a premium payment. But there must be enough excess funds (“cash value”) to pay the cost of insurance. Variable policies allow the owner to determine who the excess funds are invested, for example in stock or bond mutual funds. This increases the potential risk and return of the policy. A variable universal policy is a combination of both.
Why term is almost always best
Term almost always beats permanent life:
- It’s a lot cheaper. One analysis we saw calculated the difference as a multiple of 20.
- For most people, your need for insurance is not permanent. It ends when the kids are grown or when you have saved enough for retirement. Why buy permanent insurance for a temporary need?
- The investing tax advantage of permanent insurance is over-rated. Insurance agents will tout the ability to defer tax on investment gains for years or decades if you buy permanent insurance. That’s true. But if you buy low-cost funds that trade infrequently, they will generate a minimal tax bill.
- It’s simple to understand. A golden rule of personal finance: if you can’t understand a product, avoid it. Permanent life – especially variable universal, which has gained popularity – can be very hard to understand. That leaves a lot of room for fees, reducing the long-term value of the investment.
When would permanent insurance make sense?
Buy permanent insurance only when you will truly need it for your entire life. Here are two scenarios:
- Most of your net worth is in assets (real estate or a family-owned business) that you don’t want your heirs to sell in a hurry after your passing. They might need the money for living expenses, or to pay estate tax. Permanent insurance avoids a forced sale.
- You want to move money out of your estate and are worried about premature death. You can set up an “irrevocable life insurance trust” – a trust you do not own, which owns an insurance policy on your life. When you pass away, the death benefit goes to the trust outside your estate. The trust’s beneficiaries could be your children, for example.
Is the death benefit taxable?
No. If an insured passes away, survivors receive the death benefit free of any ordinary or capital gains tax. This is different than a typical investment, where any gain is taxable.
There can, however, be a tax due. If the deceased owned the policy on his / her life and passed away owing estate tax, the insurance proceeds are subject to estate tax.
Does the insurance company matter?
Yes. It must have a strong financial condition, because you’re relying on it to be able to pay a death benefit years from now.
There are four well-known credit-rating companies that measure insurance companies' financial strength. They are A.M. Best, Moody's, Standard & Poor's and Fitch. You can often find a "Comdex" score on-line that combines the ratings of all four. Most of the "brand-name" insurers will have very high ratings, but you should always check.
This article is not intended to provide tax, legal, accounting, financial, or professional advice. Readers should seek advice from qualified professionals who can review their specific circumstances. Old Peak Finance endeavors to provide information that is accurate and current. However, we cannot guarantee that this information has not been outdated or otherwise rendered incorrect by new research, legislation, or other changes. Old Peak Finance has no liability or responsibility to any individual or entity with respect to losses or damages caused or alleged to be caused, directly or indirectly, by the information contained on this website.