Life insurance provides invaluable protection for your family in the event of your death. It ensures the ones you care about can continue to support themselves financially when you are gone. Yet, a recent study by the Life Insurance and Market Research Association reveals more than half of Americans do not have an individual life insurance policy and 30% have no life insurance coverage at all.
What is life insurance?
Life insurance is a benefit that pays a specific sum of money upon the death of the insured. The benefit is paid to the beneficiary, or beneficiaries, named by the policyholder.
There are three basic types of life insurance:
- Term life insurance
- Whole life insurance
- Universal life insurance
How you purchase life insurance coverage is up to you. The Bureau of Labor and Statistics states that 60% of US employers offer life insurance benefits for full-time employees. You may also purchase individual life insurance coverage, as well as coverage for your dependents.
Let’s look at each type of life insurance separately.
Term life insurance
Term life insurance is usually the most simple to understand and the most affordable. It provides individual coverage for a specific number of years. The most common terms are 10, 20 and 30 years. If you die within
the term of the policy, your beneficiary will receive the full death benefit.
For example, you purchase a $1 million term life insurance policy that provides coverage for 20 years. If you die during year 17 of the policy, your beneficiary will receive $1 million. If you do not die within the 20-year term, your policy may expire and no benefit is paid.
There are three types of term life insurance:
- Level term life insurance offers you a fixed premium and a fixed death benefit.
- Yearly renewable term life insurance offers you a premium for a year at a time. Your premium will increase as you age, but you may renew your policy without evidence of insurability.
- Decreasing term life insurance offers you a fixed premium with a death benefit that decreases over time.
Regardless of which type of policy you choose, there is no savings component and benefits are paid upon your death.
How much does it cost?
Because you are only purchasing coverage for a specific time, term life insurance is the least expensive of all life insurance options. Premiums are based on the amount of death benefit you purchase and the term of your policy. The insurance company will also consider your age, sex, health and life expectancy.
And, as long as you continue to pay the premiums on time, your policy will remain in force until the end of the term.
What happens at the end of the term?
If you outlive the term of your policy, you will have a few options.
- You may renew the policy for another specific term.
- You may convert the policy to a whole life benefit.
- You may terminate the policy.
Group term life insurance
As mentioned earlier, 60% of employers offer life insurance coverage to full-time employees (source: Bureau of Labor and Statistics). Most of this coverage is provided in the form of a term life policy.
If you have coverage through your employer, your coverage will last as long as you are employed and pay the premium. The death benefit is either a specific dollar amount of coverage (e.g., $10,000) or a multiple of your salary (e.g., 2x base salary). And, it is often guaranteed issue. That means you cannot be denied coverage if you are not healthy.
If you terminate your employment, you may be offered the option to convert your coverage to an individual policy. In most cases, you will not need to provide proof of good health, but your premiums may increase.
Voluntary group supplemental term life insurance
Your employer may offer supplemental term life insurance that goes beyond your group term life coverage. You pay the full cost of this insurance, which is often elected in increments of $5,000 or $10,000, or as a multiple of your salary.
The plan typically offers a specific amount as guaranteed issue (the amount you may purchase without proof of good health). Any amount above that will require evidence of insurability.
Taxes on term life insurance
If you purchase an individual term life insurance policy outside of work, you are paying the premium with money that has already been taxed. As a result, your beneficiaries generally will not have to pay taxes if they receive a death benefit payment. The same is true if you have a term life policy through your employer.
However, the value of your group and supplemental life insurance may be considered part of your income. If you have less than $50,000 of coverage, you most likely do not have any tax liability. If your coverage is valued at more than $50,000, the IRS will set a fair market value and you may be required to pay taxes on the difference between that value and the premiums you pay for the coverage.
In most cases, if you have less than $50,000 of group and supplemental term life insurance through your employer, you will not have any associated income taxes. Any group term coverage above $50,000 is assigned a fair market value by the IRS. If you pay less in premiums than this fair market value, the difference is considered as part of your income and you would pay taxes on it. Visit the IRS website if you have questions on how the fair market value is calculated.
