How Does Life Insurance Work? Learn the Advantages and Disadvantages.
Although most people know that life insurance can be a key component in any complete financial plan, many are not familiar with how life insurance works. But having a good understanding of life insurance – as well as the many benefits it can provide – could allow the beneficiary and the insured to take advantage of this flexible financial tool.
Who needs life insurance?
If you have someone who is counting on you financially, then it is likely that you need life insurance. While many people assume that life insurance coverage is only necessary for those who are young and have children and / or other dependents, this is not the case.
For example, life insurance can provide funds that are needed in a long list of situations, such as:
- Estate tax payment
- Transfer of a business
- Funding of a child or grandchild’s college education
- Replacement of retirement income due to the death of a spouse (and possibly a loss or reduction in pension or Social Security income)
- Funeral / final expenses
- Charitable contributions
What does it cover?
Life insurance can cover a wide variety of needs. For instance, while the death benefit from a life insurance policy can help with paying off debts (such as a mortgage, car loan, or credit card balances) and replacing the insured’s income, there are many other items that life insurance may cover – both after the insured dies and while he or she is still alive.
A life insurance beneficiary may use the funds for paying the insured’s final expenses – which can run in excess of $10,000 today. Death benefit proceeds can also go towards paying off other debts, creating a stream of income for a surviving spouse, and just about any other need that a survivor may have. Plus, because death benefits from life insurance are income tax-free, survivors can make use of the entire amount of the proceeds.
Life insurance may also provide “living benefits,” too. In this case, a portion of the death benefit may be accessed if the insured is diagnosed with a terminal illness and / or if they need to reside in a nursing home. (These benefits may differ from one policy to another).
In addition, the cash value from a permanent life insurance policy may be borrowed, and in turn, received tax-free. These funds could then be used for supplementing retirement income, but without having to hand over a large percentage of the funds to Uncle Sam.
How does term life insurance work
Term life insurance provides death benefit protection for a set amount of time, or term. The length of the coverage could be as short as just one year, or as long as 30 years. Because of that, term life insurance is often used for covering needs with a defined end date, such the payoff of a home mortgage or the funding of a loved one’s college tuition.
A term life insurance policy will not provide a cash value component. Because term life is considered more of a “plain vanilla” type of coverage, the premiums are typically less than a comparable permanent life insurance policy, with all other factors being equal.
At the end of a term insurance policy’s length, it may be necessary to renew the coverage, based on the insured’s then-current age and health condition. (Typically, this will result in a high premium going forward, or possibly even a denial for future coverage).
In some cases, though, term life insurance may be converted over to a permanent policy – and it may not be required that the insured take a medical exam or even have to prove insurability in order to qualify.
How does cash value life insurance work
Cash value life insurance – also referred to as permanent life insurance – provides a death benefit component and a cash value component. Unlike term insurance coverage, permanent life insurance does not have an ending date.
So, provided that the premium is paid, permanent life insurance coverage will continue – oftentimes for the remainder of the insured’s life. This can be beneficial for someone who may contract a serious health issue, as the coverage is “locked in”. Oftentimes, the premium on a cash value life insurance policy won’t go up – even as the insured gets older.
The cash that is inside of a permanent life insurance policy is allowed to grow on a tax-deferred basis. This means that there is no tax due on the gain unless or until these funds are withdrawn. (Life insurance cash value may be borrowed tax-free.)
There are several different types of cash value life insurance, including:
- Whole life
- Universal life
- Indexed universal life (IUL)
How does whole life insurance work
Whole life insurance is a type of permanent coverage that includes a death benefit and a cash value component. The amount of the death benefit, as well as the premium due, are typically locked in. So, the amount of the premium won’t increase, even as the insured ages.
The return on the cash value’s growth is set by the insurance company. Even though this rate is usually quite low, the principal inside of the cash value is safe – regardless of what happens in the market. This cash may be accessed through withdrawals and / or loans. Any loans that are outstanding at the time of the insured’s passing will reduce the amount of the death benefit that is paid out to the beneficiary.
Some whole life insurance policies are eligible for dividends. There are several ways that whole life policy holders may use the dividends, such as:
- Receiving the funds in the form of cash
- Adding them to the cash value of the policy
- Using them to purchase additional death benefit coverage
How does universal life insurance work
Universal life insurance is a type of permanent coverage. Similar to whole life insurance, universal life has both a death benefit and a cash value component. These policies are considered to be more flexible than whole life, though.
