PERSONAL FINANCE
How Does Life Insurance Work?
written by Mike Ballew|January 23, 2019
The purpose of life insurance is to replace income in the event of an untimely death. Nobody wants to leave their family in the lurch with lots of debt and inadequate income. Life insurance provides a guarantee that your family will be taken care of in the event anything happens to you.
How does Life Insurance Work?
Life insurance pays a death benefit to your beneficiary in the event of your death. The primary purpose of life insurance is to replace your earnings to help your loved ones go on living.
There are two main types of life insurance, term life and whole life. They share one common trait: once the policy is written, the premiums never go up. That is unique to life insurance, other forms of insurance such as long-term care and home and auto coverage are notorious for raising premiums.
Types of Life Insurance
Term Life is the simplest and least expensive type of life insurance. It’s no coincidence that it’s also the most popular. As the name implies, term life provides coverage for a specific term, such as 20 or 30 years. When the term expires, the premiums cease and so does the coverage.
Why does term life insurance come with an expiration date? Because by the time most people reach the end of the term, they have accumulated other assets which can be used to cover living expenses, and their family responsibilities have diminished. That is, your children are on their own and self-sufficient. Term life is timed to expire about the time you no longer need it.
Whole Life provides life insurance with the added benefit of a cash value. The longer you own the policy, the greater the cash value. The cash value grows at a guaranteed rate on a tax-deferred basis. At any time you can borrow up to 90 percent of the cash value, or you can surrender the policy in exchange for the cash value. Upon your death the beneficiary receives the death benefit but not the cash value.
As the name implies, whole life provides coverage for your whole life. As long as you keep paying the premiums, your insurance coverage remains in place. There are two primary variants of whole life insurance:
Universal Life is a form of whole life where the policy holder gets to decide how much of the premium goes to the death benefit and how much goes to the cash value.
Variable Life is a form of whole life where the policy holder exchanges guaranteed returns for the possibility of higher gains in the stock market.
Beneficiaries
Typically the beneficiary of a life insurance policy is the policy holder’s spouse or partner. It’s important to note that minor children cannot be designated as beneficiaries. If a minor child is intended to be a beneficiary, a life insurance trust must be established.
Cost
The premiums for whole life are about 10 times higher than the cost of term life insurance. Let’s look at an example. 35 Year old Robert is in good health and married with two children. His wife doesn’t work outside the home. He needs life insurance to ensure his family will be taken care of in the event of his death.
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Robert can get $250,000 in term life insurance that will cover his family for the next 30 years. At the end of the 30 year term, he will be 65 years old and no longer need the insurance. The premiums are $21 per month.
Robert can get $250,000 in whole life insurance that will cover his family for the rest of his life. With a little more than half of the premiums going to the cash value and a guaranteed return of 5 percent, in 10 years the cash value will be $25,000. The premiums are $286 per month.
When faced with the cost of whole life insurance, most people opt for term life insurance. Some people justify it by vowing to invest the difference in premiums. The challenge is actually following through with it. In our example, the difference in monthly premiums between term life and whole life is $265. Properly invested, that would add up to a handsome sum over 30 years. It would also make a tidy little car payment.
Regardless of the type of coverage you choose, you need to get life insurance. Without life insurance, if something happens to you, your family may be headed for financial ruin. Every year you put it off you get another year older which translates into higher premiums.
Photo credit: PixabayThe Eggstack Blog will never post an article influenced by an outside company or advertiser. Our mission is to help you overcome uncertainty about retirement planning and inspire confidence in your financial future.
FAQs
Life insurance works by allowing your beneficiaries to claim a financial payout (often equal to your coverage amount) after your death. If you pass away while the policy is active, your beneficiaries can file a claim for their portion of the payout, also called a death benefit.
How life insurance is working? ›
Life insurance is a contract between you and an insurance company. In exchange for your premium payments, the life insurance company will pay a lump sum known as a death benefit to your beneficiaries after your death, as long as your policy is in force.
How is life insurance paid out to beneficiaries? ›
Depending on the insurer, a life insurance payout can typically be distributed in three ways: in the form of a lump sum, via a life insurance annuity, or through a retained asset account. Check with the insurer to see which life insurance payout options they offer.