Whole life insurance
Whole, or permanent, life insurance provides a guaranteed death benefit, covers you for your entire life and pays the face value up to the maximum age.
What differentiates whole life insurance from term life insurance is whole life builds cash value over the life of the policy. A portion of your premium is invested and provides you with a minimum rate of return. The cash value grows tax-deferred; you pay taxes on the value only when it is withdrawn.
Some policies may even offer you the chance to earn dividends. These may be taken as cash or reinvested in your policy to help pay the premium, repay loans or increase the death benefit.
How much does it cost?
Because whole life insurance has a cash value, it is more expensive than term life insurance. Your premium is determined by the amount of your death benefit, age, sex, health and life expectancy. As long as you continue to pay the premiums on time, your policy will remain in force.
Can you borrow money against your whole life policy?
One of the benefits of a whole life insurance policy is your ability to borrow money against the cash value of your policy. Some policies allow you to withdraw this money with no limitation. All you have to do is repay the loan with interest. If you fail to repay the loan, the final payout of your policy is reduced by the outstanding amount.
Taxes on whole life insurance
Whole life insurance benefits are not usually taxable to the beneficiary. However, there are some instances where the benefit may be taxed. For example:
- If you take an early payout on the cash value of the policy, you may be taxed on the amount that exceeds what you have paid in premium.
- If you receive dividends, they may be taxed if they exceed the amount you have paid in premium.
- If you fail to pay back a loan, any outstanding amount may be considered a taxable gain.
If you have questions on how your life insurance policy could be taxed, visit the IRS website.
Universal Life Insurance
Universal life insurance combines the benefits of term and whole life insurance. This hybrid policy enables you to build savings over time, but offers the flexibility to invest your savings and earn cash value on the policy. Some people refer to universal life as a savings account with a life insurance policy attached.
Policy flexibility
You decide how to manage your savings and earnings with a universal life policy.
- You may choose to deposit more than the premium, ultimately increasing your savings.
- You may choose to use investment earnings to pay the premium and any administrative costs.
- You may add earnings to your death benefit.
- You may take a loan against the cash value of the policy.
- You may withdraw savings at any time to pay for larger expenses like a down payment on a home or college tuition.
Ultimately, there just has to be enough in the account to pay the monthly premium.
Indexed universal life insurance
The value of your universal life depends on the stability of the stock market. Therefore, if the market is doing well, your account should reflect that. If the market takes a tumble, so may the value of your policy. Fluctuations are to be expected.
As a result, you may want to consider indexed universal life insurance. It can provide safer investment options and is considered less risky than traditional universal life insurance.
Taxes on universal life insurance
Universal life insurance benefits are not usually taxable to the beneficiary. However, there are some instances where the benefit may be taxed. For example:
- If you take an early payout on the cash value of the policy, you may be taxed on the amount that exceeds what you have paid in premium.
- If you receive dividends, they may be taxed if they exceed the amount you have paid in premium.
- If you fail to pay back a loan, any outstanding amount may be considered a taxable gain.
If you have questions on how your life insurance policy could be taxed, visit the IRS website.
Dependent life insurance
Dependent life insurance covers your spouse, domestic partner and children. Spousal coverage is often available in dollar increments of $5,000 or $10,000 and children are covered at a fixed amount. You are automatically designated as the beneficiary of these supplemental policies.
Individual life insurance policy rider
If you already have an individual life insurance policy, your insurance company may offer a rider that provides coverage for your dependents. Coverage may be purchased just for your spouse, just for your children, or both.
Premiums for your spouse will be higher than those charged for your children. Some insurers may require evidence of insurability, which typically requires you to complete a form about the general health of your family so they can evaluate any medical risk.
Supplemental group life insurance
If you purchase dependent coverage through your employer, your spouse is usually eligible for coverage equal to 50-100% of your covered amount. Children are typically covered for a fixed dollar amount. Premiums
for spouses depend on the face value of the policy and your spouse’s age. You may also be required to provide proof of good health. Premiums for your children usually cover all your children for one rate.
Taxes on dependent life insurance
Dependent life insurance benefits are generally not considered taxable income if you pay the full premium. If your employer pays any portion of the premium, dependent life benefits may not be considered taxable as long as the face value is below a certain amount. For more information, visit the IRS website.
