The real question isn’t if you need life insurance. The question is, what type of insurance do you need.
Life insurance is one of those things that you need, the minute you have a spouse or children who count on your income. Life insurance comes in two basic categories: term and permanent, also known as whole or universal insurance.
Term insurance is the less expensive of the two. It’s used to pay for things that your family needs in the next twenty or thirty years: paying the mortgage, financing college costs. Permanent insurance is used for leaving an inheritance, paying estate taxes or funeral costs. Permanent insurance grows in cash value that, depending on the terms of the policy, you can access while you are living.
NBC News recently published a story that asks “How much life insurance do I need?” As the article explains, term policies are cost effective and can be specifically designed to be in place when you need the coverage, like paying your mortgage or college tuition for children. Of course, the downside with term policies is that they’re only for a set duration. They’re not forever. People wait until the end of their term policy to get another one. Instead, they should buy a new policy as early as possible. Otherwise, you wind up paying more for the same amount of coverage later. Another negative about term policies, is that if you go to renew after the term, the premium will increase.
Permanent policies span your whole life and have cash value. They also grow tax free, and the savings can be borrowed from the policy tax free after a certain number of years. For higher-income earners, this can be a good way to have tax-free income in retirement and have greater tax diversification. Another benefit of permanent policies is that they can be used to pass down an inheritance tax-free. When someone dies, there may be an estate tax on their assets. Purchasing a permanent policy to alleviate this cost, is an effective way to pass down your wealth.
However, permanent life insurance policies are expensive. Returns in a life insurance policy are highly debated, with some believing in the tax advantages, and others counseling to “buy term and invest the rest.” Everyone’s situation is different. You can assess your needs by taking the “DIMEF” test:
- Debts: Look at all of your debts, except your mortgage.
- Income: Lost income from a spouse or a partner is the primary reason to buy life insurance and maintain the current lifestyle.
- Mortgage: Life insurance can pay off a mortgage, so your family can remain in the same home.
- Education: College costs for children or a spouse.
- Funeral expenses: These expenses add up quickly and your life insurance proceeds can pay for them.
Experts say you should have at least five times your annual income and enough to pay for 100% of your debts. You can calculate it with the following approach:
- Take the total of your liabilities and debts, income to be replaced, final expenses and education or extra goals;
- Subtract the savings or assets your family would use immediately, if you passed away; and
- Subtract any current life insurance you own, excluding coverage offered through your work.
The cost will differ, based on factors such as age, health, lifestyle, gender, type of insurance and amount of coverage. You may also need to take a physical exam. If you’re ill, the cost will be more, or you may not be eligible for life insurance. The older and less healthy you are, the shorter your life expectancy is—and the more expensive the policy. To get a solid quote, you’ll need to undergo underwriting. The insurance companies can pull medical records or order a full physical. If you take prescription medications, the likelihood of a paying a higher premium also increases.
Life insurance is something that people tend not to think about, until they have children or purchase a home. The younger you are when you purchase a policy, the less expensive it will be. That’s something today’s millennials need to start thinking about. More than half of all millennials don’t own a life insurance policy. That may catch up with them in the future.
Reference: NBC News (November 24, 2018) “How much life insurance do I need?”