Hi everyone! Welcome back to Melissa Making Cents!
Lately, I’ve been on an estate planning kick. With my stepfather's cancer and recent death; I have had to face estate planning on a very personal level. It has been a heart breaking experience to go through the process at such a late stage. But.. it is very important to make sure all your proverbial ducks are in a row to ensure your family and loved ones are protected.
I know it’s a little morbid to be thinking about what happens to your assets after illness or death, but it’s critical to ensure financial protection for yourself and your family. One of the best ways to provide a financial safety net for yourself and your loved ones is to invest in a good life insurance policy. There are a few questions I get often:
- What's the right amount?
- What is the right type of policy?
- Do I have/want living benefits?
- Is everything titled correctly?
Today, I will talk about the benefits of life insurance, the different types of insurance, and how to make sure you have the coverage you need.
Life insurance works in the same way as most other types of insurance: a policyholder pays a monthly fee, also called a premium, to the insurance company in exchange for a future benefit. For example, you pay your car insurance premium every month, and then the insurance company pays for damages if you get into a car accident. Similarly, you pay a health insurance premium so that your insurance company will cover expenses associated with medical bills. For life insurance, the main benefit you get in exchange for the premium is a guaranteed payout (or “death benefit”) to a designated beneficiary after your death. In addition, death benefits from life insurance are usually income tax-free, which puts even more money in your beneficiaries’ pocket.
A life insurance policy gives your family an additional source of income after your death, which is especially important if you’re the primary breadwinner. It’s common for a parent with minor children to purchase life insurance in order to make sure the children are provided for in the event of the parent’s unexpected death. A few other situations when life insurance comes in handy include if a parent has a special-needs child, a policyholder wants to make sure their funeral expenses will be covered without burdening their family, or elderly parents who are cared for by their adult children want to provide more financial compensation after death. Some life insurance policies will also pay long term care benefits, which can help cover hefty healthcare expenses in retirement.
There are different types of life insurance
There are a few types of life insurance policies, with varying benefits. The three main types of life insurance are term life insurance, universal life Insurance, and whole life Insurance. Both universal life insurance and whole life insurance are categorized as types of “permanent life insurance,” which means they last for the policyholder’s lifetime. Here’s a look at each of the three main types of life insurance and who might benefit the most from each one.
Term life insurance
Term life insurance is usually the lowest price option. That’s because it only lasts for a predetermined period of time (or--you guessed it--a “term”), such as 10, 20, or 30 years. Term life insurance is an attractive option if you want to keep your monthly premiums low, but still offer your family a safety net to cover any lost potential income during the years you would have been working. However, it is worth noting that term life insurance benefits are paid out as a lump sum, rather than continuous installments.
Term Insurance is also great for supplementing a permanent policy. One might purchase a supplemental 20 or 30 year term policy to potentially cover mortgage payments, without increasing the coverage amount on a permanent policy. This would reduce the cost of insurance coverage and provide additional coverage during the limited time needed.
Term insurance has traditionally been "use it or lose it", which means that you potentially run the risk of paying for something you may not use, much like auto insurance or home owners insurance. But... there are a few insurance companies that are now offering disability benefits as part of the policy. This means that if you meet one of the qualifications under the terms of the policy, such as a heart attack or major injury, the insurance company will pay you a reduced benefit.
Whole life insurance
Unlike term life insurance, whole life insurance provides coverage benefits for...your “whole life!” Every month, you pay a fixed premium. Part of that premium goes into an investment account, which allows the “cash value” of your policy to increase over time and on a tax-deferred basis. The benefit of having a “cash value” attached to your life insurance policy is that it can be used during your lifetime through withdrawals or taking out loans against the policy. This cash value can also generate dividends, which you may choose to receive annually, reinvest, or reduce the cost of your monthly premiums.
Whole life insurance is great for estate planning because it enables you to shield and grow your wealth for your beneficiaries, and it also offers cash value benefits while you are alive. However, whole life insurance also requires you to pay the higher monthly premiums in the long run, which may or may not be sustainable depending on your situation. Whole life policies offer the strongest guaranteed death benefits, but are the least flexible with higher, required regular premiums.
Universal life insurance
Similar to whole life insurance, universal life insurance provides lifetime coverage and comes with a higher price tag than term life. Universal life insurance also sets aside part of your annual premium for a tax-deferred investment account, so this type of policy also has a “cash value” component that you can use during your lifetime.
The main benefit of universal life insurance is its flexibility. You can change your coverage limits and the amount you pay in monthly premiums. Universal life insurance is helpful for estate planning and transferring wealth to beneficiaries, as well as replacing potential lost income by accumulating cash. A policy holder can opt to have interest credited to a separate account that may be invested in options similar to mutual funds, stock price index performance, or a fixed interest rate. The downside is that universal life insurance fixed interest option is beholden to interest rates, so the cash value may not grow as much depending on the market. Investing in the separate account subjects the policyholder to a little more risk, and the policy death benefit will not be a guaranteed amount.
How can you tell if you are underinsured or overinsured?
The amount of life insurance you need--or if you even need it at all--depends on several factors. For example, does anyone such as a spouse, parents, or children depend on you for income? How much of your income have they been depending on, and for how many years would they lose this income? What existing savings, investments, and assets could they draw upon in the event of your death? And would you want to make any financial provisions for special circumstances like your funeral, long-term care for a dependent adult, or a child’s education?
