If you are like most people, it’s unlikely that you’ve included life insurance in your personal financial plan. This is especially true if you just started working or are still figuring out your finances. Which is ironic because you’ve probably insured your car, house, and other assets, but life insurance is where you drew the line. A whopping 100 million people in the U.S. either don’t have life insurance or are under-insured. However, life insurance is one of the most important components of personal finance—it’s how you protect your dependents should you pass away unexpectedly and take care of your financial obligations.
Sure, life insurance policies can be complex to understand and choose from, but this shouldn’t be a deterrent. With the right guidance and information at your tips, finding a life insurance policy that works for your unique situation will be as easy as eating pie.
Read on to learn everything about life insurance. From the different types of life insurance to its benefits and how to choose a policy, this guide will be your go-to reference for all your life insurance questions.
Introduction to life insurance in financial planning
Before we get into the nitty gritty of financial planning and life insurance, let’s first understand what exactly it is. When talking about life insurance, there are several terms you’ll hear mentioned, so it’s vital that you familiarize yourself with them:
- Policy holder: This is the person who owns the life insurance policy and is responsible for paying the premiums.
- Insured: This is the person the life insurance policy covers.
- Insurer: This is the insurance company issuing the life insurance policy.
- Beneficiary: This refers to the person(s) the insurance company pays the death benefit once the insured dies, usually your family.
- Premiums: These are payments the policy holder makes to ensure the coverage remains active. They can be monthly or annually, depending on the policy.
- Death benefit: This is the amount of money the beneficiary receives from the insurance company after the insured dies.
With these terms now explained, let’s define life insurance.
Life insurance is a contract you get into with an insurance company or insurer, where you pay premiums, and upon your death, they pay a designated amount of money (death benefit) to your named beneficiary.
Types of life insurance policies
The most common policies offered under life insurance fall into two main categories, namely:
Term life insurance
As its name suggests, term life insurance or term insurance refers to a life insurance policy where you insure your life for a set term or period. If you die within that period and the policy is active, the insurance company pays the death benefit to your beneficiaries. Usually, the terms or periods for term policies are 10, 20, or 30 years. If you don’t die within the policy term, your policy expires, and you don’t get back any of your premium payments.
Term life insurance is almost the same as buying car insurance. You pay premiums to protect yourself financially in case you get into an accident, and if you don’t get into an accident within the policy term, your premiums are not compensated.
This type of life insurance is usually the most affordable policy. You pay lower premiums for a specific period until it expires and can choose to either renew it or buy a new term life insurance policy.
Permanent life insurance policy
This life insurance requires you to pay premiums throughout your whole life. Permanent life insurance doubles up as an insurance policy and an investment vehicle, thus its expensive nature compared to term policies.
While much more costly than term life insurance, a permanent life insurance policy has a cash value component. This is where the insurance company allocates a portion of your premiums to a cash value account, which accumulates over the period the policy stays active. You can access the accumulated cash value at any time through policy loans or withdrawals, but this can have tax implications and negatively affect the total death benefit your beneficiaries receive. After you (the insured) die your beneficiaries receive the death benefit.
Under permanent life insurance, there are several life insurance options you can choose from, depending on your needs:
- Whole life insurance: This insurance coverage is usually considered the original permanent life insurance. You pay fixed premium amounts throughout your entire life, and these go toward paying for the actual coverage and the cash value component.
- Universal life insurance: With this insurance coverage, you can adjust your premium payments and death benefits depending on your financial situation. For instance, you can use your accumulated cash value to make your premium payments lower by using part of them to pay for the premiums.
- Variable life insurance: This permanent life insurance option lets you determine how the insurance company invests your cash value component. This means that there is more risk attached to this option because if you invest the cash value component in a low-performing vehicle, the risk will be entirely on you and not the insurance company.
The role of life insurance
Life insurance is important for several reasons, including:
Protection against financial losses
Death comes with several financial liabilities, such as loss of income and funeral costs. For instance, it costs about $7,848 to cover funeral expenses in the U.S., according to the National Funeral Directors Association (NFDA). Would your family be able to cover these costs if you died unexpectedly?
