There are two basic kinds of life insurance: term and permanent. Term insurance can be used for paying for the things you would need (or want) to finance, were you to die during the next 20 to 30 years. Permanent insurance (such as whole life or universal life) will pay for the things you want to have taken care of when you die, like funeral costs or leaving an inheritance. Permanent insurance also builds cash value that you can access over time.
NBC News recently published a story that asks “How much life insurance do I need?” As the article explains, term policies are cost effective and can be specifically designed to be in place when you need the coverage, like paying your mortgage or college tuition for children. Of course, the downside with term policies is that they’re only for a set duration. They’re not forever. People wait until the end of their term policy to get another one. Instead, they should buy a new policy as early as possible. Otherwise, you wind up paying more for the same amount of coverage later. Another negative about term policies, is that if you go to renew after the term, the premium will increase.
Permanent policies span your whole life and have cash value. They also grow tax free, and the savings can be borrowed from the policy tax free after a certain number of years. For higher-income earners, this can be a good way to have tax-free income in retirement and have greater tax diversification. Another benefit of permanent policies is that they can be used to pass down an inheritance tax-free. When someone dies, there may be an estate tax on their assets. Purchasing a permanent policy to alleviate this cost, is an effective way to pass down your wealth.
However, permanent life insurance policies are expensive. Returns in a life insurance policy are highly debated, with some believing in the tax advantages, and others counseling to “buy term and invest the rest.” Everyone’s situation is different. You can assess your needs by taking the “DIMEF” test:
- Debts: Look at all of your debts, except your mortgage.
- Income: Lost income from a spouse or a partner is the primary reason to buy life insurance and maintain the current lifestyle.
- Mortgage: Life insurance can pay off a mortgage, so your family can remain in the same home.
- Education: College costs for children or a spouse.
- Funeral expenses: These expenses add up quickly and your life insurance proceeds can pay for them.
Experts say you should have at least five times your annual income and enough to pay for 100% of your debts. You can calculate it with the following approach:
- Take the total of your liabilities and debts, income to be replaced, final expenses and education or extra goals;
- Subtract the savings or assets your family would use immediately, if you passed away; and
- Subtract any current life insurance you own, excluding coverage offered through your work.
The cost will differ, based on factors such as age, health, lifestyle, gender, type of insurance and amount of coverage. You may also need to take a physical exam. If you’re ill, the cost will be more, or you may not be eligible for life insurance. The older and less healthy you are, the shorter your life expectancy is—and the more expensive the policy. To get a solid quote, you’ll need to undergo underwriting. The insurance companies can pull medical records or order a full physical. If you take prescription medications, the likelihood of a paying a higher premium also increases.
The younger you are when you buy a life insurance policy, the lower your premium will be. However, this once standard investment isn’t being considered by many millennials the way it was by previous generations. Almost 60% of millennials are not carrying any life insurance, but they should be thinking about it, because there’s a big cost for delaying.
Reference: NBC News (November 24, 2018) “How much life insurance do I need?”