Life Insurance 101
The concept of insurance is simple. It is financial protection for when something bad happens. Car insurance protects you and your car, home insurance protects your property, and health insurance covers unexpected medical issues. Somehow, that simplicity scurries when the discussion switches to life insurance. It could be the fear of an insurance salesperson presenting an overwhelming menu of choices, or perhaps it’s the difficulty of talking about our own death, or the death of a loved one. Whatever the reason, it is important to understand how the various life insurance policies work so that you can purchase the right policy to meet your goals.
Life insurance is a contract that guarantees a beneficiary a death benefit in exchange for premiums paid by the policy owner. The amount of the premium is based on your age, health, and the death benefit amount. If the policy owner dies, the beneficiary receives the benefit payment free of income taxes. Each client’s situation is unique, but the end goal is to determine how insurance can most efficiently support your overall financial plan. Here are the basics:
Term Life Insurance
Term insurance has a pre-defined duration for which it provides coverage. The premiums are lower because the death benefit expires at the end of the term. Term policies are “use it or lose it.”
Key Features to Consider:
Policy Term: The length of the policy term can range from 10 to 40 years. The longer the term, the more expensive the policy.
Death Benefit Amount: The death benefit is the sum of money that will be paid to your beneficiary upon your death. The larger your death benefit, the larger the premium.
Convertibility: Some term policies offer the option to convert from term to permanent within the life of the policy. The benefit of a conversion policy is that while pricing is based on your age at the time you convert, you do not have to qualify medically or provide any health information. Adding convertibility will increase the overall premium but offers flexibility in the future.
Group Life Insurance: Many companies offer a basic group life insurance policy within their benefits package. We recommend taking advantage of the low prices offered by group insurance and purchasing the largest policy amount that the company offers. Group insurance is a cost-effective way to supplement your whole or term policy but should not be relied upon solely as it is non-transferable.
Permanent Life Insurance
Permanent policies, often referred to as “whole life policies” provide coverage for the entire life of the insured, assuming annual premiums are paid. These policies also have a savings component that can grow within the policy, referred to as the cash value. Although permanent policies can be over-sold and tend to have a bad reputation, for certain situations they can be a useful tool to help families and individuals meet their insurance needs. Having insurance that is guaranteed till death can also have advantages when it comes to estate planning, which we will discuss later.
Cash Value: With permanent policies, part of the premium goes towards paying for the death benefit, and part goes into an investment account vehicle referred to as the cash value. Any growth in the investment account is tax deferred. The policy holder has access to the cash value and can take tax free distributions in the form of a loan. Any loans taken from the investment account will reduce the death benefit by an equal amount. Over time, the interest and dividends that built up in the investment account can potentially help to pay some or all the premiums of the policy.
Drawbacks of Permanent Life Insurance Policies
Higher premiums: Permanent policies are often 10x the cost of a term policy.
Lower returns: Most investments within permanent policies act more like fixed income, having lower overall returns than equities. Depending on investment goals, investors are typically better off saving in traditional retirement vehicles than using life insurance policies as a savings vehicle.
Limited flexibility: Permanent insurance has limited flexibility compared to other life insurance. For example, policyholders cannot adjust the premium amount or change the death benefit amount.
What type of permanent policy should I purchase? When purchasing insurance, always remember what you are insuring. If you are looking for the maximum death benefit, purchase a policy that prioritizes the death benefit over the cash value. If, on the other hand this is a savings vehicle where the death benefit is secondary, ensure that most of the premium is funding cash value. The key is to avoid wasted expense in a policy that does not align with your stated goals.
Questions to Consider when Choosing Life Insurance
What is the best insurance for me? Term and permanent policies serve different purposes. Term is primarily used for income replacement or liability management, while permanent can be used for income replacement, legacy planning and estate planning.
