If you’re in the market for life insurance, or already have it, you don’t need to be told that proper coverage is an important pillar of personal finance, providing much-needed protection for those who depend on you. But with all the coverage options available, and costly errors common, it might just help to explore some of the biggest mistakes people make when purchasing policies of their own – from waiting too long to buy, to getting the wrong type of coverage, to being underinsured.
“Mistakes happen all the time,” said Todd Novelli, a financial advisor at Novelli Financial Network in Pittsburgh, Pennsylvania, in an interview. “A lot of times people come to me with preconceived notions about the life insurance products they think they need, but it’s not necessarily what’s right for them.”
Waiting too long to buy life insurance
Perhaps the most common mistake, when it comes to buying life insurance, is waiting too long to buy.
Indeed, young people with competing financial priorities often delay the purchase of life insurance until they have kids, which may be in their mid- to late-30s. But age is one of the biggest factors that affects premiums. Generally, the younger you are, the cheaper your insurance will be.
By holding out, you also run the risk of developing a serious health condition before you buy, which would render future premiums far more expensive, or leave you uninsurable.
“The cost of insurance is a common excuse because everything else in our lives seems more important at the time, but successful people buy life insurance—bottom line,” said Novelli. “They buy term insurance for their families when they’re 30 or 40 and then they buy more, usually permanent insurance, when they’re 50 or 60 because that can be leveraged to meet other financial goals.”
A term life insurance policy, he noted, is often more affordable than many consumers think. (Get a life insurance quote here)
When asked how much a $250,000, 20-year term life policy would cost annually for a healthy, non-smoking 30-year-old, the median estimate among all age groups surveyed was $400 – more than twice the actual cost, according to Life Happens, a nonprofit consumer education group funded by the financial services industry. Consumers who were aged 30 years or younger guessed even higher, with the majority selecting a median estimate of $500 annually, and 25 percent suggesting it would cost at least $1,000 per year. The actual cost of that policy? About $160 a year, or $13 per month. 1
Wrong type of policy
Both term and permanent life insurance can protect your family from financial risk, but they are very different tools. If you pick the wrong policy, and many people do, you could leave your family vulnerable when they need protection most.
To make a good decision, you first need the facts:
Term life policies provide coverage for a fixed period of time – often 10 or 20 years. Because there is no cash-value accrual, they are generally far less expensive than permanent policies. If you die before the term expires, your beneficiaries get a death benefit, generally tax free. If you outlive your term, most policies allow you to continue coverage, albeit at higher premiums.
Permanent life insurance, on the other hand, such as whole or universal life, guarantees a death benefit to your heirs when you die, as long as you make your required premium payments. As such, they can be a valuable estate planning tool.
They also have the potential to build cash value that can be accessed during the policyowner’s lifetime to supplement retirement income, pay for college tuition, or for any other reason. (Keep in mind that tapping into the cash value of a permanent life insurance policy reduces the future death benefit and increases the chance the policy will lapse, which may trigger a taxable event.)
Young families with significant financial risk (a new mortgage, kids to educate, dependent spouse) often opt for a low-cost term life policy to maximize their safety net, said Novelli. In many cases, a convertible-term life insurance policy that allows the policyholder to convert to permanent coverage at a future date as their income allows can be the most flexible, cost-effective solution, he said. (Calculator: How much life insurance do I need?)
Generally, convertible-term policies do not require policyowners to submit to a medical exam, which may be an added benefit if they develop a health condition after they buy the policy but before the conversion window closes.
Having only group life insurance
Many employers offer group life insurance as part of their benefits package, which delivers an added layer of financial protection. But for most employees, it’s not enough, said Cynthia Richards-Donald, a financial advisor in Charlotte, North Carolina, in an interview.
“Having group insurance with your employer and not having a standalone policy for yourself is a big mistake,” she said. “It may not be enough coverage, and most often it is not portable, meaning when you leave your employer, you don’t take it with you.”
By the time you leave your job, you may be years older and potentially less healthy, making it far more difficult to get affordable coverage on your own. Also, group insurance is often more expensive and the cost tends to increase as you get older.
