Monday, July 15, 2024

How Does Life Insurance Work? [Simple Guide]

How Does Life Insurance Work? [Simple Guide]

Many people recognize the importance of life insurance but there is a big gap between how many need life insurance and how many actually have it. Life Insurance Awareness Month is designed to educate people about life insurance and help them make the right coverage choices. The Covid pandemic has made it clear that everything can change in an instant. We can protect ourselves and our loved ones with life insurance.

What is life insurance month?

In 2004, the nonprofit organization Life Happens designated September as Life Insurance Awareness Month. It’s designed to help educate Americans about the importance of life insurance and how it can help provide financial security for their families. 

What is life insurance and how does it work?

Life insurance is an agreement between an insurance company and a person, or a legal entity.  You pay a monthly or annual premium and then the insurance company will pay a tax-free lump sum of money to your beneficiary if you die as long as your plan is still active. 

When you purchase life insurance you will need to choose one or more beneficiaries such as a business partner or spouse. The insurance company will pay a lump sum to your beneficiaries once they file a claim after your death. The beneficiaries can use that money however they decide. 

You can customize your life insurance according to your own personal situation. You can choose the type of policy, how many years you want it to last, and how much money you want to be paid out to the beneficiaries.  Depending on the type of policy that you choose, you may need to have a medical exam.

What does life insurance cover?

Life insurance can be used to cover more things than you may realize. Some examples include day-to-day expenses,, paying off debt and burial expenses, and a child’s college expenses. A good first step is to decide how much you want to be covered for. Every family’s needs are different so it’s important to think about your personal situation.

Why is life insurance important?

Research shows that 4 in 10 American households are putting their financial future at risk by not having life insurance. You can protect your family even if you don’t have a lot of money in the bank. This will mean that when you pass away, your family won’t be overwhelmed trying to find money to cover everything. Life insurance offers peace of mind and financial security.

Who needs life insurance?

Not everyone needs life insurance. If your spouse, child or a family member depend on you and your income to cover living expenses or pay off debt, then you may need life insurance. 

What does life insurance cost? 

This depends on your health and how much coverage you want. A healthy adult in their 40s might pay around $50 a month for a $500,000 policy that lasts 25 years. Life insurance does get more expensive as you get older. The younger you get life insurance, the more affordable your policy will be. 

Can I have more than one life insurance?

You can have more than one life insurance. They don’t have to come from the same company. 

What are the main types of life insurance?

There are two main types of life insurance: term and permanent life insurance. Term life insurance provides coverage for a specific amount of time. Once the term is over, then the insurance ends with no value.  Permanent life insurance lasts your entire life. It includes a cash value component that can be withdrawn. There are two main types of permanent insurance: whole and universal life. 

What’s the difference between whole and universal life insurance?

Both policies offer permanent life insurance coverage. With whole life insurance, policyholders have to pay a set premium and there is also a set death benefit amount. With universal life insurance, policyholders can typically adjust the amount that they pay in premiums and the death benefit amount. 

What’s the difference between term vs whole life insurance?

Term insurance provides protection for a set amount of time and generally only pays a benefit if you “die” during the “term” of the policy. It’s a good choice if you know that a mortgage or college costs are going to disappear after a certain period of time. Term life insurance is generally more popular than whole life insurance because it’s cheaper.  The term usually ranges from 5-30 years, but the most common length is 20 years.

Whole life insurance is permanent insurance. It offers life long protection as long you keep paying your premiums. It allows the policy holder to accumulate cash value on a tax-deferred basis. 

Term vs Whole vs Universal Life Insurance

What’s the difference between individual and group life insurance? 

Individual life insurance covers you as an individual. You pay for it and own it. Group life insurance is a single contract that covers a group of people. The policy owner is usually an employer or an organization. Since the coverage is spread out across multiple people, then the rate is usually cheaper. One of the downsides of employer-paid group life insurance is that you will generally lose coverage if you leave the company.

