What is Life Insurance and How Does it Work

Life Insurance

Life insurance protects your family financially in case of your unexpected demise. After all, you don’t want the money you are making to be cut off abruptly in the instance of your death. Therefore, it is a good idea to obtain a policy to ward off any problems in this respect.

How Much Insurance Should You Buy and What Type of Policy Should You Purchase?

If you have people in your household who depend on your salary, you need to carefully consider your life insurance options. Three major questions should be addressed.

  • Do you need life insurance?
  • If you do need the coverage, how much do you need to buy?
  • What type of policy should you purchase?

Buying the product should not become complicated or confusing. The primary fact you need to to note is that life insurance is designed to meet your family’s financial needs.

Don’t Fall into Buying the Wrong Policy for Your Needs

Naturally, if you express an interest in buying a policy, an insurance agent will be more than delighted to showcase the bewildering selection of plans that are featured in the marketplace. Unless you learn more about the function of life insurance and a little bit about the lingo, you can end up paying for a policy that may not meet with your requirements.

The Two Basic Kinds of Plans: Term Life Insurance and Permanent (Whole) Life Insurance

To give you a basic overview of your choices, the following information introduces the various types of plans

Term Life Insurance

Term life insurance supplies a pre-set cash amount upon your death if the policy is in force. For instance, a five-year $120,000 term policy will pay off if you pass away within a five-year period. If you live past that time, nothing is paid to your family. Also, you only pay premiums for the coverage. The plan will not develop reserves.

A Good Candidate for Term Life: A Young Family

Term life insurance is quite affordable for younger people, and therefore is a very cheap form of protection for a young person. Younger parents can benefit from a plan, which offers a large amount of coverage at a reduced cost. Since the risk of dying is pretty low in one’s 20s, 30s or 40s, obtaining this coverage when you are young is typically advisable.

Short-term Insurance

If you need insurance for a short period of time too, you also want to look at term coverage. For example, if you need life insurance in order to qualify for business financing, then opt for a term life insurance plan.

Types of Term Plans

With that being said, term life policies can vary in form. For example, some term policies automatically renew at the end of a term without the need for a medical exam. These policies frequently are available at higher premiums.

Some policies also have a premium amount established for a period of years while other plans guarantee a premium rate for the first year. Just remember – with a term policy, you are not locked into maintaining the policy, regardless of your age. If you want the insurance to stay in force for your entire life, then you should choose another type of life insurance policy.

Permanent Insurance

While permanent insurance is more costly than term insurance, it can never be canceled – that is, as long as you continue to pay the premiums. This kind of insurance coverage is also an investment. Therefore, when you take out a permanent policy, your premium payments for the initial years of coverage cover more than the insurer’s cost of your risk of death. The additional money is directed into a reserve account, which, in turn, is invested by the insurance provider.

The investments’ normal yields return in either dividends or interest. A proportion of these returns are given to the holder of the policy. Policyholders can either borrow against the reserves or add them to the plan’s reserves. If you decide to terminate the policy, you can also cash in the plan for its cash surrender value.

The cash surrender value of a life insurance policy is the savings component of the life insurance plan, especially with respect to whole life insurance policies. The surrender value is also called the policyholder’s equity. If you terminate the plan during the early years of the policy, the savings you accumulate will normally bring a sparse return when compared with the premiums paid.

Non-taxable Income

The returns you accumulate on a permanent insurance policy are not taxed, not unless, that is, the cash is distributed to you. Even some partial withdrawals can be made without the need to pay tax. By comparison, the interest accumulated in a bank account is always subject tax, even if it remains untouched.

While a permanent insurance policy does function as an investment, that should not be the reason for taking out a policy. If you want to invest your money and obtain a better return, you would be better off buying a term policy, which is more affordable, and placing the remaining cash in a tax-deferred investment.

Take Your Time When Selecting a Policy

If you feel you are a good candidate for buying life insurance, you need to estimate how much insurance you will need. Doing so will give you a good overview of your current and future financial needs, all which will make it easier to select a policy. When you discuss the purchase with an agent, don’t fall into a trap of feeling like you have to make a decision immediately. There are plenty of carriers and companies. So, take your time to ensure you are making the right decision for you and your family.

Carefully Assess Your Options

Not everyone needs to buy life insurance. For example, if you are single and have no dependents, you really do not need to buy a plan. However, if you are married or have children or aging parents who depend on you, then you definitely need to look at the various life insurance options that are available.

Life insurance is designed for wage earners who want to provide for their dependents should they pass away during their working life. The insurance not only can be used to replace lost income but enables the insurer to provide for a family’s additional needs, such as college tuition, mortgage payoff or career education for a spouse gaining re-entry into the workplace.

Considering the Amount of Insurance to Carry

When determining the amount of insurance you need to purchase, you also have to consider varying scenarios. For example, would your spouse who works need to take some time off with the children after your passing? If so, how much money would be needed to ensure your family’s financial comfort?

Also, if you stay at home, think about what it may cost to hire someone to perform the same tasks you do each day. These tasks can include day care, financial management, housekeeping, grocery shopping and cooking. Perhaps you care for someone in your family who has special needs. You also need to assess what it could cost to ensure that the person gets the care he or she needs if you should die.

When buying life insurance, review your current standing in life. For instance, if you are retired or close to retiring, how would the income of your spouse change if you died or how would it affect you if he or she died? If you have access to retirement savings or most of a pension fund, you may not need to buy life insurance.

An examination of your tax situation is helpful too. A long time ago, insurance policies were carried to ensure that the estate taxes on a property would not force the sale of assets or a home. However, today, higher thresholds prevail. As a result, few people need to buy insurance in order to pay an estate tax bill.

Making a Calculation

Once you have some idea about what you would be replacing, calculate the amount. How much would you need to provide for your family if you died? Next, tally how much it would take, if invested conservatively, to generate an annual amount without touching the principal. Calculate the interest at around 5% per year.

For example, suppose you want to pay off personal loans totaling $200,000 and leave the same amount to put your child through college. If so, you need to purchase a plan with a face value of $1.4 million. If you wish to substitute an income of $100,000 annually, you will need to obtain a $2 million policy. It takes $2 million to generate $100,000 at a 5% annual interest rate.

Be Absolutely Truthful

When you consider how much insurance you need to buy, make sure you purchase what you actually need to provide for your family. You don’t want to over-buy or under-buy insurance. Try to calculate the amount so it comes as close as possible to what your family will require. Make sure all your statements and information on your application are truthful as well. Any false or misleading information can instantly void the terms of a policy.

Whether you are a young parent who wants to buy a term insurance plan or a middle-aged purchaser who wants to obtain a whole life insurance policy, you can ensure your family’s financial security by purchasing one or either of these kinds of plans.