How does life insurance make me money? ›
There are several ways to use your life insurance as an asset. As you contribute to your policy over the years, you earn the ability to borrow against what you've saved. Also, all your earnings are growing on a tax-deferred basis. Here's a look at some of the ways to maximize your asset's potential.
How is life insurance paid after death? ›
If the insured passes first, then the beneficiary's heirs or estate will receive the death benefit. If there are no beneficiaries left alive at the insured's death, the death benefit will be added to the insured person's estate.
How to use your life insurance while you're alive? ›
The Bottom Line. While life insurance does pay out a death benefit when you pass away, you could also use your policy while you're alive in certain cases. You may be able to withdraw accumulated cash value, take a loan against your coverage, access a living benefit rider or sell your policy.
How much is life insurance per month? ›
Average life insurance cost by state
| State | Average Annual Life Insurance Premium | Average Monthly Premium |
|---|
| California | $668 | $56 |
| Colorado | $645 | $54 |
| Connecticut | $724 | $60 |
| Delaware | $657 | $55 |
47 more rowsMay 23, 2023
The vast majority of life insurance policies pay out
People get life insurance with the expectation that if they pass away during the period of coverage, their policies will help their loved ones financially. But there are times when a company has no choice but to decline to pay a death benefit.
What is the lowest life insurance payout? ›
Minimum Life Insurance Coverage Amount
For most term life insurance companies, the smallest life insurance policy offered is for $100,000 in coverage. However, some companies, such as Genworth Life Insurance Company and AIG American General Life Insurance, offer term coverage in the amount of $50,000 or even $25,000.
How long do you have to pay life insurance before it pays out? ›
How Long do You Have to Pay Into a Life Insurance Policy Before It Pays Out? Life insurance will pay out upon the death of the insured as soon as it is in force. This usually counts as the first premium payment.
You can cash out a life insurance policy. How much money you get for it will depend on the amount of cash value held in it. If you have, say $10,000 of accumulated cash value, you would be entitled to withdraw up to all of that amount (less any surrender fees). At that point, however, your policy would be terminated.
Can I withdraw my life insurance? ›
You can withdraw up to the amount you've paid in premiums without paying taxes on the funds. Withdrawals will reduce the death benefit. Take out a loan. A life insurance policy loan allows you to borrow money from your life insurance policy.
How do the rich get richer using life insurance? ›
Tax-Free Transfer of Wealth: Life insurance proceeds are generally tax-free, which makes them an ideal way to transfer wealth from one generation to the next. This can help to minimize the impact of taxes on the family's financial situation and ensure that more of the wealth is passed down to future generations.
What is the cash value of a $10,000 life insurance policy? ›
The $10,000 refers to the face value of the policy, otherwise known as the death benefit, and does not represent the cash value of life insurance policy. A $10,000 term life insurance policy has no cash value.
What are the cons of life insurance? ›
Disadvantages of buying life insurance
- It can be expensive if you're older or have health conditions.
- Whole life insurance can be unaffordable in the long run.
- Cash value can be a weak investment tool.
- Applying can be daunting.
Depending on the policy you apply for, your life insurance coverage can begin immediately after you apply. For some companies, it can take six weeks or more for you to receive an offer of coverage.
How many years does it take for life insurance to pay out? ›
In many cases, it takes anywhere from 14 to 60 days for beneficiaries to receive a life insurance payout. But many factors impact this time frame. These include the insurance company's procedures, when the claim is filed, how long the policy was active, the cause of death, and state laws regarding insurance payouts.
How long do you have to pay life insurance before? ›
How Long do You Have to Pay Into a Life Insurance Policy Before It Pays Out? Life insurance will pay out upon the death of the insured as soon as it is in force. This usually counts as the first premium payment.
How many years do you pay life insurance? ›
How term life insurance works: The basics. A term life insurance policy is the simplest, purest form of life insurance : You pay a premium for a period of time – typically between 10 and 30 years – and if you die during that time a cash benefit is paid to your family (or anyone else you name as your beneficiary).