Evidence of insurability
Some insurers ask for proof of good health, or evidence of insurability, before issuing a policy. This may be required if:
- You purchase a policy with a high death benefit
- Your medical history, or family medical history, shows a high level of risk
- You are planning to or often travel in certain areas of the world deemed risky
- You participate in dangerous hobbies such as skydiving, racecar driving, bungee jumping, etc.
- You have other high risk factors such as a poor driving record
The insurance company wants to get a clear picture of your physical condition before agreeing to sell you a policy. They may request medical records or send a nurse to your home to conduct an in-person health screening. These exams will include a measure of your cholesterol, blood sugar, blood pressure, thyroid function, etc.
The insurance company may also review your personal credit history, business credit reports (if you own a business), and criminal background.
Coverage becomes effective once your evidence of insurability is approved.
Beneficiaries
One of the most important things you must do when purchasing a life insurance policy is to designate a beneficiary or beneficiaries. This is the individual or individuals who will receive the benefit in the event of your death.
You may choose to leave the entire death benefit to one person, or you may designate several. If you name more than one beneficiary, you will need to determine the percentage of the death benefit each individual will receive. If you do not, the benefit will be divided equally between them all.
You will also need to designate a secondary or contingent beneficiary. This is individual or individuals who will receive the benefit in the event that your primary beneficiary is no longer living. Again, if you name more than
one contingent beneficiary, you will need to determine the percentage of the death benefit each individual will receive. If you do not, the benefit will be divided equally between them all.
Be sure to provide as much information as possible about the beneficiaries you name. Names, addresses and even Social Security numbers may be required. This makes it easy for the administrator to locate the individuals.
Limitations and exclusions
There are some instances when life insurance benefits are not paid. Be sure to check your policy for the following exclusions:
- War or act of war
- Suicide or self-inflicted injury, including voluntary use of poison, chemical compound or drug unless used according to the direction of a physician
Many policies will also include an aviation exclusion. This exclusion does not apply to commercial air travel, only to those individuals killed while flying in a privately owned aircraft.
Other policies limit coverage if you are involved in dangerous activities, such as auto racing, rock climbing, hang gliding, etc. If you do participate in these activities, you may be able to obtain coverage by paying a higher premium.
Riders and modifications
Some of the most common riders or modifications to life insurance policies include:
- Early access to death benefits if you are considered terminally ill
- Accidental death benefits (also called double indemnity)
- Coverage for dependents
Your policy may also include a disability rider. This prevents you from having to pay the premium if you become totally disabled.
How much life insurance do you need?
Determining how much life insurance you need depends on how you answer a number of questions. First, you need to determine whom, if anyone, relies on you for their financial well-being:
- Are you married? Does your spouse have his or her own source of income?
- Do you have any children? If so, how old are they? When will they become financially independent?
Then you need to consider your financial situation:
- How much debt do you have? Does that amount increase every month or do you pay it off regularly?
- How much do you spend every month?
- How much do you save every month? Does that include savings for retirement?
If you are considering term life insurance, you will also want to calculate:
- The amount of income your family would need to replace if you were no longer there to help pay the bills
- The number of years you want the policy to cover expenses like your mortgage and college education for your children
If you are considering whole or universal life insurance, you will also want to determine the funds needed to:
- Pay funeral expenses and medical bills
- Provide for a special needs child
- Cover estate taxes
No matter what type of policy you purchase, you will also need to consider inflation and the amount of coverage you will need as time goes by may change. For example, while the cost of cars may increase due to inflation you may not need to adjust the amount of coverage you need because your house is almost paid off.
Which type of life insurance is right for you?
When deciding which type of life insurance product to purchase, there is no “one size fits all.” Everyone has their own answer when it comes to choosing how to protect their family from loss of income. Let’s review the three choices.
Term Life Insurance
With term life, you can often lock in a low premium if you purchase individual coverage when you are young and healthy. This may even be cheaper than the coverage offered by your employer. However, if you aren’t healthy or are having trouble purchasing individual coverage, group insurance may be the way to go.