Often the biggest consideration is cost. Whole life policies are significantly more expensive. Those higher premiums can reduce the amount of savings that could go into retirement, investment, and education accounts. One of the biggest reasons to buy term is the low cost. Investing the savings from choosing a term policy over permanent can result in a higher value than the future death benefit from a permanent policy, while also offering greater flexibility.
For individuals that have a difficult time saving money, a permanent policy can act as a “forced savings” vehicle, with access to the cash value if needed. While it can be easy to skip saving towards an investment account for a few months, it is much more unlikely to skip an insurance premium.
For most people, term insurance does the job. It is simple and cost-effective. The major downside is that it has a defined expiration, at which point the cost of buying more insurance will be higher. Therefore, it is important to understand the tradeoffs.
How much coverage do you need? This question gets to the fundamental reason for life insurance. What are you insuring against? A loss of future income? Paying off a current liability? The comfort of knowing your family will have enough assets in the case of untimely death? Think about what would happen if you were to pass away suddenly. Not only will your loved ones be grieving your death, but they will also have to start to think about finances. How will they pay the mortgage? Who can help watch the kids? Can they pay the bills this month? Next month? Next year? Thinking about these difficult answers will help to determine how much coverage you need.
How long of a term do I need? Determining the length of your policy involves educated guess work. Think about where you will be in 10, 20, or 30 years. Will you still have a mortgage? Will the kids still be living at home? Will you still be working? Ideally, your term provides coverage until retirement or until you have accrued significant savings. If you have a strong career trajectory, a shorter term might make sense. On the flipside, if things are less defined, a longer term or permanent policy might make sense.
Financial Planning Strategies with Life Insurance
Insurance can be the foundation of a financial plan or can be used to fill gaps within a plan.
Key Person Life Insurance: This is a business policy that is purchased by a company or individual to help protect against the loss of an owner, partner, or essential employee. The proceeds can be used to replace a key employee. Life insurance policies can also be used by companies to pay out ownership shares to the surviving family without having to liquidate assets in the company.
Pension Gap Coverage: Many pensions offer single life or second to die pension pay outs. Generally, the second to die pension payout options have a much lower annual pension pay out amount because it covers the life of the pension owner, and their spouse. With single life pension options, the payments will stop when the owner passes away leaving the surviving spouse with an income gap. An effective strategy is to purchase a life insurance policy on the pension holder while choosing the single life option payout option. You will collect the larger pension payout during your lifetime and in the event of an untimely death, the insurance policy will fill the income gap from the stopped pension payments. If you have a pension, it is important to consider this strategy early so that you can have lower life insurance premiums.
Estate Planning: The current gift and estate tax exemption is $12.92 million per individual and $25.84 million per married couple. This high exemption will be sunset on December 31, 2025, at that point it is expected to be cut in half. If, during the financial planning process you discover that you may have an estate tax liability upon your or your spouse’s death, life insurance can be an effective way to cover the taxes. When you pass away, the death benefit from insurance is there to cover the taxes allowing your heirs to inherit the full estate. A second to die life insurance policy that covers the life of both spouses is another way to cover potential tax liabilities on the second death.
Irrevocable Life Insurance Trusts: Insurance proceeds are considered an asset to the owner when they are paid out so it’s crucial to understand how it fits into your overall estate. If a person owns their policy in their name it is included in their estate regardless of who they name as the beneficiary, including spouses and children.
One way to move the death benefit out of your estate is to purchase the policy within an Irrevocable Life Insurance Trust (ILIT). ILITs ensure that the death benefit will avoid any estate taxes because the policy is treated as a gift from the policy holder to the trust. Like other trusts, the ILIT lets the insured dictate how the proceeds are distributed to beneficiaries. The trust is irrevocable, so it cannot be changed or undone once it is established. In summary, an ILIT helps minimize estate taxes, avoid gift tax, protects your death benefit from creditors and allows you to dictate asset distribution.
These are just a few of the many strategies that can be used with life insurance. During our planning process we will discuss your specific situation and work to help you sleep well at night knowing that your loved ones are protected.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.