There are two basic types of life insurance: term and permanent.The fundamental difference is right there in the name
For most people, term is the way to go.Term life insurance is way simpler than permanent. You pay a (much lower) premium for a set period of protection, which typically coincides with your prime working years. You can think of it as insurance on the income you haven’t yet earned. The advantage is pretty obvious: You can guard against uncertainty by securing a large death benefit for relatively little money. And if you invest the money you save by not going with a permanent insurance policy, you can wind up with more cash at the end of your life than a permanent policy would’ve paid anyway (of course, the tricky thing is actually putting aside that difference rather than spending it).
But even if you don’t invest the balance of what you’d pay for a permanent policy, term life insurance still offers a ton of value by safeguarding your dependents when they’re most vulnerable. You can buy a 20- or 30-year term policy with the expectation that your kids will be able to provide for themselves by its end, and when you and your partner will also hopefully be reaping the rewards of prudent investing, not to mention Social Security and pensions. Sure, your term policy has no value once it expires, but that’s OK — you were paying for the protection
But there are some cases when permanent makes sense.Life insurance is all about covering need, and in some cases the need for it lasts your entire life. One example is for those with special-needs children who will always require care.
Permanent life insurance also makes sense if you’ve built up enough wealth that your heirs will need to pay an estate tax — this year, that bar is set at $5.45 million. Life insurance death benefits are not subject to income tax, so if you get a permanent policy, you’ll know that your heirs will have cash-on-hand to pay the estate tax. This may make even more sense if the majority of your wealth is in property or other non-liquid assets.
Permanent life insurance should never be purchased as an investment for the policyholder.The value of life insurance is in the death benefit, but insurance companies realized they could sell more of it (and justify higher prices) if people believed it was a sound investment not only for their dependents, but also for themselves as well. As a result, permanent life policies come with a cash-savings feature that you can access during your lifetime. A portion of each premium you pay goes into the “cash value,” which earns interest over time based on how the company invests it. It sounds good, but the returns are generally low because insurance companies are obligated to invest mostly in safe, low-yield securities like bonds.
There are also limits on how you can use the cash value in your policy. You can apply it to future premiums or use it to purchase more death benefits, but you can never allow it to run out completely — that will cancel your policy. You can also take out a loan based on your cash value, but if you do, you’ll need to repay it with interest — even though you’re the one who funded the account in the first place!
As a rough example, imagine you buy a permanent life insurance policy with a $500,000 death benefit at age 55. If you leave the cash value untouched, after 30 years it might be worth in the neighborhood of $250,000. You could cash that out (and cancel the policy), but your investment wouldn’t have generated as much return as it would have in, say, an index fund. However, if you keep the policy active, the death benefit for your heirs might be double what you put in.
“Permanent life insurance is rarely a good investment for the policyholder. However, it can be a very good investment for their heirs.”
Independent Life Insurance Agent & Investment Advisor Representative
Your health and age at the start of the policy are the biggest factors in determining your premiums.The formulas life insurance companies use to set premiums are incredibly sophisticated, but they’re all designed to gauge life expectancy, which means age and physical health are the primary factors. However, your physical health is only actually measured once, via that medical exam when you first apply for coverage. The insurance company then uses population data to project your average risk of dying over the course of the policy (and sets your premiums accordingly).
This means that the younger and healthier you are at the start of the policy, the lower your premiums will be. It’s also why guaranteed renewability and a guaranteed conversion option are so important, because they too rely on that initial health picture, which is most likely the healthiest you’ll be at any time during your coverage. The following table shows how age and smoking affect monthly premiums, based on a 20-year term policy with a $100,000 death benefit (I excluded Lincoln Financial because it requires a minimum death benefit of $250,000).
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