Whole life insurance
If you want to leave a legacy for your beneficiaries, then you might want to consider whole life insurance. These policies earn cash value and provide you with a substantial death benefit.
Universal life insurance
Like whole life, universal life insurance will enable you to build additional cash value with your policy. It also offers you flexible options on premium payment, policy loans and long term financial savings. However, if you are purchasing this coverage late in life, it may not be the right choice for you.
Accidental Death & Dismemberment insurance
Accidental Death & Dismemberment (AD&D) coverage only pays benefits if you are killed or injured in an accident. It can be purchased on its own, as a stand-alone policy, or it may be combined with your life insurance.
The amount of the accidental death benefit is usually a specific dollar amount (e.g., $10,000) or, if you purchase life insurance through your employer, a multiple of your salary (e.g., 2x salary). The portion paid for accidental dismemberment varies according to the type of injury you sustain. For example, you may receive the full benefit if you are blinded by an accident, but receive only 25% of the value of the policy if you lose a finger. The exact payout will be listed in your policy.
AD&D policies have limitations just like life insurance policies. They do not typically cover accidents that are the result of high-risk activities like skydiving or car racing. They also don’t cover deaths or injuries caused by drug overdose, driving while intoxicated, complications from surgery and mental illness. Remember to check your policy for any excluded activities.
How life insurance and AD&D work together
Many life policies purchased through your employer offer AD&D coverage at the same benefit level. For example, if your policy offers term life in the amount of $10,000 you may also receive AD&D in the amount of $10,000. In this example, if you died of natural causes, your beneficiary would receive a payment of $10,000. If you died in an accident, your beneficiary would receive a payment of $20,000 ($10,000 term life + $10,000 AD&D = $20,000).
Other group policies allow you to purchase AD&D as a standalone product. In this case, you would purchase a dollar amount or multiple of your salary to be paid in the case of your accidental death or an accidental injury covered by the policy. For example, let’s say you have life insurance in the amount of one times your salary ($50,000). You decide to purchase AD&D insurance in the amount of $25,000. If you died of natural causes, your beneficiary would receive $50,000. If you died in an accident, your beneficiary would receive $75,000 ($50,000 term life + $25,000 AD&D = $75,000).
In either case, if you were injured as the result of an accident, you would receive the AD&D benefit and the life benefit would remain intact. For example, if you had an AD&D policy in the amount of $25,000 and lost a leg in a car accident, you might receive 75% of the policy amount ($18,750). Your beneficiary would receive nothing.
Do you need both?
Often, group term life policies offer AD&D coverage at no additional cost. In this case, it’s clear that you should accept the coverage.
If your employer offers AD&D as a standalone product or you are considering purchasing individual coverage, you should consider your lifestyle before deciding whether to purchase a policy. Are you an avid surfer? Do you ride a four-wheeler every weekend during hunting season? If you answered yes, you may want to think about AD&D coverage. Even if you are not prone to adventure or rarely participate in activities that put you in unfamiliar situations, accidents happen and you may want to consider the additional safety net AD&D insurance can provide.
Regardless of your lifestyle, combining life insurance and AD&D coverage gives you a more comprehensive benefit and can help protect you and your beneficiaries should you die or suffer a grave injury as the result of an accident.
For more information
Life and AD&D can help protect the financial stability of your loved ones.
- Term Life: provides individual coverage for a specific number of years. The most common terms are 10, 20 and 30 years. If you die within the term of the policy, your beneficiary will receive the full death benefit
- Whole Life: provides a guaranteed death benefit, covers you for your entire life and pays the face value up to the maximum age.
- Universal Life: enables you to build savings over time, but offers the flexibility to invest your savings and earn cash value on the policy.
- Accidental Death & Dismemberment: pays benefits if you are killed or injured in an accident. It can be purchased on its own, as a stand-alone policy, or it may be combined with your life insurance
If you would like more information about any of these types of coverages, how they are taxed and how to determine the amount of coverage you will need, talk to your broker or benefits adviser.
This content is for informational purposes only and not for the purpose of providing professional, financial, medical or legal advice. You should contact your licensed professional to obtain advice with respect to any particular issue or problem.
