What is Life Insurance and How Does It Work?
According to the National Association of Insurance Commissioners, Life insurance is a contract between an insurance company and a policyholder. A life insurance policy guarantees the insurer pays a lump sum of money, tax-free, to designated beneficiaries when the policyholder dies, in exchange for the premiums paid by the policyholder during their lifetime.
- What is Life Insurance and How Does It Work?
- The Benefits Of Life Insurance
- Apply For Life Insurance Coverage
- Qualifying for Life Insurance
- Who Should Buy Life Insurance?
- The Components Of A Life Insurance Policy
- How Much Life Insurance Do I Need?
- Is Life Insurance Taxable?
- Is Life Insurance Tax Deductible?
- Types Of Life Insurance
- Term Life Insurance
- Permanent Life Insurance
- Comparing Life Insurance
- Living Benefits and Riders
- Life Insurance Companies
- How to Find Life Insurance Policy on a Deceased Person
- Frequently Asked Questions
The Benefits Of Life Insurance
Life insurance policy benefits include:
- Provides financial protection for families and businesses after unexpected life changes, giving peace of mind.
- The proceeds at death is tax-free to beneficiaries.
- Some policies can provide a tax-free income during retirement.
- The coverage can leverage the death benefit while alive to pay for long-term care expenses, including nursing homes, assisted living, home healthcare, and hospice costs.
- Coverage options can pay for final expenses such as medical bills, funeral and burial costs.
- Certain policies can be utilized as a college savings plan to pay for tuition in the future.
Apply For Life Insurance Coverage
Qualifying for Life Insurance
If you are younger and healthy, it will be easier to get coverage. If you are old and not healthy, it will be harder. Lifestyle choices that are unhealthy, like smoking or skydiving, also make it harder to get a policy in addition to more expensive coverage. If all else fails, you can apply for a policy that does not require a medical exam.
Who Should Buy Life Insurance?
Life insurance is designed to provide financial support after the death of the insured. Some examples are:
- Parents with young children
- Parents with special-needs children.
- Spouses who own property together.
- Elderly parents who want to leave money to their adult children.
- Parent with children in private school or paying college tuition.
- High-net worth individuals wanting to offset estate taxes
- Adults wanting to prepare for funeral and burial costs.
- Seniors wanting to an alternative method of paying for long-term care expenses.
- Key employees (C-Level Executives) in corporations
- Married retirees living on a fixed income or pension income.
The Components Of A Life Insurance Policy
A life insurance policy has either two or three parts. Term life insurance products have two components: a death benefit and premiums. Permanent insurance has a third component called cash value.
Death Benefit and Face Value
What is the face value of life insurance? The death benefit or face value is the amount of money that an insurance company guarantees to give beneficiaries when the insured dies.
The insurance company will decide if the person wanting to buy insurance is a good candidate. Age, medical history, occupation, credit history, height, and weight are all considerations when determining if the applicant is a good fit.
Premiums are the money you pay to get insurance coverage. The premium amount is based on the amount of coverage and the insured’s life expectancy. Life expectancy is factored by age, gender, medical history, prescription drug history, whether the insured is a tobacco/cannabis user, has a high-risk occupation or hobby.
The cash value in a permanent life insurance policy is a savings account that the policyholder can use while active. The cash value grows on a tax-deferred basis. The insured can use the cash value for retirement income or pay the premiums owed for the coverage. Beneficiaries do not inherit the cash value, only the face value (death benefit).
How Much Life Insurance Do I Need?
To calculate life insurance needs, solve for how much of the incoming income that you provide in your household. This will determine the financial loss when you die, and your household’s financial needs will need to supplement.
Ask yourself these questions:
- If you were to die early, what is my family’s financial impact?
- How would my spouse and children pay the bills such as a mortgage, car payment, or education?
- Who else depends on me financially, such as a parent, grandparent, sibling?
- Do I want to set aside money for my child’s current or future education in the event of my death?
