You’re working hard for your money and you’d like your family to enjoy the fruits of your labor throughout the coming years. Preparing for your family’s future, however, means more than investing appropriately in order to achieve the right combination of growth and stability for your goals and time horizon. For many people, it also involves purchasing the right amount of life insurance during their working years.
Life insurance can help mitigate the financial impact on your loved ones in the event of your death. With a life insurance policy, your family can use the proceeds to help replace lost income, eliminate debt, pay for college, keep a business afloat, or address other financial needs and goals while they adjust to a new life.
How does life insurance work?
A life insurance policy provides a payment in the event of your death that can help protect your family’s lifestyle in the absence of your earning power. “Many people have financial goals they are trying to meet with hard-earned income—such as paying off a mortgage, putting a child through college, or supporting an elderly parent. Life insurance can help support your family goals,” says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company.
Here’s how it works: When you purchase a life insurance policy, you’re buying a contract with the issuing insurance company. The issuing insurance company guarantees that upon your death, it will pay a preset amount to your beneficiaries. The guarantee is subject to the insurance company’s claims-paying ability. The proceeds are typically free from income taxes. The insurance company pays your beneficiaries directly, so they receive the funds without the delays and expenses associated with the probate process that governs assets passed down via a will. Depending on the size of your estate, benefits from a life insurance policy may be subject to estate tax.1
What types of life insurance are available?
Life insurance policies fall into two general categories: term and permanent. A term insurance policy covers a specific period of time, such as 10 or 20 years. At the end of that period, you normally stop paying premiums and your coverage ceases. A permanent insurance policy covers you until your death, regardless of age—so long as premium payments are up to date. Permanent insurance generally includes an investment component along with the insurance policy, and generally carries higher premiums as a result. Permanent insurance is commonly used for wealth transfer and estate planning purposes, while term insurance is used for replacing lost income in the event of premature death.
Term insurance is generally more affordable, and in many cases more appropriate, for most purchasers. “Term insurance allows you to gain access to life insurance with a lot less money than you’d need if you were trying to buy the same amount of permanent insurance,” says Ewanich. One helpful comparison is the economics of leasing a car versus buying one: You can often get a more expensive car for the same payment by leasing, rather than buying, the vehicle.
When is the right time to buy life insurance?
Many people could benefit by having life insurance. “When someone else is depending on your income, there’s generally a need for life insurance,” explains Ewanich.
You may already have life insurance coverage through your employer. Even so, it’s usually a good idea to consider purchasing additional coverage independently, because policies you buy outside an employer’s plan are portable, meaning your coverage continues even if you lose or leave your job. Also, your employer’s coverage may not meet your financial obligations for adequately protecting your family. To learn about insurance options to protect your family’s income needs in the event of disability, read Viewpoints: “Insure your paycheck.”
It’s a good idea to review your need for life insurance whenever a major life event occurs. Consider the following events and the ways in which life insurance might help protect your family in each scenario:
- New home purchase or major home improvements. Life insurance can cover your mortgage or home equity obligations in the event of your death.
- Marriage. A wedding should prompt you to review your entire financial situation, including your income needs, debt, and other liabilities, and to add a layer of protection for both spouses.
- Birth or adoption of a child. A life insurance policy can provide protection for your family’s increased income needs and any debt you may have taken on, including college expenses.
- New job. A term insurance policy can replace any group coverage you may have had from a former employer, and enable you to increase your coverage amount in accordance with your new salary.
For families with children, if one spouse is staying home, it may be important to have life insurance for that spouse in addition to insuring the primary wage earner. Consider the value of the stay-at-home parent and the services he or she provides. If a premature death were to occur, in addition to being a devastating loss, it would put a tremendous financial strain on your loved ones and might impact the working spouse’s ability to continue to earn the same living.
Term life insurance can cover future college expenses, funeral and estate expenses, and even business ownership needs. (Small businesses may wish to consider purchasing life insurance policies for key individuals, such as an owner or top employee, to help prevent financial distress if that person were to die.)
As you consider purchasing life insurance, bear in mind that you’ll generally have to provide “evidence of insurability.”2 This means that before an insurer issues a policy, the company will typically require you to undergo a basic medical screening, often scheduled at your home or workplace. Generally speaking, the better your overall health, the lower your premium will be. “Many factors contribute to the price you will pay for insurance, such as your age and your health. Low blood pressure and low cholesterol, along with a healthy body weight, will typically lead to a lower price,” notes Ewanich. “It’s usually easier—and less expensive—to buy life insurance in your twenties and thirties than in your forties, fifties, sixties, and so on. Sometimes health issues arise later in life that can make insurance difficult or costly to obtain.”
How much life insurance do you need?
There are several ways to go about determining how much coverage you need. One simple method is to buy coverage equal to five to 10 times your annual salary, bonuses, etc. Following this rule of thumb, if you make $50,000 annually, you’d buy a policy between $250,000 and $500,000.
Other methods are more precise and take certain aspects of your financial situation into consideration, such as the capital you’ve already accumulated, the liabilities you’ve accrued, and the specific costs for which you’d like your family to be covered in the future.
“We believe that the amount of insurance you need is tied to the annual income you would need to replace in the event of a premature death,” says Ewanich. “If you can afford to retire—meaning you no longer need to work to support yourself and your family—then you may no longer need term insurance. However, most people who are in their working years aren’t in a position to afford to retire, and need coverage.”
When purchasing term insurance, you’ll also have to determine how long you’d like to have the coverage in place. One benchmark to use is the number of years you have until you can comfortably afford to retire. You may, however, want to consider other scenarios, such as the number of years until all your children complete college.
One of the major benefits of term life insurance is its ability to protect your assets at an affordable price. Take care to avoid buying a policy with premiums you may not be able to afford in the future. “It’s better to buy a smaller policy with premiums you can comfortably afford than to buy a bigger policy that you have to let lapse because you can’t pay the premium,” says Ewanich.
As your life progresses, you will likely accrue greater financial responsibilities for your loved ones. Term life insurance can provide the money they need to help meet their expenses and maintain their standard of living.
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