You may or may not need life insurance, depending on your personal situation. To figure out whether or not you need life insurance, consider its purpose, which is to replace income in the event of the policyholder’s death. If you’re single and have no dependents, nobody is relying on the income you bring in, so you don’t need life insurance.
However, if you’re certain that you want to have a family (and you are otherwise financially healthy—eliminating debt, saving for retirement, etc.), you might take a look at a term policy. By purchasing a policy while you’re young, you lock in lower costs. Further, you can buy a policy before any health problem rears its head and you become uninsurable (or insurance becomes more expensive due to your health problems).
If your salary is important to supporting your family, paying the mortgage, or sending your kids to college, life insurance can ensure that these financial obligations are covered in the event of your death. However, just because you’re not receiving a signed paycheck doesn’t mean you don’t contribute to your family’s income. If you are a stay-at-home mom, and something happened to you, your spouse is probably going to need some outside help to cover your absence. In 2006, financial guru Dave Ramsey estimated a $300,000–$400,000 policy would be necessary to make up the costs of everything a stay-at-home mom does every day.
Despite the benefits, people make all kinds of mistakes when they buy life insurance. In this article, I fill you in on the most common ones so that you can avoid falling into any traps.
Getting Life Insurance
The purpose of life insurance is to provide a death benefit to the beneficiary’s heirs or other beneficiaries upon the death of the owner. It is designed to replace any income lost due to the death of the individual, cover any outstanding debts or obligations of the deceased, and provide an inheritance or legacy.
There are many types of life insurance. In general, you can think of two main categories: term insurance and permanent insurance. A term insurance policy provides a level death benefit for a set period of time (e.g., 20 years) and is adequate for most young people. Upon expiration, you will need to reapply for new coverage. A permanent life insurance policy can cover your entire life, and it often comes with an accumulation component. In addition to being more expensive than term insurance, these types of policies also provide additional benefits.
Any type of insurance you choose will have a similar application process. The application requires basic information about you, your financial picture, and a health questionnaire. As part of the survey, you may also be asked to undergo a paramedical exam, in which a health professional examines you and may test your blood or urine. Because insurers are required to pay out life insurance claims based on the statistical likelihood that you will die.
This results in lower insurance premiums for people who are younger (and have a longer life expectancy). The cost of insurance may be higher for people with medical conditions or who lead riskier lifestyles (e.g., smokers).
Once approved, you must pay regular premiums (which can be set anywhere from monthly to annually). In the absence of payment of premiums, the policy may lapse, forfeiting your coverage.
Mistake #1: Trading cash value for death protection needs
Being under-insured with permanent life insurance may be the biggest single mistake that people make in buying life insurance. They get swayed by the lure of the investment portion or cash value of the policy but can’t afford to have their cake and eat it, too. In other words, they can’t afford to pay for all the death protection they need plus the investment, so they buy a cash value policy with less death protection than they need in order to have some investment — something to show for it in the end when they don’t (unlike the rest of us) die. However, when they do die, their family doesn’t have enough money to live on, creating a serious financial problem.
The most important thing about life insurance is the protection it offers. So first things first. Determine how much life insurance you need by using a credible method. Then buy as much of that protection as you can afford, using term insurance, and even lower-cost reentry products if necessary. If your budget has something left over, only then is it okay to look at permanent life products for part of your coverage. Never trade critical protection for less-important investment opportunities.
Mistake #2: Buying your life insurance in pieces
Buying your life insurance in pieces is a lot more expensive than covering all your needs in one policy. Plus, buying in pieces leaves you vulnerable to a gap in your coverage. Examples of piecemeal buying are having mortgage insurance through your lending institution, credit card insurance through your credit card company, credit life insurance with your car loan, supplemental group life insurance at work, flight insurance at the airport, and so on. With some of these insurances, you don’t have to qualify medically; therefore, if you’re in poor health or near death, buy all you can. Otherwise, they’re often three or four times the price of what you would pay if you’re in good health.
When buying life insurance, figure out how much insurance you need to do the whole job and buy one policy. It’s smarter — and cheaper! Only one policy fee instead of several. Plus you have the advantage of a trusted professional agent to help with determining how much coverage you need, the type of policy, the proper listing of beneficiaries, and so on.
