You probably know that having a life insurance policy is important, but may not know which of the array of options is right for you. Here, we break down the different types of policies and explain which may be better for certain situations.
There are two basic types of life insurance: term life and permanent (cash value) life.
Term life insurance.
Term policies provide life insurance for a specific period of time. If you pass away during the coverage period, your beneficiary receives the policy’s death benefit. If you’re alive at the end of the term, the policy either ends or automatically renews with an annually increasing premium until age 95. Term policies are generally available with level premiums for periods of 10 to 30 years. In general, term life insurance is less expensive than permanent life insurance.
One specific type of term life insurance is guaranteed level term insurance. With these policies, both the premium and the amount of coverage remain the same (level) for a specific period of time.
Permanent life insurance.
Permanent insurance policies offer protection for your entire life as long as you pay the premium to keep the policy active. As you pay your premiums, a portion of each payment is placed in a cash-value account. The cash-value account is a portion of your policy where your money can grow tax-deferred, and you can access it if you need to. During the early years of the policy, a larger part of your payment will go to the cash-value account. As you get older, and the true cost of your insurance increases, the portion of your payment devoted to the cash-value account decreases.
One perceived advantage of permanent insurance policies is that the cash-value part of it grows tax deferred as long as the policy is active. You can borrow against the cash-value account, but unpaid loans will reduce the death benefit that your beneficiary will receive. If you surrender the policy before you pass away, you’ll receive the cash value, minus any loans and surrender charges. However, you should consider whether other more traditional tax-advantaged investment options (such as a 401(k) or IRA) may be a better place to grow your assets.
Many different types of cash-value life insurance are available, including:
- Whole life: You generally make level (equal) premium payments for life. The death benefit and cash value are pre-determined and guaranteed (unless the issuing insurance company goes under). Once you buy a whole life policy, all you have to do is pay the fixed premium.
- Universal life: You can pay premiums at any time, in varying amount (subject to certain limits), as long as the policy expenses and the cost of insurance coverage are met. The amount of insurance coverage can be changed, and the cash value will grow at a specific interest rate, which may change over time.
- Indexed universal life: This is a form of universal life insurance. With these policies, however, earnings in the cash value account are tied to an index, such as the S&P 500.
- Variable universal life: As with whole life, you pay a level premium for life. However, unlike whole life, the premium can fluctuate based on the policy’s performance. The death benefit and cash value fluctuate depending on the performance of investments in what are known as subaccounts. A subaccount is a pool of investor funds — like a mutual fund.
What type of insurance is right for you?
Before deciding whether to buy term or permanent life insurance, consider the policy cost and potential savings that may be available. Also, keep in mind that your insurance needs will likely change as your family, job, health, and financial picture change — so you’ll want to build some flexibility into the decision-making process. Here are some common reasons for buying life insurance and which type may best fit your needs.
- Mortgage or long-term debt: For most people, a home is one of their most valuable assets. It’s also the source of the largest amount of debt. If you pass away, your family will no longer have your income to help pay down the mortgage. Term life insurance can replace the lost income by providing payments for the length of the mortgage.
- Family protection: Your income not only pays for day-to-day expenses, but also covers future costs such as college education expenses and retirement income. Term life insurance of 20 years or longer can take care of both immediate needs and income for your survivors’ future needs.
- Business needs: If you’re a business owner, you need to consider what will happen to your company after you pass away. Life insurance can provide cash needed to fund the company’s buy-sell agreement, provide key employees protection, and pay off any corporate debt.
The type of life insurance policy you buy is a personal decision and should be carefully considered. In general, term is the best fit, as it offers adequate coverage at a more reasonable cost. But there’s no one-size-fits-all solution. Knowing what you’re working with can help give you peace of mind now — and will give your loved ones a reason to thank you later.