Life insurance provides your family protection from having to deal with these financial obligations during a difficult time. With the death benefit protection, your family can cover funeral expenses and pay any outstanding debts and other expenses comfortably without strain.
Income replacement for dependents
If you are the primary breadwinner and you die unexpectedly, your life insurance coverage can help take care of your family financially. The death benefit protection the insurer pays your family can help cover daily living expenses, such as mortgage payments, utilities, groceries, and childcare (if you have younger children). This way, your family gets to maintain its living standards when you’re gone.
Estate planning and wealth transfer
You don’t have to be a high-income individual to consider estate and tax planning. If you have assets, you want to ensure that you pass them on to the people you value most. Moreover, estate planning can help protect your heirs and family members from estate taxes, which can significantly reduce the value of the assets you intend to leave behind.
How much life insurance do you need?
While there isn’t a specific answer for how much life insurance you need, there are several things you can assess to ensure the coverage you buy is enough. Here are a few things you may want to consider:
Your family’s financial obligations
Before buying a life insurance plan, you must consider how much money your family would need to sustain their current living standards if you passed away unexpectedly. Therefore, consider all the expenses you currently handle as the primary breadwinner, including:
- Rent or mortgage
- Monthly bills like electricity, water, gas, and internet
- Groceries and household essentials
- Debt payments like credit cards and loans
Total everything up, and the death benefit should cover all these expenses if you die.
Your dependents’ age and number of dependents
Your dependents are the sole reason why you’re buying life insurance. These can include your spouse, children, parents, or any other family members who depend on your income. Therefore, you must consider them when choosing life insurance policies.
One of the very first things you should consider is their age. For instance, if you have young children, they require financial assistance for a longer time compared to older children who are closer to financial independence. However, even older children might still need you to take care of them for expenses like college tuition (which can be very expensive).
Next, you must also consider the number of people who depend on your income. The more dependents you have, the more coverage you will require to ensure they live a comfortable life.
Your risk tolerance
The type of permanent life insurance you choose will highly depend on your risk tolerance. In this case, risk tolerance refers to the amount of uncertainty or volatility you are willing to accept in your life insurance policy’s cash values.
If you have a low-risk tolerance, you’re better off choosing a whole life policy because the insurance company bears any investment risk made on the cash value of your policy. However, if you have a high-risk tolerance, variable life insurance may be the best for you.
Your current assets and liabilities
Your net worth is also a huge factor in determining your family’s life insurance needs. To determine your net worth, you must analyze how many assets and liabilities you have.
Your assets represent all the resources your family or designated beneficiaries can use to generate income when you pass away. These can include things like savings, investments, real estate, etc. For instance, savings and investments can be a source of income for your family, while they can liquidate or sell real estate to cover immediate or ongoing expenses.
Your liabilities refer to any financial obligations and debts you owe, such as mortgages, car loans, personal loans, and credit cards. If you were to die, these obligations would cause financial burdens on your family.
If you calculate your net worth and your assets are more than your liabilities, you may not need a lot of life insurance to replace lost income. However, if your liabilities outweigh your assets, you may need much more insurance to ensure your family doesn’t deal with a financial deficit after your passing.
The coverage amounts
Coverage amounts refer to the death benefit protection your family receives from the insurer after you die. This means conducting a comprehensive analysis of your financial obligations. How much income do you make in a month? How much goes into ongoing expenses and debt repayments? How long do you plan on supporting your family after death? Ten years, thirty years? How much would this cost? And don’t forget to factor in inflation and how it can affect the death benefit protection.
Once you have a figure for how much your family would need to maintain their living standards, you should choose a life insurance policy with death benefit payments equal to or exceeding this amount.
Strategies and best practices for choosing life insurance
When choosing and managing your life insurance policies, there are several best practices you can implement to ensure that you get the best deal. These strategies include:
Compare quotes from different insurance companies
Before settling on a life insurance policy, it’s best to shop around and ask for quotes from multiple insurance companies. This is essential for comparing premium payments, coverage amounts, and policy features to ensure you get the most value for your money.
Remember that the policies with higher premiums don’t always guarantee the best death benefit protection. Neither should you go for the cheapest alternatives—it’s best to find a middle ground that gives your family protection and doesn’t drain you financially.
