by Tricia Bush, CPA, CFP®, Partner, Bestgate Advisors

Understanding Life Insurance

What You Need To Know

Life insurance is one of those financial tools that you’ve heard of and know you probably need but aren’t sure where to start. It’s easy to put off or ignore, but having the right life insurance policy can make a world of difference for your family in a time of need. In this article, we’ll break down the basics of life insurance, explain the differences between term life insurance and whole life insurance, recommend how much coverage the average family should have, and help you determine whether you even need life insurance.

What Is Life Insurance?

At its core, life insurance is a contract between you and an insurance company. In exchange for regular payments (known as premiums), the insurance company promises to pay a lump sum, called a death benefit, to your beneficiaries if you pass away during the term of the policy. This money can help cover funeral costs, pay off debts, replace lost income, or support your family’s future needs, such as funding your children’s education.

Term Life Insurance vs. Whole Life Insurance

When shopping for life insurance, you’ll likely encounter two main types: term life insurance and whole life insurance. Understanding the differences between them is crucial for making the right choice for your situation.

1. Term Life Insurance

Term life insurance is the simplest and often the most affordable type of life insurance. As the name suggests, this policy covers you for a specific term or period—usually between 10 and 30 years. If you pass away during this period, your beneficiaries receive the death benefit. If you outlive the term, the policy expires, and no benefit is paid.

Pros of Term Life Insurance

Affordability: Term life insurance generally has lower premiums, making it an attractive option for families on a budget.

Simplicity: The policies are straightforward, with no complicated investment components or hidden fees.

Flexibility: You can choose a term that aligns with your financial obligations, such as until your mortgage is paid off or your children are financially independent.

Cons of Term Life Insurance

•  Temporary Coverage: Once the term ends, you no longer have coverage unless you renew or purchase a new policy, which can be more expensive as you age.

•  No Cash Value: Term life insurance does not accumulate cash value, so if you don’t pass away during the term, you won’t see any return on your premiums.

2. Whole Life Insurance

Whole life insurance, on the other hand, is a type of permanent life insurance. It covers you for your entire life, as long as you continue to pay the premiums. In addition to the death benefit, whole life insurance includes a savings component, known as the cash value, which grows over time. This cash value can be borrowed against or withdrawn, although doing so may reduce the death benefit.

Pros of Whole Life Insurance

•  Lifelong Coverage: As long as you pay your premiums, your beneficiaries will receive a death benefit, regardless of when you pass away.

•  Cash Value: The policy accumulates cash value over time, which you can access while you’re still alive.

•  Fixed Premiums: Your premium payments generally remain the same throughout the life of the policy.

Cons of Whole Life Insurance

•  Higher Cost: Whole life insurance is significantly more expensive than term life insurance. The higher premiums can strain a family’s budget, especially if you’re paying for coverage you don’t really need.

•  Complexity: The policies are more complicated, with fees, penalties for withdrawing cash value, and often lower returns on the cash value compared to other investments.

•  Overselling as an Investment: Whole life insurance is often marketed as a good investment, but it typically doesn’t deliver the best returns compared to more straightforward investment vehicles.

How Much Life Insurance Does the Average Family Need?

Determining how much life insurance you need depends on your specific circumstances. A common rule of thumb is to have coverage that is 7 to 10 times your annual income. For example, if you earn $50,000 per year, you should consider a policy that provides $350,000 to $500,000 in coverage.

However, this is just a starting point. You should also consider:

•  Outstanding Debts: Factor in your mortgage, car loans, credit card balances, and other debts that your family would need to pay off.

•  Income Replacement: Calculate how many years your family would need to replace your income to maintain their standard of living.

•  Future Expenses: Think about future costs, such as college tuition for your children or your spouse’s retirement.

•  Funeral Expenses: The average funeral can cost between $7,000 and $10,000, so it’s essential to include this in your calculations.

Who Needs Life Insurance?

Life insurance is not one-size-fits-all, and not everyone needs a policy. Here are some guidelines to help you decide whether life insurance is right for you.

You Need Life Insurance If…

•   You Have Dependents: If you have a spouse, children, or other family members who rely on your income, life insurance is crucial to ensure they are financially secure if something happens to you.

•   You Have Significant Debt: If you have a mortgage, car loan, or other debts, life insurance can prevent your family from being burdened with these payments.

•   You Want to Leave a Legacy: Life insurance can be a way to leave an inheritance or charitable donation, even if you don’t have substantial assets.

You May Not Need Life Insurance If…

•   You’re Single with No Dependents: If no one depends on your income and you have enough savings to cover your funeral expenses, life insurance may not be necessary.

•   You’re Financially Independent: If your savings, investments, and other assets are sufficient to cover your family’s needs, life insurance may not be essential.

•   You’re Retired with a Spouse Who Can Support Themselves: If your spouse has enough income or assets to live comfortably without your financial support, life insurance might not be needed.

Beware of the Sales Pitch

It’s important to be cautious when shopping for life insurance, especially if you’re considering whole life insurance. Insurance agents may push whole life policies because they earn higher commissions on them, but these policies aren’t always the best choice for everyone. The idea of having lifelong coverage and a built-in savings component can sound too good to be true—and, in many cases, it is.

Conclusion

Life insurance is a vital part of financial planning. Understanding the differences between term and whole life insurance, assessing your family’s needs, and making informed decisions can provide peace of mind knowing that your loved ones will be protected. Before signing on the dotted line, make sure the policy you choose truly meets your needs—without stretching your budget or buying into promises that don’t deliver.