The ins and outs of insuring the one thing you are guaranteed to lose eventually.
Introduction
Life insurance is one of the most important financial tools available for securing your family's future, paying off debts, and ensuring that your financial legacy is preserved. While no one likes to think about death, the reality is that life insurance can offer peace of mind by providing a financial safety net for loved ones in the event you pass away earlier than you expected to. With various types of life insurance policies available, including term, whole, and universal life, it’s crucial to understand the differences, subcategories, and appropriate use cases for each. I hope this article will help you navigate these options so that you can make a more informed decision about your life insurance needs.
1. Why Life Insurance Matters
Life insurance is a contract between you and an insurance company. You pay regular premiums, and in exchange, the company pays a death benefit to your beneficiaries upon your death. You lock in a set loss to transfer the risk of a much greater loss. The death benefit can be used to cover a variety of expenses, such as:
Income replacement: If you’re the primary breadwinner, life insurance ensures that your family can continue to maintain their standard of living for a while while they get adjusted to your absence.
Paying off debts: Life insurance can help your family pay off the mortgage, car loan, credit cards, or student loans that they would still be on the hook for.
Funeral costs: The average funeral in the U.S. can cost between $15,000 and $25,000. Life insurance can help cover or reimburse these expenses.
Education: A life insurance policy can provide funds for your children's or grandchildren’s education. Children of single parents are unfortunately significantly less likely to qualify for scholarships, so you can provide one via your policy.
Estate taxes: For high-net-worth individuals, life insurance can help cover estate taxes, ensuring that your heirs receive their inheritance without having to sell any of your assets to cover the taxes. I would personally rather make sure your assets are set up to not be taxable in the first place, but that’s a conversation for another article.
We typically recommend using the L.I.F.E. formula to easily calculate your insurable need.
L: Liabilities (All of your debts including your mortgage)
I: Income (10 years worth of your actual take-home pay)
F: Final Expenses (to cover the cost of your funeral)
E: Education (to give each of your children a full-ride scholarship)
For example, a primary breadwinner with a $330,000 mortgage, $80,000 in household student loan debt, a $45,000 HELOC, $7,000 in credit card debt, $60,000 in take-home pay,
and 4 children would calculate:
330,000+80,000+45,000+7,000+(60,000x10)+20,000+(4x50,000) = $1.282M
We would then formally recommend $1.3M in total coverage for the breadwinner, but not necessarily all with one type of life insurance. We also want to cover stay-at-home moms with an additional 50% of the household insurable need, since there is a lot of economic value they’re bringing to the table. Imagine if you had to pay for a full-time live-in nanny, house cleaner, cook, and teacher out of pocket. We’ll want to make sure you can just in case.
2. Types of Life Insurance
Life insurance comes in three main types: term life, whole life, and universal life. Each has its own pros, cons, and use cases, making them suitable for different individuals and financial goals. This is why blanket advice on life insurance products is highly inadvisable, and could definitely be used as a marker for determining if a financial professional is actually competent. Not that any specific bald person comes to mind…
I. Term Life Insurance: Simple and Affordable
Term life insurance is the most straightforward and affordable type of life insurance. It provides coverage for a specific period (the “term”), usually 10, 20, or 30 years. If you pass away during the term, your beneficiaries receive the death benefit. If the term expires and you’re still alive, the coverage ends, and there is no payout (Unless you have an ROP rider, see below).
Types of Term Life Insurance:
Level Term: The death benefit and premiums remain the same throughout the term. This is the most common type of term insurance, and is perfect for covering your more temporary insurable need during your working years. The house will eventually be paid off, the kids will be out of the house, and your wife won’t be relying on your paycheck someday.
Decreasing Term: The death benefit decreases over time, usually in line with a mortgage or other loan. Premiums remain the same, but this type of insurance is less expensive since the payout reduces as the policy ages. These are usually marketed as Mortgage protection or credit life insurance.
Renewable Term: This policy allows you to renew your term coverage without a medical exam at the end of the term. However, premiums typically increase with each renewal. Annually Renewable Term (ART) is the most common, and it can get quite expensive.
Convertible Term: A convertible term policy allows you to convert your term insurance into a permanent policy (like whole or universal life) without needing a medical exam. This is useful if you decide you want lifelong coverage later on. Keep in mind, you can usually only convert to a permanent policy with the same insurance company.
Group Term: Usually made available through an employer or association, group term is by far the cheapest form of the cheapest type of life insurance, and often does not require a medical exam. The only major concern is that the coverage is tied in with your employment or association, and will lapse the moment you are no longer employed or associated.
Use Cases for Term:
Temporary financial obligations: Term insurance is ideal for covering specific financial responsibilities that will eventually disappear, such as your mortgage, child expenses, car payment, your penchant for book buying (you’ll run out of space eventually) or your cigar habit which coincidentally also makes insuring you really expensive.
Income replacement: If you’re the primary breadwinner, term life insurance can replace your income during the working years, ensuring your family is financially secure for a while after your untimely passing.
Riders: Term Life is often very customizable with riders. The most common being Accidental Death and Dismemberment (ADD), Accelerated Death Benefit (ADB), Child riders, Waiver of Premium (WOP), and Return of Premium (ROP). Some of these riders may be included at no cost and are often available to be added to the policy for an additional fee. We tend to recommend at least an ADB rider on term policies.
