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Once you’ve reached certain milestones in your life — like getting married, buying your first home, or welcoming your first child, for instance — it’s time to consider the not-so-fun topic of how your family or other dependents may fare upon your passing. Life insurance guarantees your loved ones a safety net in the event you die, which is especially important if anyone is financially dependent on you.
Let’s explore the basics of life insurance, including how it works, types of life insurance, and more.
Life insurance is a contract between you and an insurance company that promises a monetary payout, commonly called a death benefit, to designated beneficiaries — typically family members — after you pass away. As long as you’ve paid your premiums and the policy is active upon your death, the death benefit will be paid out.
In order to obtain life insurance, you must qualify by submitting an initial application. The process typically includes a phone screening and a medical examination to determine your health status, including any chronic or pre-existing conditions. Your health information is a major contributing factor to your life insurance premium. Once you finalize how much life insurance you need and your rate, you must keep paying your premium to keep the coverage in place.
After you pass away, your beneficiary must file a claim with the life insurance company and submit relevant documentation, such as a death certificate. The beneficiary may choose how the death benefit will be paid out to them — either via lump sum or annual payments. Each life insurance payment option is paid out tax-free.
Most causes of death are covered by life insurance, including natural causes, accidents, and illness. There may be stipulations around suicide, however, and life insurance may consider it exempt from coverage within the first number of years of having the policy. Fraud is the most common reason for denial of life insurance claims, and life insurance companies can also deny coverage in cases where a beneficiary murders the policyholder.
Another factor to consider — aside from how much insurance you need — is what type of life insurance is best for you and your family members. The two primary differences between these types of life insurance policies are the length of coverage over your lifetime and the potential to increase your death benefit over time via cash value.
These differences are explained below.
A term life insurance policy only covers you for a set number of years and is considered the most basic level of life insurance coverage you can buy. If you’re lucky enough to still be alive once the term policy expires, you must renew to keep the coverage in place and guarantee your beneficiary gets your death benefit once you do pass. Term life policies tend to be the cheapest of all the different types of life insurance.
Considered a form of permanent life insurance, you must pay premiums for the duration of your life if you have a whole life policy. Whole life insurance may also be known as cash value life insurance; this is because a percentage of every premium payment you make is diverted as tax-deferred cash value that accrues interest at the rate specified on your policy.
This cash value amount of your permanent policy is separate from the death benefit and is meant to be used while the policyholder is still living. Beneficiaries should not expect to receive both in the event of the policyholder’s death. Think of it as a savings account built into your whole life policy.
Another key benefit of a whole life insurance policy is that your premium will typically remain unchanged through the years as you age.
Universal life insurance is another type of permanent policy. The main difference between universal and whole life policies is that the cash value is associated with a specific stock index instead of a fixed percentage. This leaves the cash value vulnerable to decline if the market underperforms.
Insurance companies will assess who you are, including the condition of your health and details about your lifestyle and your past. Factors affecting life insurance rates include:
Life insurance premiums are generally not tax-deductible. One of the rare exceptions is business owners, who can deduct life insurance premiums paid for employees. However, this comes with a few more provisions; for example, you cannot deduct premiums if you own the business with your spouse and the business must not be named as a beneficiary on the policy.
The death benefits payout beneficiaries receive is not considered taxable income. If your family is expected a death benefit of $1 million after you pass, they can expect the full amount. Many policyholders strategically plan to pay future family expenses tax-free — including college tuition or mortgage payments — by enrolling in life insurance.
If anyone is financially dependent on you, life insurance is always recommended — the earlier the better. It’s also worth it if you have assets, debt, or a business. Death benefits can be used by beneficiaries to pay for just about anything following the passing of the policyholder, including funeral expenses, childcare, mortgage payments, business debt, student loan debt, and inheritance or estate taxes. The cash value component can even be used to fund part of your retirement.
Life insurance could be a smart long-term investment for those who are:
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Evaluating your life insurance needs, understanding your options, and shopping around for life insurance quotes is the most effective method in securing the most affordable rate. Having this important coverage is one of the best ways to ensure some financial security for your beneficiaries if anything should befall you — whether that be 50 years down the line or five.