Mistake #3: Buying accidental death/travel accident coverage
Both accidental death and travel accident policies are varieties of Las Vegas insurance, transferring only the accidental portion of your risk. In other words, you have no coverage for death from natural causes. Buying these policies is an especially bad move if you buy them in lieu of the full life insurance you really need. My belief about travel accident coverage is that anyone who buys it at the airport or from a travel agent is really saying, “I’m not comfortable with the amount of life insurance I have.” The bottom line is that if you need insurance to cover a flight you’re taking, you also need it for driving down the street, potential heart attacks, and the like.
When buying life insurance, buy only coverage that pays for any death — natural or accidental.
Mistake #4: Covering the children in lieu of the parents
When your child is born, you try to be a responsible parent. You’re deluged with a lot of solicitations about life insurance because of the birth announcement in the newspaper. You have hopes and dreams for your children, so you buy a nice cash value policy on your baby. It’s understandable — you’re so proud. But the economic effect on the family of a child’s death is minimal compared to the major impact that one of the baby’s parents dying would have.
When a child is born, seriously reevaluate and raise the amount of life insurance coverage that you and your spouse have.
Mistake #5: Being unrealistic about how much you can afford to pay for life insurance
In the 25-plus years that I’ve been an agent, I can’t tell you how many times I’ve seen young people commit more money than they can actually afford to a large cash value life insurance policy and then two or three years later have to drop it and take a large financial loss — and perhaps even be exposed to the risk of a death without insurance.
I recommend term insurance for young families. It provides the most coverage for the money spent. If you want a permanent policy later with more bells and whistles, you can always convert your term policy.
How Much Insurance Do I Need?
The amount you need depends on your other sources of income, the number of dependents you have, your debts, and your lifestyle. There’s no hard and fast rule of thumb, but the general guideline is between five and ten times your annual salary.
To estimate your need, list your family’s annual expenses, such as the mortgage, day-care expenses, debt payments, and educational costs. Multiply the total by the number of years you need the insurance to cover. For example, if you have a child who has four years of high school ahead, you need coverage for at least four years. Add the costs of the funeral and burial of the insured person. If you can afford the premiums, consider adding in the total balance of your mortgage so your family can pay it off after your death, as well as the cost of sending your kids to college.
The cost of pure life insurance is based on actuarial tables that project your life expectancy. If you’re considered a high risk—for instance, if you’re overweight or a smoker, have a pre-existing health condition, or have a generous hobby or occupation (such as flying)—you’ll pay higher rates. It’s not a good idea to lie about any of these factors on your application. The insurance company could end up refusing to pay your beneficiaries if they find that you didn’t tell the truth.
Which Type of Insurance Is Best?
Many financial experts recommend that you keep your life insurance and your investments separate. If you need life insurance, buy term life. If you want to invest money, do it yourself. If you’re convinced that you want a whole life policy, consider consulting with a fee-only insurance advisor who, for a fixed fee, will research the various policies available to you and recommend the one that best suits your needs. Make sure the advisor isn’t affiliated with any particular insurance company and receives no commissions so you can be sure you’re getting objective advice.
Are Life Insurance Payouts Taxed?
If the ownership of a life insurance policy is properly structured, the death benefit is free of estate taxes. This part of the sales pitch is about the only sound reasoning that exists for buying cash-value life insurance. Under current federal laws, you can pass on $11.2 million ($22.4 million for a married couple) free of federal estate taxes thanks to the 2017 tax bill that took effect in 2018. But even if you have that large of a nest egg, you have numerous other ways to reduce your taxable estate.
What Is the Best Age to Buy Life Insurance?
Life insurance premiums will be lower if you’re younger and healthier. Thus, many suggest purchasing a policy in your 20s if possible, even if you don’t feel that you need one at that point.
It is important to make the right decision when it comes to buying life insurance. Read your insurance contract carefully before committing to a policy, and ensure you understand all of its provisions. Non-purchase of life insurance may not ruin your life, but it will certainly hurt those you are protecting.