Life insurance is meant to protect a person’s family from the financial consequences of the insured person’s premature death. The traditional purpose of life insurance is to provide beneficiaries with a lump-sum cash payment, known as a death benefit, upon the policyholder’s death. These days, however, life insurance is also often used to create a tax-advantaged estate for the policyholder’s survivors, regardless of whether his or her death occurs unexpectedly or prematurely.
There are two main types of life insurance: term and permanent (also known as cash value insurance).
Term life insurance provides a death benefit, but only for a specific term, or period. If you die within the term, the policy pays out the death benefit to your beneficiaries. If you survive the term, you must reapply to continue coverage. Term life insurance is based upon the presumption that you’ll die before you have significant assets to pass on to your beneficiaries: it gives you the security of knowing that your beneficiaries will have money to live on if you die prematurely, before you’ve built up significant wealth. There are three types of term life insurance:
Permanent life insurance is the only type of life insurance that has no specified term and provides guaranteed coverage until death. Permanent policies also differ from term policies by adding an investing component—some policies allow the policyholder to receive annual cash dividends or invest the death benefit to grow its value. There are three main types of permanent life insurance:
Permanent life insurance costs significantly more than term life insurance, but that doesn’t mean that permanent life insurance is always the better choice. One strategy many policyholders use is “buy term and invest the difference.” Under this strategy, you set aside the money you save by buying term life insurance instead of permanent insurance, then invest that money diligently in the stock market. Because the average annual return of the stock market has historically been 8–10%, chances are you can build more wealth than you would with a permanent policy, whose average annual return is just 3–4%. If you’re not comfortable investing in stocks, however, a permanent life insurance policy may be a better choice for you.
The amount of life insurance coverage you need depends on your health, age, financial situation, family obligations, and other personal factors. For a rough estimate of the amount of money your family should need to maintain its lifestyle should you die, add together:
The cost for life insurance varies widely depending on the type of policy you buy and your specific situation. The older you are when you apply for a policy, the more expensive the premiums will be. Expect permanent life insurance premiums to be three to five times greater than those for term life insurance.
Given the multitude of options involved, it’s best to purchase life insurance through a captive or independent agent. The agent should be able to explain all the options involved and help you make the best choice for your individual circumstances.