Based on the terms of a universal life insurance policy, the “excess” premiums (i.e., those that are not used for funding the policy’s death benefit) are credited to the policy’s cash value, which is then credited with interest each month. The funds in the cash value are allowed to grow tax-deferred.
The owner of a universal life insurance policy may be able to skip premium payments if there is a sufficient amount of cash to fund the insurance component. Universal life insurance may be used as a funding tool for paying the insured’s final expenses, as well as for:
- Payoff of debts
- Estate tax payment
- Business succession
- Income replacement
- Deferred compensation and / or executive bonus plans
Many universal life insurance plans will also offer “living benefits,” where a portion of the death benefit may be accessed by the insured if he or she has a terminal illness and / or they need to reside in nursing home for a certain amount of time.
An indexed universal life (IUL) policy has its cash value return based on the performance of an underlying market index, such as the S&P 500. With these policies, the cash value has the opportunity to obtain market-linked returns – usually up to a certain maximum, or “cap.”
However, if the underlying index performs poorly during a given period of time, the cash value will not be credited with a loss. Rather, it will be credited with a 0% for that period. So, while there is no gain for that time period, there will also be no loss to the policy’s cash component.
Indexed universal life insurance policies can provide a way to take advantage of upward moving markets without having to put principal at risk. In addition, similar to with other types of permanent life insurance policies, the cash inside of an indexed universal life plan is allowed to grow tax-deferred.
How do I choose a policy
Choosing a life insurance policy may seem a bit overwhelming, as there are many different options to choose from. The best life insurance policy for your needs, however, is one that can help you with covering your specific objectives and that fits into your budget.
Before making a commitment to purchase a life insurance policy, it is recommended that you first discuss your short- and long-term financial objectives with an independent insurance expert. That way, you will be better able to narrow down the right life insurance plan for you.
Because independent insurance professionals are not usually tied to just one insurance carrier (and in turn, a limited choice of products), they are able to go out into the market place to locate the very best option.
They can also help you with comparing different life insurance policies – and premiums – side-by-side. So, working with an independent life insurance professional can save you a lot of time when researching the proper coverage for your – and your survivors’ – needs.
How does life insurance work when you die
When an insured dies, his or her life insurance beneficiary (or beneficiaries) will need to submit a claim to the insurance company. It is typically required that a certified copy of the insured’s death certificate be provided, along with the life insurance claim form. Depending on the insurance carrier, it may be possible to download claim forms directly from the company’s website. You may also wish to have your insurance agent assist you with submitting the necessary information.
Life insurance beneficiaries will typically be allowed to choose how they want the proceeds from the policy to be paid out. For instance, while most people opt to receive a lump sum, other potential options may be:
- A set amount of income on a regular basis for a certain amount of time
- Income that is paid out monthly for the remainder of the beneficiary’s lifetime
- Income paid to the beneficiary and another individual (i.e., joint and last survivor income)
If the lump sum option is chosen, the funds from the life insurance policy will not be subject to income tax. However, if the funds are paid out over time, any of the gain that is received by the beneficiary will be taxed as ordinary income to the recipient.
In some instances, a life insurance claim may be denied. This can occur if it is found that the policy holder gave false information to the insurance company during the application process. This may include a misstatement of the insured’s age and / or a misstatement regarding the insured’s health.
A claim for life insurance proceeds may also be denied if the insured took his or her own life within the first two years of the coverage. (However, the beneficiary may still receive a return of the premiums paid in).
Some other instances that could result in non-payment of life insurance proceeds include:
- The insured being killed in the act of war
- The death of the insured while he or she is committing a crime or participating in other illegal activity
- The death of the insured due to a private plane crash
- The insured dying while participating in a dangerous activity (such as rock climbing, hang gliding, or scuba diving)
With that in mind, it is important to make sure that you are aware of any exclusions in the policy.
How do I shop for coverage
When shopping for life insurance coverage, it is important to ensure that the policy you choose will meet your anticipated needs. Comparing both coverage and cost of life insurance can be easier when you work with an independent insurance professional. That way, you will have access to coverage from a number of different insurance carriers.
An independent insurance agent can also help you to find life insurance coverage in the event that you have a pre-existing condition. In this case, an experienced agent can work with you on submitting all of the additional information that may be necessary for the insurance company to review.
If you want to save time and assure you get the most coverage at the best price you should use our quote engine in the sidebar of this page to compare all the top insurance carrier in the country. It’s fast and easy. Plus you will get to work with one of the expert agents who will make sure you get the best plan.