“A lot of people have hundreds of thousands of dollars’ worth of coverage in group life insurance, but then they have nothing when they leave,” said Richards-Donald.
Focusing on premium
The premium, or cost of life insurance, matters to everyone. But if you focus on price alone, you could be putting yourself at risk. While the industry is heavily regulated and has multiple protections in place, policyowners who do business with a cash-strapped or disreputable company may regret it.
The life insurance industry is regulated on the state level, where state insurance commissions license agents and brokers, monitor products sold within their jurisdictions, and review whether insurers have the resources to meet their financial obligations. Should an insurer falter, all 50 states, plus the District of Columbia and Puerto Rico, have a guaranty mechanism to help pay the covered insurance obligations of those insurers licensed in the state. To learn more about a state’s specific guaranty association and what it covers, you can visit the website for the National Organization of Life & Health Insurance Guaranty Associations (www.nolhga.com).
The Insurance Information Institute recommends that consumers perform their own due diligence before they buy. Contact your state insurance department to be sure the company you are considering buying from is licensed in your state and inquire as to whether it has many consumer complaints filed against it relative to the number of policies it has sold.
For consumers, established companies with a solid reputation and a history of meeting their financial obligations are the goal.
It takes a big death benefit to replace a family breadwinner's monthly income if his or her paycheck suddenly stopped – more than most people realize.
Consider: A $500,000 term life policy might sound sufficient, but if you earn $50,000 a year, that death benefit would only replace your income for 10 years.
“Even wealth management clients and high-net-worth individuals are usually underinsured,” said Richards-Donald.
To ensure that your family would be able to maintain its current standard of living, you’ll need to project your expenses. A financial advisor can help.
Your policy should not only cover your lost income, but also potentially your mortgage, funeral costs, college tuition for your kids, and any other expense you anticipate – including braces for your son or your daughter’s future wedding.
While Social Security, pension plans, annuities, and other guaranteed sources of income you may have may sustain your surviving spouse in retirement, keep in mind that those funds may not be available to your spouse for many years. Life insurance can potentially help fill the gap until those income streams kick in. If the stay-at-home spouse is prepared to return to work in the event you pass away, however, it may be sufficient (and more cost effective) to purchase a policy that replaces only a portion of your income.
As you estimate your life insurance needs, don’t forget to include your spouse. A non-working parent who quits work to care for the kids should have a policy as well to cover the cost of childcare or housecleaning services if he or she should die prematurely.
Bonus: Being overinsured
Yes, it’s possible. And it happens all the time, said Novelli, particularly to those with fluctuating incomes.
By purchasing more coverage than you need, you not only miss the opportunity to save or invest those extra dollars, but you also run the risk of getting in over your head financially and losing your coverage.
“Young people, in particular, sometimes buy permanent life insurance based on two incomes, but then they start a family, buy a bigger house, and one spouse quits work to take care of the kids,” Novelli explained. “Now they’re stuck with a policy they can’t afford.”
If you stop paying the required premium on a term life policy, your coverage lapses. With a permanent policy, you have three choices: let the policy lapse, stop paying the premiums and access any available cash value, or stop paying the premiums in return for a reduced death benefit and no cash value, according to the Insurance Information Institute.
Here again, those with income instability may wish to start with term life to maximize their coverage. As their budget allows and their family matures, they may wish to convert to a permanent policy, or purchase a separate permanent life policy, to meet other financial goals, including estate planning or charitable giving. With such considerations, many people opt to talk with a financial advisor.
Indeed, permanent life insurance offers three tax advantages. The death benefit to your heirs is paid out income tax free, the cash value that accumulates in the policy grows tax deferred, and policyowners can potentially access their cash value on a tax-advantaged basis, since money borrowed or taken from the cash value is not subject to taxes up to the “cost basis” – or the amount paid into the policy through premiums.
(Related: Life insurance: 3 income tax advantages)
“The most tax-efficient way to leave any type of financial legacy to your heirs is through life insurance,” said Richards-Donald.
Life insurance can wear many hats in your long-term financial plan. To make the most of your policy, however, you need to know what you need, when to buy, and which money missteps to avoid.
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1Life Happens.org, “Insurance Barometer Survey”, 2016.