Update coverage amounts as your financial situation changes
Your financial situation won’t always be the same. You’ll have ups and downs—one day, you’re financially stable, the next you’re living paycheck to paycheck. Essentially, life insurance serves as an income replacement for your family once you die. Therefore, it should align with your current financial plan and situation.
Moreover, you should adjust your coverage with life changes, such as marriage, divorce, and childbirth. In such scenarios, you may need to change or update beneficiary designation and coverage amounts.
Understand policy terms and conditions
With life insurance policies, the last thing you want are surprises down the line. Therefore, you must thoroughly analyze policy terms and conditions for things like premium payment schedules, coverage periods, renewal options, and potential penalties or restrictions.
Work with a financial advisor
Aligning life insurance needs with your financial plan is vital, but it isn’t as easy, especially if you just started earning. That’s why it’s best to work with a financial advisor—they’ll help analyze your insurance needs and present the best policy options that align with your financial plan.
Evaluate insurance companies and financial strength ratings
The insurance company you buy life insurance from also matters. It doesn’t matter how long the insurance company has been in the market or how good their coverage amounts are. If they can’t pay death benefit claims, that should be a major red flag. One way you can ensure that an insurance company will pay your claims even during hard economic conditions is by evaluating their financial strength ratings.
You can do this by looking at ratings from independent rating agencies like A.M. Best, Standard & Poor’s, Moody’s, and Fitch Ratings. These agencies assess insurance companies’ financial stability based on factors such as capital adequacy, operating performance, and business profile.
You can also check customer review sites for their ability to pay claims. If an insurance company has overwhelmingly bad customer reviews, this should indicate that it may not be the best choice. Some popular review sites you can leverage include Better Business Bureau (BBB), Consumer Affairs, and Yelp.
Integrating life insurance with other financial tools
We’ve mentioned the importance of integrating your financial plan and life insurance multiple times throughout this guide, but how exactly do you do this? Here are several ways you can integrate life insurance with your overall financial plan:
Coordinate with retirement accounts (401(k), IRA)
You can supplement your retirement income by coordinating your life insurance policy with retirement accounts such as 401(k) and IRAs that provide tax advantages. The savings component in these retirement accounts accumulates tax-deferred, similar to permanent life policies, such as whole life insurance.
Moreover, coordinating life insurance with retirement accounts can help with income tax optimization and diversification in retirement. This is because you can access income tax free by making withdrawals from life insurance cash value up to the policy’s basis (total premiums paid).
Lastly, unlike retirement accounts, which may be subject to fluctuations in interest rates, some cash value life insurance policies are not affected since insurance companies bear the risk. This provides stability and predictability in retirement income.
Consider health savings accounts (HSA) and emergency funds
You should consider HSA accounts and emergency funds when including life insurance in your financial plan. Emergencies and medical expenses involving a terminal illness can quickly deplete your savings.
Policy cash values can serve as a source of liquidity to cover expenses or supplement your emergency savings when this happens. This helps strengthen your financial plan even in times of crisis.
Align life insurance with long-term financial goals
Your long-term financial goals should also align with the life insurance you choose to buy. This is because the type and amount of life insurance you purchase can directly impact your ability to achieve those goals. For instance, if funding your children’s or grandchildren’s education is one of your long-term financial goals, life insurance may be able to help you achieve it.
You can do this by buying a policy plan with a cash value. Once accumulated to a substantial amount, you can use it to pay for college tuition and other educational expenses.
Does everyone need life insurance?
No, but this will vary depending on unique situations. There are several circumstances where buying life insurance may not be beneficial for you. These include:
- You don’t have anyone depending on you
- You don’t have any debt
- You have enough personal savings
If you don’t meet all of the above requirements, buying life insurance as soon as possible can help achieve your financial goals.
Need life insurance that integrates with your financial plan? Fidelity Life is the best insurance company to help you with your insurance needs. Highly rated by A.M. Best for its financial stability, you can count on us to thoroughly evaluate your financial plan and provide the best policy options.
Get a curated quote today or contact us at 866-912-7775 for further inquiries.