Is life insurance taxable?

In most instances, life insurance proceeds are not subject to income or estate taxes. Beneficiaries generally don’t have to report the payout as income which means that it’s usually a tax-free lump sum that they can use however they desire. However, there are exceptions.

The exceptions where life insurance taxes may need to be paid are:

  • If your policy’s payout means that your estate exceeds $12.06 million. The federal estate tax exemption limit for 2022 is $12.06 million for an individual, and $24.12 million for a married couple filing jointly. If your estate exceeds this then the heirs will generally need to pay an estate tax within 9 months of your death. Some states will also levy their own estate or inheritance taxes.
  • If your beneficiaries choose to receive the payout in installments. The interest that accumulates on the death benefit is generally subject to income tax.
  • If the policy is owned by a third party.

Life insurance tax examples

Sample situation What’s taxable?
The beneficiary chooses to receive the payout in installments and earns interest. The interest amount.
The life insurance payout is rolled into your estate. The amount that exceeds the IRS’ estate tax threshold for the year. In 2022, that’s $12.06 million for individuals and $24.12 million for married couples.
You withdraw money from your policy’s cash value The premiums you paid minus the dividends you received.
You surrender a policy for cash. The amount you get above the policy basis.
You sell your life insurance policy. Cash value above the policy basis (income tax) and any other profits from the sale (capital gains tax).

Are life insurance premiums tax-deductible?

Most life insurance premiums are not tax-deductible. The IRS considers it a personal expense.

What is life insurance cash value?

Cash value life insurance is a form of permanent life insurance and offers lifelong coverage. It has a cash value savings component. The beneficiary will receive the death benefit but any cash value that accumulates over time can be used by you for many purposes. Some of these purposes include a source of loans or cash or to pay policy premiums. You can also choose to terminate your policy at any time and withdraw all of the cash value.

Some other common life insurance questions:

  • Am I too young for life insurance?
    • No one is too young for life insurance. In fact, the younger you get life insurance, the easier it is to lock in a lower rate.
  • Can you get life insurance with a pre-existing medical condition?
    • If you have a pre-existing medical condition then it can be difficult to get life insurance but it’s not impossible. If the pre-existing medical condition is covered then you will likely pay higher premiums.
  • Can a life insurance policy be tailored to my specific needs?
    • Nearly all life insurance policies have optional features called riders. The riders can provide value added benefits that tailor the policy to your specific needs.
  • Is there a set deadline to file a claim for life insurance?
    • There is no set deadline for filing a claim for life insurance. However, the sooner you do it, the better. The beneficiary must file a claim by submitting the death certificate, the policy and the claims form. Most insurance companies pay within 30 to 60 days of your claim.
  • Can I name my child as a beneficiary?
    • You can name anyone as a beneficiary. However, naming a minor child as your life insurance beneficiary may be problematic. Life insurance policies cannot make a distribution to a minor child. It may be better to select an adult guardian or to set up a trust.

If you already have life insurance, here are some quick reminders:

  • Check your beneficiaries regularly to make sure that you have the people that you want on there.
  • If you have a major life event such as purchasing a house or getting married, it’s important to review your coverage. 
  • Make sure that your loved ones know where to find your policy if something does happen to you.

Is life insurance worth it?

Life can change quickly. Life insurance is an affordable way to provide financial support to your beneficiaries when they will need it the most. September is a great month to discuss life insurance with your loved ones and determine which coverage best fit’s your family’s needs. If you are interested in having a comprehensive financial plan, schedule a free discovery call with one of our financial advisors today.

Alvin Carlos

About the Author

Alvin Carlos is the founder of District Capital Management, an independent, fee-only financial planning firm. He helps professionals and entrepreneurs in their 30s and 40s elevate their finances and maximize their money.

Did you know XYPN advisors provide virtual services? They can work with clients in any state! Find an Advisor.

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