Certified Safe Money Admin
Certified Safe Money Admin
Life Insurance – Benefits of Life Insurance
Life insurance can be a key component of almost any financial plan. That’s because the benefits of life insurance can provide a “safety net” for loved ones and survivors who might otherwise struggle with debt payoff or ongoing living expenses following the loss of an income earner.
But, while the income-tax-free proceeds from the death benefit can be helpful to the beneficiary (or beneficiaries), life insurance can also be used for various financial needs while the insured is still alive.
This can make life insurance an even more flexible financial tool. Before you purchase any type of coverage, though, it is important to keep in mind that all policies are not the same. So, having a good understanding of how life insurance coverage works can help you to narrow down and buy a life insurance policy that is right for you.
Types of Life Insurance
While there are many life insurance coverage variations today, there are two primary categories that this protection falls into. These are term and permanent. A term life insurance policy will remain in force for a pre-set time, or “term.”
These periods may be short, such as one-year renewable term coverage, or long, such as 10-, 20-, or even 30-year coverage options. This type of life insurance provides death benefit protection only, with no cash or investment value buildup. This is one of the reasons why the premium that is charged for a term policy is usually less than that of a comparable permanent life insurance plan.
With a level term insurance policy, the amount of the death benefit and the amount of the premium will usually remain the same throughout the policy’s lifetime. These guarantees can make it easier to budget for your life insurance expenses. (There are, however, other types of term insurance coverage, including increasing term – where the death benefit goes up – and decreasing term, where the death benefit decreases over the life of the policy.)
If the insured maintains a term life insurance policy for its entire duration, he or she may be able to renew it. Typically, in this case, the premium on the new coverage will be higher due to the insured’s then-current age and health condition. In some instances, if the insured has contracted a serious health condition, he or she may not qualify to renew the term life policy.
Many term life insurance policies include a conversion feature. This means that the term policy may be converted to a permanent life insurance plan – oftentimes without the insured having to go back through the underwriting process.
Permanent life insurance offers death benefit protection, as well as cash value buildup. As its name implies, this type of protection is meant to remain in force for the remainder of the insured’s lifetime – providing safe funds for retirement given that the premium is paid.
The funds inside of the cash value portion of a permanent life insurance policy grow on a tax-deferred basis. This means that there is no tax due on the gain unless or until the money is withdrawn. Given its tax-advantaged nature, the cash value can compound exponentially – especially if the policy is kept in force for many years.
It is also possible to borrow cash from a permanent life insurance policy. In this case, money can be accessed tax-free and used for any purpose. If the loan is not repaid before the insured dies, funds from the death benefit will be used for paying the balance. The remainder, if any, will be paid income tax-free to the named beneficiary (or beneficiaries).
There are several different types of permanent life insurance. These include:
- Whole Life Insurance
- Universal Life Insurance
- Variable Life Insurance
- Variable Universal Life Insurance
- Indexed Universal Life Insurance
Whole Life Insurance
Whole life insurance is considered the simplest form of permanent life insurance coverage on the market. This type of policy offers death benefit protection, as well as a cash value component. The cash in a whole life insurance policy grows tax-deferred at a rate that the insurance company sets.
Although the premium on a whole life insurance policy is typically higher than that of a comparable term insurance policy, the amount is locked in and guaranteed not to increase with whole life insurance (whereas term life insurance premiums can rise significantly – especially if the insured has contracted an adverse health condition before he or she renews their term life coverage).
A whole life policy’s cash value can typically be accessed at any time by the policyholder through withdrawals or policy loans. Paying back the loan is optional. However, any portion of the loan that is not repaid at the time of the insured’s death will decrease the amount of death benefit that the policy’s beneficiary receives.
Universal Life Insurance
Universal life insurance is a type of permanent coverage that offers a death benefit and a cash value component. This type of protection can be purchased with one single lump sum or with premiums paid over a period of time – or even for the remainder of the insured’s lifetime.
The funds in the cash value component of the policy are allowed to grow on a tax-deferred basis. This means that there is no tax due on the gain unless the money is withdrawn. However, cash may be accessed tax-free in the form of a policy loan.
This type of life insurance is considered to be more flexible than a comparable whole life insurance policy. One reason for this is that the owner of a universal life insurance plan may change the timing and the amount of the premium. (If this is the case, though, the coverage and cash value could be affected.)
Variable Life Insurance
Variable life insurance is a type of permanent life insurance. As with other types of cash value life insurance coverage, variable life provides both a death benefit and a cash value component within the policy. The cash value is the “savings” component of permanent life insurance policies, where the policyholder can essentially build up cash in the policy.
But variable life insurance differs from other types of permanent life insurance, like whole life when it comes to the cash value portion’s investment options. Rather than the insurance company choosing the investment type, fund allocations, or rate of return for the cash, the policyholder can choose from a wide array of investments such as stocks, mutual funds, and other types of equities.