- How much money is set aside for my family to pay final expenses (funeral expenses and burial expenses) and repay any debts after my death?
- Do I have family members, charities, or organizations to whom I would like to pass on an inheritance?
- Will my beneficiaries have to pay any estate taxes after my death?
- Is life insurance part of an estate?
- Will my family maintain their lifestyle financially but keep up with inflation as well in the future?
When solving for assets, count the insurance coverage you have now, including any group insurance from your employer or veteran’s insurance.
Figure out the assets your family will sell or cash in to pay expenses after your death.
Is Life Insurance Taxable?
Do beneficiaries pay taxes on life insurance policies? In most cases, no, a life insurance payout is not part of an estate. However, there are a few scenarios when they pay taxes.
- Death Benefit: Life insurance proceeds are not taxable to beneficiaries.
- Loans: Loans taken against a permanent life insurance policy can be tax-free. If an insurance policy is canceled or lapses, any loans that have not been paid back could be taxable if the outstanding balance is more than what you have paid into the policy.
- Cash Value: The cash value component in a permanent policy can earn taxable interest, and the interest will not be taxed until a withdrawal is taken.
Is Life Insurance Tax Deductible?
Can you write off life insurance? Unfortunately, your life insurance premiums are not tax-deductible because they are considered a “personal expense” by the IRS. You cannot deduct life insurance payments from your taxes if you buy it for yourself. The only times when this is possible are when you pay for someone else’s policy.
Types Of Life Insurance
The first thing you should know is that not all life insurance policies are the same. Each type of policy can serve a different purpose than financial security.
- Some plans give you coverage for your life while others cover you for a specific number of years.
- Some policies build up a cash value, and other policies do not.
- Some policies combine different kinds of insurance like mortgage insurance (mortgage protection), and others let you change from one kind of insurance to another.
- Some policies may offer other benefits while you are still living, such as long-term care benefits.
Above all, your choice should be based on your needs and what you can afford long term.
There are two basic types of life insurance: term life insurance and cash value life insurance.
Term insurance generally has lower premium amounts in the early years but does not build up cash values that you can use in the future. You can combine cash value life insurance with term insurance for the period of your greatest need for life insurance to replace income.
13 Types of Policies
There are 13 types of life insurance.
- Term life insurance lasts for a certain number of years before it expires. You choose how many years you will buy when you initially sign up. Most people purchase 10-30 year policies, however, 20 is the most common term length.
- Level term insurance means the premiums are the same every year.
- Increasing term insurance (yearly renewable term) means the premiums are lower when you’re younger and increase as you get older.
- Return of premium (ROP) term insurance policies will pay you your premiums back at the end of the term.
- Group life insurance is term insurance an employer provides to it’s employees.
- Permanent insurance stays in force for the insured’s entire life unless the policyholder stops paying the premiums or surrenders the policy.
- Single-Premium life insurance describes paying the entire premium upfront instead of making monthly, quarterly, or annual payments.
- Whole life insurance is a type of permanent life insurance that accumulates cash value at a fixed rate.
- Universal Life is a type of permanent insurance with a cash value component that earns interest. Premiums and coverage can be adjusted over time.
- Guaranteed Universal is a type of universal life insurance that does not build cash value and typically is cheaper than whole life.
- Variable Universal allows investing the policy’s cash value. Policyowners can lose money in a stock market crash.
- Indexed Universal is a type of universal life insurance that lets the policyholder earn an indexed rate of return on the cash value component without the ability to lose money due to poor market performance.
- Burial insurance or Final Expense insurance is a type of permanent insurance that has a small death benefit used for funeral expenses.
- Guaranteed Issue is a type of permanent insurance available to people with pre-existing medical issues. The policy will not pay a death benefit during the first two years the policy is in force in most cases due to the high risk of insuring the person. However, policy premiums plus interest will be paid to the beneficiaries if the insured dies during that two-year period.
Term Life Insurance
Term life insurance is incredibly straightforward, easy to understand, and cheap. But, as the name implies, the coverage only lasts for a specific period of time, starting as low as five years and extending up to 30 years.
