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A Quick Reference Guide to Life Insurance

| July 19, 2018
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Life insurance is a sensitive subject for many people. It’s often easier to avoid having difficult conversations about how the family will manage if you die than to face it head on.

Part of the hesitance in tackling the topic of life after you’re gone is the fact that many people understand very little about life insurance, how it works, and the advantages it provides as part of a holistic, long-term financial plan.

The first step in having a conversation begins with getting a better understanding of this unique insurance, while dispelling myths and common misconceptions about life insurance.

  1. You should consider a policy now, even if you’re young and healthy

Many young adults who are healthy think that they don’t need to secure life insurance at this point in their lives – after all, they’re in their prime. Unfortunately, the reality is that many people consider life insurance once they’re older or start suffering from illnesses – making insurance costlier and more difficult to secure. 

Interestingly, some life insurance policies can even accrue funds over time, growing that life insurance nest egg, while others allow you to withdraw funds. With this in mind, securing a policy that fits your lifestyle and needs is important and will give you greater peace of mind so you don’t have to worry about:

  • How your family will handle daily expenses and pay the rent or mortgage
  • How funeral and burial costs will be handled
  • How your children will pay for college
  • How other people you love and charities you support will cope
  • How your family will handle liquidity needs, estate taxes, and generation skipping transfer taxes, especially if you have a large estate or family business
  1. There are different types of life insurance

Life insurance isn’t a one-size-fits-all affair. There are two types of life insurance: Term and Permanent.

Term life insurance sets a specific time limit to your policy, usually 10, 20, or 30 years. If you die within the time period that the policy is in effect, your heirs receive a monetary death benefit. If you live longer, there is no benefit payable and the premiums paid over many years are a sunk cost, although you may renew the policy at the end of the term if you choose at a much higher premium. This type of policy can provide a higher death benefit with lower premiums in the short run.

Permanent life insurance policies do not expire if appropriately funded, ensuring that your heirs receive a payout upon your passing. Permanent policies can be lower cost overall during your lifetime. As another benefit, depending on your situation, the income tax and estate tax advantages associated with permanent life insurance can be very attractive. There are three types of permanent life insurance:

  • Whole Life Insurance is the oldest permanent life insurance product, providing coverage for the life of the insured party.
    • This option provides payout in the event of your death and has a savings component where cash value may accumulate tax-deferred or even tax-free.
    • Premiums are fixed and the costs are not itemized.
    • The policy owner can withdraw or borrow funds tax-free as long as the policy stays in force.
    • The cash value rate of return is similar to bank CDs and there is a minimum guaranteed return.
  • Universal Life Insurance provides more flexibility than whole life insurance.
    • It has flexible premiums and offers an investment savings element.
    • Costs are itemized and transparent.
    • As cash value accumulates, the insured can withdraw or borrow a portion of the funds which may affect the death benefit. If done right, this can be tax-free.
    • Policyholders have the ability to adjust their premiums and death benefits.
    • The cash value rate of return (and risk) is similar to the bond market.
  • Variable Universal Life Insurance is comprised of separate accounts containing different investment funds, like bond funds, equity funds, money market funds, and more.
    • Variable Universal Life policies offer several tax benefits, including tax-deferred accumulation of earnings and potentially tax-free distributions.
    • Premiums are not fixed, allowing policyholders to adjust their payments based on needs, investment goals, or cash flow.
    • Costs are itemized and transparent.
    • The death benefit may be dependent on the performance of the investments in the policy.
    • There is often also a fixed account that provides a similar rate of return as Whole Life or Universal Life.
    • Variable Universal Life policies offer a cash value rate of return (and risk) similar to a regular investment account made up of a diversified mixture of stocks and bonds.
  1. Different types of life insurance offer different benefits

Life insurance policies offer death benefits and can also offer disability and long-term care benefits. The death benefit is the payout your family would receive if you passed away in order to pay the mortgage, put food on the table, and maintain their quality of life. Disability benefits add to the cash value accumulation if you are unable to work for an extended period of time due to disability or another medical condition. Long-term care benefits are paid out to you and reduce the death benefit amount if you need to pay for assistance with activities of daily living.

Term insurance only pays the death benefit, while permanent life insurance pays death benefits and can also pay disability and long-term care benefits. With a permanent policy, the death benefit is available to your heirs and the disability and long-term care benefits are available to you, the policy holder. A financial planner can help you determine which type of life insurance is most advantageous for you.

  1. Your health now impacts the cost of your insurance

Since healthier people generally live longer, the healthier you are, the lower the cost of insurance, which also builds the case for why it’s important to purchase life insurance when you’re younger and healthier.

In the case of term insurance, this means that healthy people will most likely outlive the term of their policy, so the insurance company will never need to pay out. For permanent insurance, this means that the inevitable payout is far into the future and when that time comes, the accumulated cash value is expected to be high and the amount at risk low (the amount at risk is the difference between the cash value and the death benefit).

  1. The premium and cost of insurance are different things

Many people think the premium and cost of insurance are the same thing, but they differ greatly. The cost of insurance is how much the company charges you to handle administrative, investment, and sales expenses, and accounts for the risk they take in writing your policy. Sales expenses are in part used by the insurance company to compensate the advisor making the policy recommendation to you.

The premium is the amount you contribute each period. For term insurance, your premium is the same as the cost of insurance. With permanent insurance, the premium builds up a cash value which earns a rate of return. The cost of insurance is deducted from the accumulated funds.

Understanding the intricacies of life insurance and the policy that best fits your current and desired lifestyle can be very complex. That’s why as financial planners, we sit down with our clients to get a better understanding of where they are and where they want to be, as life insurance is just one component of a well-balanced financial plan. In the same vein, it’s an investment in your and your loved-ones’ wellbeing that provides greater peace of mind when looking into the future.

Contact our team to learn how we can assist you with a variety of life insurance and financial planning needs.

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