II. Whole Life: Lifelong Coverage and Cash Value
Whole life insurance is a type of permanent insurance, meaning it provides coverage for your entire life as long as premiums are paid. In addition to the death benefit, whole life insurance builds cash value over time, which grows at a guaranteed rate and can be accessed through loans or withdrawals during your lifetime. It is usually also the most expensive form of insurance, limiting its use cases.
Types of Whole Life:
Traditional Whole Life: This is the most common form of whole life insurance. Premiums, death benefit, and cash value growth are guaranteed and remain consistent throughout the policy's life.
Limited Payment Whole Life: This policy allows you to pay higher premiums over a shorter period (such as 10, 15, or 20 years), after which the policy is paid up, meaning you won’t owe any more premiums but still retain the death benefit and cash value.
Single Premium Whole Life: This policy is fully paid for with a one-time lump-sum payment, offering immediate cash value and lifelong coverage without the need for ongoing premium payments.
Participating Whole Life: This policy allows you to receive dividends, which are portions of the insurer’s profits. These dividends can be used to reduce premiums, increase cash value, or be taken as cash.
Use Cases for Whole Life:
Estate planning: Whole life insurance can be a valuable tool in estate planning, helping to cover estate taxes and providing liquidity for heirs without the need to sell assets as the death benefit is not taxable. Look up the Rockefeller’s “waterfall method” for a prime (albeit dated) example.
Wealth building: The cash value component of whole life insurance can be used as a form of savings, offering a conservative, low-risk way to accumulate wealth over time with some beneficial tax implications (See: Infinite Banking).
Guaranteed lifelong coverage: Whole life insurance ensures that a death benefit will be paid no matter when you pass away, as long as you pass away before you turn 100, which can be reassuring for those looking to provide for dependents or charities in their estate planning.
III. Universal Life: Flexibility and More Flexibility
Universal life insurance is another form of permanent life insurance but offers much more flexibility than whole life, and along with that, complications. With universal life, you can adjust your premiums and death benefit as your needs change. Additionally, the policy’s cash value can grow based on a guaranteed interest rate akin to whole life, by mirroring an index, or by the interest earned from the insurer’s investments within the account, all offering the potential for higher growth compared to whole life. Life is rarely static, especially over the decades, and your universal life policy can change with you. Being so customizable, you really need an agent who is ethical and knows what they're doing. You can end up with a perfectly crafted, bespoke cash-value life insurance policy that suits your needs to a T, or you could end up with a cookie cutter policy that maximizes the agent’s commission and eats itself with fees over the following years. Tread wisely.
Types of Universal Life:
Guaranteed Universal Life (GUL): GULs focus on providing a guaranteed death benefit with minimal cash value accumulation. It offers the security of a permanent policy at a lower cost than traditional whole life, making it ideal for those who want lifetime coverage and don’t prioritize building cash value.
Indexed Universal Life (IUL): IUL policies link the cash value growth to a stock market index, such as the S&P 500 coupled with an earnings floor (usually 0%) and often an earnings ceiling. This allows for variable but on average higher returns than whole life, by taking advantage of most of the growth of an index with a mitigated downside risk.
Variable Universal Life (VUL): VUL policies allow you to invest the cash value in a variety of sub-accounts, which function like mutual funds. This offers the potential for substantial growth but also exposes the policyholder to market risk. This is about as far from whole life as you can get in the cash-value life insurance space and does require active management to stay competitive.
Use Cases for Universal Life:
Flexibility: Have I told you these policies are flexible? Universal life insurance is ideal for individuals who want the ability to adjust their premiums and death benefit over time. For example, if your financial situation changes, you can increase or decrease your payments while still maintaining coverage or increase your coverage as your insurable need increases.
Tax-advantaged savings: The cash value in a universal life policy grows tax-deferred, making it an attractive option for those who want to accumulate wealth with the flexibility to borrow against it later.
Retirement planning: Some people use universal life insurance as a supplement to their retirement strategy, allowing them to borrow from the cash value to fund expenses later in life, or to replace your retirement income entirely in down and recovery years, offering you the freedom to never be obligated to sell your assets at a loss.
3. Which Type of Life Insurance is Right for You?
The type(s) of life insurance that’s best for you depends on several factors, including your financial goals, age, health, and family situation.
If you need temporary coverage at an affordable price, term life insurance is usually the best option. It provides cheap and significant coverage for a set period, making it ideal for younger families or those looking to cover specific debts like a mortgage.
If you want simple lifelong coverage and the ability to build cash value, whole life insurance is a strong option. It offers guaranteed returns and can serve as a conservative savings vehicle while ensuring that your beneficiaries receive a death benefit.
If you’re looking for flexible premiums and the potential for higher cash value growth, universal life insurance may be the best fit. Its flexibility makes it attractive for those whose financial circumstances or coverage needs might change over time.
A blend of coverages is usually the best solution. A smaller permanent policy to cover your baseline insurable need and potentially serve some retirement planning functions, as well as a term policy to cover your more temporary insurable need.
Conclusion
Life insurance is a critical component of financial planning, providing security and peace of mind for both you and your loved ones. Whether you choose term life insurance for its simplicity and affordability, whole life insurance for its lifelong coverage and savings component, or universal life insurance for its lifelong coverage, flexibility, and growth potential, it’s essential to tailor your policy(s) to your specific needs. By understanding the different types of life insurance and their subcategories, you can make an informed decision that helps protect your family's financial future and meet your long-term goals.
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