Because of the tax-deferred growth in a variable life insurance policy, there is potential for the policyholder’s funds to compound and increase exponentially, as no tax will be due on the gain unless or until the time of withdrawal. Unlike a whole life policy, though, variable life insurance policies do not guarantee a minimum cash value, as poor investment performance could potentially diminish the entire amount.
Variable Universal Life Insurance
Variable universal life insurance, or VUL, is a type of permanent life insurance policy that offers a death benefit and a cash value or investment component. The funds that are in the cash component of the policy grow tax-deferred. This means that no tax is due on the gain until the time of withdrawal.
The return on the cash component of a variable universal life insurance policy is based on the return of underlying investments, such as mutual funds. There is also usually a maximum cap and a minimum floor (which is often 0%) on the investment return. The policyholder’s funds are not invested directly, though, but rather are placed in the insurance company’s sub-accounts.
Similar to regular universal life insurance, the premium is flexible on a VUL policy. While there is an opportunity to generate large returns on a VUL policy’s cash value, there can also be risk incurred.
Indexed Universal Life Insurance
Indexed universal life insurance is very similar to regular universal life insurance. However, it offers its policyholders the ability to allocate their funds to different “segments” that represent underlying market indexes. (There is typically at least one fixed segment in each IUP policy, too.)
Overall, indexed universal life insurance combines life insurance protection with more accumulation potential in its cash value component. These policies offer essentially the same features as regular universal life insurance, such as premium flexibility. Yet, they also provide more growth potential – with less risk than variable universal life insurance products.
The policy’s cash value earns interest based in part on the upward movement of an underlying stock market index (or, in some cases, more than one index). However, it is important to note that the policyholder’s cash is not invested directly into the stock market.
These policies also offer a guaranteed minimum rate of interest. So, the policyholder actually will earn a minimum or a “floor” below which his or her interest rate will not fall. This can provide them with principal protection during market downturns.
In the crediting of interest, the index movement is measured over a specific index term. Then, the annual percentage change – if any – is calculated. The annual percentage change in the index is adjusted by the interest rate cap, participation rate, or annual spread.
The resulting interest rate is then credited to the contract values. If, however, the underlying market had a down year and the interest calculation is negative, the interest rate that is credited to the account will be zero. This means that, although the account holder will not earn anything for that period, he or she will also not lose anything either. This can be a positive thing given that others who are invested in the market may have lost substantial amounts of money.
The most common factors that determine and set limits on the amount of interest that is credited are the participation rate, cap rate, and spreads and asset fees. A segment is also created when excess money – after premiums and policy charges are taken out – is directed to a crediting strategy.
The Many Benefits of Life Insurance
Because everyone’s needs are not the same, different life insurance strategies may be implemented. Once life insurance is purchased, it is not a “set it and forget it” situation. Instead, the coverage should be regularly reviewed with income for life advisors to ensure enough protection is in place going forward.
Life insurance death benefit proceeds are received income tax-free. So, typically, the entire amount may be used without having to hand over a portion of it to Uncle Sam. Oftentimes, life insurance beneficiaries will have the option of receiving the entire amount of the death benefit at one time, or they could opt to receive payments over time.
Debt Payoff / Payment of Final Expenses
One of the biggest reasons people purchase life insurance is that loved ones and survivors are not left with debts to repay. These could include a mortgage or vehicle loan(s). With the average cost of a funeral in the United States at approximately $8,000 to $10,000, the insured’s loved ones may use some or all of the policy’s proceeds for the cost of a memorial service, burial, transportation, headstone, and burial plot.
Another one of the key benefits of life insurance is the income replacement it can provide for survivors. This can be the case for couples and families who rely on the insured for an ongoing stream of income to pay living expenses.
This can also be the case with retirees. For example, when one spouse dies, their income from a pension or Social Security could disappear. Therefore, the proceeds from a life insurance policy could be used to replace this incoming cash flow so that the survivor does not need to reduce his or her lifestyle – or worse, stop paying for necessities, such as prescription medication.
Many people use life insurance as a college-funding mechanism. For instance, the cash value of a permanent life insurance policy grows tax-deferred and can be accessed when a child or grandchild goes to college. If the insured dies, the student/beneficiary can use the death benefit proceeds towards his or her higher-education costs.
Payment of Estate Taxes
Estate taxes can reduce the net value of an estate by 50%. This is why some wealthy individuals use life insurance proceeds for paying this tax obligation, and in turn, leave the value of their assets intact.
For the life insurance death benefit to avoid being included in the overall estate value (and because of that, also to be subject to estate tax), assigning an irrevocable life insurance trust (ILIT) to be the owner of the policy is recommended.
Business Succession Funding
Business owners or partners may also use life insurance in conjunction with succession planning. For example, suppose a key individual passes away. In that case, the death benefit proceeds can be used to keep the company afloat while a successor is being located or until the business can be sold.
Which Type of Life Insurance is Right for You?
There are many benefits that life insurance can provide. But because not all policies are the same, what might work for one person or family may not be suitable for another. That is why it is important to work with a safe money advisor before purchasing a policy.
If you have questions about how to keep your loved ones financially secure with life insurance, feel free to contact us at [email protected].