There are a few ways to calculate your life insurance needs. In the simplest method, life insurance coverage is calculated based on how much potential income your dependents would lose in the event of your death, minus your assets. You can use an online calculator to help you arrive at your ideal life insurance amount. Compare this number to what your current policy states, and see if you can adjust it accordingly. Working with a CERTIFIED FINANCIAL PLANNER™ to create a comprehensive financial plan can help you evaluate policies that may best meet your needs.
Life insurance policies are typically offered through an employer, although you can also buy them on your own through an insurance company. Many employers provide Basic Life Insurance coverage to their employees for free, in the amount of 1.5 times your annual salary. This is a great start to getting coverage to protect your family. However, this is often not enough.
Even if your employer offers life insurance with a default policy option, you can usually purchase supplemental coverage. It is also important to evaluate what may happen to your policy if you decide to leave that employer. Some companies provide insurance coverage that is portable, meaning you can take it with you for an extra cost paid by you.
You should monitor your life insurance policies to make sure they are working for you
Many of my clients have assumed that life insurance is “set it and forget it.” But that’s not necessarily true! Your circumstances may change drastically, and the life insurance you have may not be sufficient for protecting yourself and your family financially. In addition, older policies can get expensive, but often don’t always offer many of the newer benefits.
A huge perk of life insurance policies is the ability to add riders, which are basically add-ons to include more coverage for specific scenarios. You may find that adding a few riders to your existing policy will provide you with the coverage that better suits your needs. In addition, if you have universal life insurance, you can easily change your coverage and premiums to reflect your current situation.
Long-Term Care Rider
Few things change your financial situation more than illness. Newer life insurance policies can include a Long-Term Care rider, which would entitle you to receive a portion of the death benefit while you are still alive if you are diagnosed with a chronic illness that hinders your ability to take care of yourself. This is typically used to pay for expenses such as a nursing home, assisted living facility, or home aides. This type of rider can be added to either whole life insurance or universal life insurance because they last for a lifetime. As I mentioned above, some term life insurance policies now provide this benefit as well!
Critical Illness Rider
Similarly, a Critical Illness rider provides a lump sum payment if you are diagnosed with a life-threatening disease, such as cancer, heart disease, or Alzheimer’s disease. Note that this rider would need to be purchased before you are diagnosed with an illness (not after!), and you may have to provide the insurance company with medical records in order to receive it.
Other Types of Riders
Other common types of riders that you may wish to add to a life insurance policy include an accidental death benefit rider (which provides additional coverage if your death is the result of an accident) or a waiver of premium rider (which allows you to stop making premium payments but still retain your policy if you become disabled and can no long work). Keep in mind that life insurance is not a replacement for disability insurance, but it can provide extra protection at a relatively low cost.
If you want to add a rider to your existing policy, contact your current life insurance provider. Not all riders are compatible with all types of life insurance, and not all insurers offer the same riders.
Make sure you review your beneficiaries often!
Since the death benefit associated with your life insurance goes to a designated beneficiary, you will need to make sure you review your beneficiaries regularly. This is especially important to do after major life events, such as a marriage, a child’s birth, a divorce, or the death of your previous beneficiary. Even if there’s no major life event, it’s still a good idea to review once a year to make sure the person you have listed is still who you want to receive the death benefit. You can keep a list of your current beneficiaries in your personal financial binder, which would make annual reviews much easier.
I also recommend listing contingent beneficiaries on your life insurance policy, in the event that the first beneficiary dies before you. If you haven’t listed a contingent beneficiary, the death benefits would go to your estate and pass through probate. That’s a lot more time-consuming and labor-intensive for the eventual recipient, so it’s always best to have a Plan B in place.
There are, however, some other scenarios where things get trickier regarding your life insurance beneficiaries. For example, what if you and your first beneficiary die at the same time in a car crash? The passage of assets in this case varies by state and might be paid out to someone’s estate or to the contingent beneficiary. You can check with the insurance company, an estate planning attorney, or a CERTIFIED FINANCIAL PLANNER™ to learn what would be the case for you.
How do beneficiaries receive the death benefits?
To receive your life insurance benefits, your beneficiary must submit a death claim and copy of the death certificate to the insurance company. This should be done as quickly as possible, and many insurance companies let you fill out the required forms online. It typically takes 30 to 60 days for the insurance company to review the claim and then issue the payout, which would be either a lump sum or installments over time depending on the terms of the policy.
While death benefits are generally income tax free, the beneficiary may have to pay income tax on any interest that accrues before the total benefit is paid out. These tax implications might incentivize the beneficiary to take a lump sum payment or an annuity payment over a shorter time frame, if permitted.
One point to remember is that life insurance proceeds are paid directly (by contract law) outside of probate. This generally saves probate costs, can’t be contested, and is private not public information. These are important and often overlooked benefits, particularly for wealthy families and families with black sheep or warring children.
Still not sure what type of life insurance is right for you?
Life insurance is one of the most versatile assets you can have. Depending on your policy, it can be an additional source of income for you if you become terminally ill, it can provide another resource to borrow money from, and most importantly, it provides financial protection for your family after your death. How you want to use the policy will determine which type of life insurance is best for you.
Part of my job as a CERTIFIED FINANCIAL PLANNER™ is to help my clients determine if life insurance is right for them, as well as the type of coverage they need. If you are currently exploring life insurance options, creating your estate plan, or going through an overall financial checkup, call or email to schedule an appointment with me.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor in Dallas, Texas.