Because these policies are temporary, the premium amount tends to be more affordable than their permanent life insurance counterparts, making it perfect for families on a budget or those who need supplemental accidental death insurance coverage.
Types of Term Insurance
- Mortgage Protection Insurance
- Return of Premium Term Insurance
- Convertible Term Insurance
- Accidental Death Insurance
Policy owners can renew most term insurance policies for one or more terms, even if your health has changed. However, premiums may be higher each time you renew the policy (extended-term insurance) for a new term.
Questions To Ask
- Always ask for the annual premium and the monthly premium amount. Sometimes the annual premiums can be cheaper if you pay once a year.
- Always ask what the premiums will be if you continue to renew the policy at the end of the term.
- Another question to ask is if you will lose the right to renew the policy at a future age.
For a higher term insurance premium, insurance companies will give you the right to keep the policy in force for a guaranteed period at a fixed price each year. Then at the end of that time, you may need to pass a physical examination to continue coverage, and your premiums may increase.
You may be able to convert the term insurance policy into a cash-value policy during a conversion period, even if you are not in good health. However, premiums for the new policy will be higher than the fixed premiums you have been paying for the term insurance up until that point.
Permanent Life Insurance
There are three types of cash value life insurance (permanent insurance) which are:
Cash-value insurance is also known as a Permanent Life Insurance Policy, which will protect your beneficiaries for the duration of your life. Permanent insurance is a type where the premiums charged are higher at the beginning than they would be for the same amount of term insurance.
These policies tend to be more expensive than term policies due to policy provisions, non-forfeiture options, and cash value. However, these features give the policy owner more flexibility, security, and sometimes an income replacement.
Whole Life Insurance
Whole Life Insurance covers you for as long as you live if the premiums are paid. So you generally pay the same amount in premiums for your entire life.
When you first take out the insurance policy, premiums can be several times higher than you would pay initially for the same amount of term insurance. However, they are smaller than the premiums you would eventually pay if you keep renewing a term policy until your later years.
Some whole life policies let you pay premiums for a shorter period, such as 20 years, or until age 65. Premiums for these policies are higher since the premium payments are made during a shorter period.
Types of Whole Life Insurance
Universal Life Insurance
Universal Life Insurance is a type of flexible policy that lets policy owners vary the premium payment amounts. Universal life also allows you to adjust the face amount of your insurance coverage.
Any increases may require proof that you qualify for the updated death benefit.
The insurance premiums you pay (less expense charges) will go into a policy account that earns interest. Any charges will be deducted from the account. If your annual premium payment plus the interest your account earns is less than the charges deducted from the policy, your account value will become lower. If the account’s value keeps dropping, eventually, your coverage will end.
To prevent that, you may need to start making additional premium payments, increase your premium payments, or lower your death benefits.
Even if there is enough in your account to pay the premiums, continuing to pay premiums yourself means that you build up more cash value for yourself.
Types of Universal Life Insurance
- Universal Life Insurance
- Guaranteed Universal Life Insurance
- Index Universal Life Insurance (IUL)
- Protection IUL
- Accumulation IUL
Variable Life Insurance
Variable Life Insurance is insurance where the death benefits and cash values depend on one or more separate accounts’ investment performance, which may be invested in mutual funds or other investments allowed under the insurance policy.
Be sure to get the company’s prospectus when buying this kind of policy and study it carefully.
You will have higher death benefits and cash value if the underlying investments do well.
Your benefits and cash value will be lower or may disappear if the investments you chose didn’t do as well as you expected.
You may pay an extra premium for a guaranteed death benefit.
Comparing Life Insurance
In order to find the best life insurance policy for you, start shopping for life insurance quotes. This will provide you with the best value for the long term.
A simple comparison of the premiums is not enough. There are other things to consider such as financial strength, coverage parameters, and additional benefits.
Questions To Ask Yourself:
- Do your insurance premiums or benefits vary from year to year?
