When you’re thinking about buying life insurance to protect those you care about from the financial cost of your death, the first choice you must make is whether to purchase a term life insurance policy or a permanent one.
To make an appropriate choice, you need to think about your goals, such as:
- Who does the coverage need to provide for, and for how long?
- Will you need a policy that has living benefits?
- Are taxes a consideration?
Each consideration will likely take some thought. And the answers will determine the type of policies you should consider.
Providing for dependents
“When purchasing life insurance, it’s important to first think about what risks you are insuring against,” said Paul Jacobs, vice president and chief investment officer of Palisades Hudson Financial Group in Atlanta, Georgia.
“Typically, life insurance is first purchased when someone new is relying on your income to support themselves,” he said in an interview. That can be a spouse or a new child.
The risk for which people are insuring against, in that case, is the loss of caretaking responsibilities and income. If you died today, would your spouse and/or child live a financially comfortable life without you? If the answer is no, you need insurance. Its death benefit, which is generally income tax free and payable almost immediately, can help compensate for lost income and help contribute to child care or anything else your survivors need.
While spouses and children are the most common life insurance beneficiaries, it might make sense to purchase a policy for the benefit of anyone in your life who depends on you financially. This could be a sibling, parent, other family member, business partner, or friend. (Calculator: How much life insurance do I need?)
To provide for dependents, a term policy can often be sufficient. But financial professionals often suggest a multipronged approach.
Jacobs, for instance, recommends buying term life insurance along with investing in a long-term diversified portfolio for retirement. “Life insurance can protect against the risk of an early death, but your portfolio will be what protects you against the risk of outliving your assets,” he said.
A common term life insurance strategy is to buy a policy that will last until your projected retirement age. The idea is that by the time the policy expires, your dependents will be self-sufficient and you will have enough retirement assets to support a surviving spouse.
Term life insurance can be inexpensive for the amount of coverage it typically provides. Some term policies can have level premiums, while others can have annually increasing premiums. The term of coverage expires after the designated number of years that you choose when you take out the policy, although most policies provide for extending the coverage at a higher rate. Term insurance periods can typically range from 10 to 30 years. And some term policies can be converted to permanent policies under certain conditions.
Let’s say you’re 30 years old and you buy a 30-year term policy worth $1 million, naming your spouse as your primary beneficiary and your child as your contingent beneficiary. If you die any time before age 60 and you’ve kept up with your premiums, your spouse will get $1 million, tax free, from the insurance company. If your wife has predeceases you, your child will get all the money.
Benefits from life insurance policies can be paid directly to beneficiaries, and typically avoid the costs and delays associated with probate. (Learn more: Why people fear probate)
However, it should be noted that although the proceeds are income tax free, they may still be included as part of your taxable estate for estate tax purposes.
If you stopped paying your premiums when you were 57 and let your policy lapse, neither your spouse nor your child would get anything. And if you die at age 62 after the term has expired, and you didn’t take advantage of any extension provisions, they also won’t get anything.
Permanent life insurance options
In some cases, permanent life insurance may be a better option to provide for dependents.
Permanent life insurance provides a guaranteed death benefit no matter how old you are when you die, if you’re current on your premiums. Varieties of permanent life insurance include whole life, universal, and variable. These policies have additional features such as cash value that can grow tax deferred, and some may be eligible to receive dividends that can be used to pay your premiums or purchase a larger death benefit. It’s important to note that dividends aren’t guaranteed.
If you have a child, spouse, or other loved one you support who has lifelong special needs, a permanent policy, along with proper planning, can help make sure they’ll receive a benefit no matter how old you are when you die. Permanent life insurance may also be a better choice if you don’t expect to ever have enough money to retire and you need a way to provide for your survivors, or at least cover your final expenses.
For a need that exceeds 20 years, permanent life insurance may be more cost effective, said Rob Drury, the executive director of the Association of Christian Financial Advisors in San Antonio, Texas, which offers no-cost financial expertise and advisory services from a coalition of more than 3,000 financial planners, CPAs, estate planners, and other financial professionals. In an interview, he said he prefers whole life or fixed universal life with a no-lapse guarantee when someone needs to provide a guaranteed, lifelong death benefit for heirs. (Learn more: How to make sure your heirs won’t fight)
Providing for dependents and your own end-of-life care
Life insurance policies exist that also provide so-called living benefits, provisions allowing you to access a percentage of your policy’s benefit while you’re still alive in the event of a disability or if you have a chronic or terminal illness.
For example, once you can’t perform two of the six activities of daily living (eating, bathing, dressing, going to the toilet, walking, and continence) or have a mental impairment, you’ll be able to access a portion of your death benefit under a policy with such provisions. Also sometimes called accelerated benefits, these provisions are typically added to policies as riders and will increase the premium. (Related: Understanding insurance riders)
“Generally, life insurance passes 100 percent income tax free to your heirs if you never need it for medical care,” said Richard Sabo, an independent financial planner with RPS Financial Solutions in the greater Pittsburgh area. (Related: The cost of long-term care: Tipping point approaching?)
“You also don’t have to take the full amount available for the living benefits if you don’t need as much, so it maintains more death benefit for your heirs,” Sabo added. The living benefits you use typically reduce your death benefit dollar for dollar. If you have a $500,000 policy and use $50,000 in living benefits, your heirs will receive $450,000.
An insurance death benefit, whether from a term or permanent life insurance policy, generally passes income tax free to your beneficiaries. Since such payments can be large, avoiding a major tax bill can be significantly advantageous.
Permanent policies offer additional tax advantages. For one, the cash value grows on a tax-deferred basis. And that cash value can be tapped on a tax-advantaged basis through loans or partial surrenders (so long as the policy isn’t a modified endowment contract). Doing so, however, has some consequences, as accessing the cash value of a life insurance policy reduces its cash value and death benefit and increases the chance the policy will lapse. (Related: Tax advantages of life insurance)
Permanent insurance can also help you pass more wealth to your heirs if you have assets that have never been taxed, such as a large 401(k) account. The account balance will often be distributed to your beneficiaries as a lump sum that is taxable at ordinary income tax rates. Some people will buy a permanent life insurance policy to help cover those taxes.
Best of both worlds
Glen M. O’Connor, a financial advisor with Pensionmark Financial Group in Wexford, Pennsylvania, pointed out in an interview that having both term and permanent coverage is a possibility and often offers more benefits than either option alone.
“If you are 28, married, and have three children and want to provide for your spouse’s living expenses should you pass away, as well as funding college for the kids, your insurance need will be substantial,” he explained. “You may not be able to properly fund a permanent policy for your total need — however, you may be able to purchase a large term policy for the majority of the need and a smaller, permanent policy to assure you have coverage throughout your life.”
Indeed, various options are available in insurance coverage, from using a combination of term and permanent policies, to taking advantage of term coverage conversion to adding riders to standard policies. In many cases, people opt to discuss the possibilities with a financial professional to figure out the life insurance coverage that best fits their personal situation.
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