- How much do the benefits build up in the policy?
- Which portion of the premiums or benefits is not guaranteed?
- What is the effect of interest on premiums paid and received at different times on the insurance policy?
- Who are the best life insurance companies, and will they be around for my lifetime?
You should know that no one insurance company offers the lowest cost of all ages for all kinds and amounts of life insurance coverage.
If you are thinking about dropping a policy, here are some things you should consider:
- Don’t cancel the old policy until you have received the new one.
- A new policy may be costly to replace the old policy since you are older.
- If your health has changed, remember there probably will be a medical exam, and the new policy’s insurance premium amount will often be higher.
- You will not be able to buy a new policy because now you are not insurable.
- You may have valuable rights and benefits in the policy you now have that are not in the new one.
- You might be able to change your policy or add to it to get the coverage or benefits you now want.
Living Benefits and Riders
Many insurance companies will let you change your policy and customize it to meet your own needs. Life insurance plans with living benefits or riders are a type of change that you can make to your plan. You may need to pay more for the rider or an extra fee, but there are some that come with the base plan, so this won’t happen as often.
- Accidental death benefit rider provides additional coverage if the insured’s death is accidental.
- Waiver of premium rider waives premium payments if the insured becomes disabled and unable to work.
- Disability income rider pays a monthly income if insured becomes unable to work for several months or longer due to a serious illness or injury.
- The accelerated death benefit rider allows the insured to collect a portion or all of the death benefit if diagnosed as terminally ill.
- The long-term care rider pays for a nursing home, assisted living, or in-home care when the insured requires help with activities of daily living (ADL), such as bathing, eating, transferring, and using the toilet.
- A guaranteed insurability rider offers the option to buy additional insurance in the future without a medical review.
Life Insurance Companies
- New York Life
- American General (AIG)
- Metropolitan Life (Metlife)
- State Farm
- John Hancock
- American Income
- Servicemembers’ Group
- Jackson National
- Northwestern Mutual
- Freedom Life
- Pacific Life
- Lincoln Financial Group
- Penn Mutual
- Cincinnati Life
- Midland National
- North American
- American National
- Ohio National
- Security Mutual Life
- Globe Life
How to Find Life Insurance Policy on a Deceased Person
Beneficiaries can find life insurance policies from the deceased by contacting the National Association of Insurance Commissioners (NAIC). A death certificate from the funeral home that conducted the burial or cremation would improve the NAIC’s search for forgotten policies.
The policy locator service is free with no limitations, and the process could take up to 90 business days.
Be prepared to have as much personal info on the deceased as possible.
Buying coverage is an essential part of anyone’s financial strategy as it is the best way of safeguarding your family from the potential economic downfalls associated with death.
The financial support can help pay off debts, including mortgage, car loans, student loans, and replace day-to-day income. Business owners can use the insurance payout to pay off business debts as well.
Term insurance provides coverage for a set period of time, while permanent insurance (whole life and universal life) provides lifetime coverage.
If you are struggling with the buying process, feel free to contact us for assistance.
We will discuss your goals and find the best life policy at the cheapest rates.
Pre-existing Medical Conditions: If you feel your health could prevent you from being approved for a policy, contact us. Very rarely can we not find a solution for most people.
Frequently Asked Questions
What is term life insurance?
Term insurance covers you for a term of one or more years. It pays a death benefit only if you die within that term. Term insurance generally has lower premiums in the early years but does not build up cash value.
What is whole life insurance?
Whole life insurance offers guaranteed level premiums, death benefits, and cash value.
What is universal life insurance?
Universal life insurance is a flexible policy that lets you vary your premium payments. In addition, universal life has the ability to earn interest to grow the cash value within the policy either by a fixed interest (Fixed Universal Life), the positive change of a major market index without directly participating in the markets (Indexed Universal Life), or direct market performance (Variable Universal Life).
I’m a licensed financial professional. I’ve sold annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.
My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you.