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Life insurance is one of those personal finance areas that we just don’t want to think about. It’s confusing and overwhelming enough that researching or reviewing policies takes low priority. But in this post I’ll review everything you need to know about the different types of life insurance, how to choose the right type of life insurance and how to determine how much life insurance you should buy.
According to the 2018 Insurance Barometer Study, 1 in 3 American families admit that they would face a financial disaster if the main income earner were to suddenly pass away. Of the roughly 60% of individuals that do have life insurance, 20% report that they don’t have enough coverage.
There are many reasons why this is. It is overwhelming and tedious to understand the different types of plans, the amount of coverage you need, and determine how much life insurance costs. Surprisingly, many Americans believe that the cost is 5 times higher than it actually is.
My problem wasn’t the cost. I just had no clue what I actually needed. About 10 years ago, my husband suddenly passed away. He hadn’t gotten around to setting up his life insurance. I wouldn’t wish this financial disaster on anyone. I called my bank to establish my own policy to ensure that if I were to die, my son would be financially taken care of. It was quick and easy, I just went along with what the financial advisor suggested and within a couple weeks I had a new policy.
And up until a couple weeks ago, I had no idea what type of life insurance policy that was.
But I finally started rethinking my life insurance coverage recently. I haven’t revisited my policy in 10 years! How much life insurance coverage do I need? What type of policy should I have? Is my life insurance plan in alignment with my future financial goals?
It was time for a thorough review of the different types of life insurance plans available. Here is everything that I have researched in order to feel confident in my own selection of coverage, and should be enough to get you started as well.
The main types of life insurance
There are two different types of policies to choose from. Term life insurance or permanent life insurance.
Of these two types, there are a few subcategories to choose from.
Here is a flow chart to quickly summarize the different categories of life insurance policies.
Term Life Insurance
Term life insurance is the simplest and most affordable type. It is purchased in blocks of time, typically 5-35 years in 5 or 10 year intervals and it lasts the length of the term. Once it expires there is no cash value and no remaining policy.
If the policy holder dies within the period of coverage, it pays quickly, which is helpful for the remaining family to make arrangements and adjustments without financial burden.
For example, a $250,000, 30-year policy can be purchased for a monthly premium of $25. This means that every month, for 30 years, the cost to maintain the policy is $25. If the owner of the policy were to die within the 30 years, a payment of $250,000 would be issued to the designated beneficiary. If the owner were to die just after the 30-year window, the policy would be expired and no payment would be issued. There is no cash value after 30 years.
There are two main types of term life insurance.
Level Term Life Insurance
This type of term life insurance is good for long term budgeting because the premiums are consistent and low. This is the cheapest type of policy to purchase.
The value and premium payments remain the same for the life of the policy, then it expires at no cash value.
Renewable/Convertible Term Life Insurance
The difference with this type of policy is the option to either renew at the end of term or convert it into permanent life insurance.
The benefit to this type is that you are guaranteed the option to renew or convert, regardless of insurability.
With certain health conditions it can become very difficult to qualify for coverage. This is a way to guarantee coverage. The cost of the policy is adjusted upon renewal.
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Permanent Life Insurance
Permanent life insurance is exactly as it sounds, it is a permanent policy that lasts for your entire life.
There are two main components to a permanent life insurance plan. There is the insurance policy, which is the death benefit, and there is a savings (cash-value) portion.
Similar to building equity in your home as you pay down the mortgage, there is a cash value component to permanent life insurance which increases as you contribute the premium payments.
This cash value grows tax deferred and can be accessed in the form of a loan. If you take money out, the coverage (insurance component) decreases by that amount. You pay interest on the loan and are only taxed if you borrow more than you have paid into the policy.
There are two terms that are useful to know here, the face value of the policy is the coverage that will be paid out to the beneficiary upon death. Otherwise known as the death benefit. The cash value, or savings component, is the amount that has been contributed through premium payments.
How to access the cash value of your permanent life insurance policy
As you pay your monthly premium, the cash value of the policy increases. Each payment is divided into three categories, the amounts depend upon the policy type, insurance company, and other factors such as your age and insurability, and the policy age. Premiums go into:
- Death benefit amount
- Cash value
- Investing fees, operating costs and insurance company profit
Similar to a home mortgage, more of your monthly premium payment is applied to the cash value of the policy, less goes to the death benefit amount. As you grow older, it becomes more expensive to cover the insurance, therefore, less money is applied to the cash value and more to the cost of the policy.
As the cash value grows, you have the ability to:
- Use that cash value to cover premiums
- Borrow from the cash value
When you borrow money, there are less restrictions on how you use the funds and the interest rate is often lower than borrowing from traditional lenders.
Unpaid loans will reduce the death benefit paid to the beneficiary by the amount borrowed plus the interest rate of the loan.
There are two main types of permanent life insurance policies.
Whole Life Insurance
Whole life insurance is a type of permanent life insurance. The premium payments and coverage never changes.
There is some flexibility in how you long you choose to make payments. For example, you could choose a higher premium that is paid in full within 20 years, in which case the policy would reach full coverage and remain in place for the remainder of your life. This is useful if you don’t want any added expense during retirement.
Or, you could choose to pay a lower premium that remains in place until well into retirement.
There is also the option to purchase additional coverage. This would be beneficial if you were to purchase a new home and wanted to ensure that your spouse or family could pay off the mortgage after you die. It is also helpful if you marry and need additional coverage for your spouse, or when you have kids and need to cover the added expenses of childcare and college.
Because this type of plan gains cash value over time and remains in place permanently, it is more expensive.
Universal Life Insurance
Universal life insurance is very similar but is more flexible than whole life insurance.
This type of policy allows for flexible coverage to meet your needs. You can decide how much to pay and when. For instance, you can pay more before you have children and then lower the premium when expenses increase later. After the children move out, you can increase payments again.
Additionally, the cash value grows as an investment, with interest. There is a minimum interest rate that is guaranteed as well as a maximum cap rate.
There are three main types of universal life insurance, based on the way the cash value is invested.
Guaranteed Universal Life Insurance
- No adjustment in payments so the premium remains stable
- You can’t miss a payment or the policy lapses and there will be no payout
- This is a more affordable type of whole life insurance
- Choose the age of guaranteed payment – otherwise cash value grows over time and payout is based on total invested
- Not much cash value in early period
- Variable Universal Life Insurance
- Tied to an investment account such as bonds, money market or equity accounts
- You can borrow against the cash value
- Larger gains are possible
- Requires more hands on management and therefore greater management fees
- Indexed Universal Life Insurance
- Cash value depends on stocks
- There is a cap rate, you won’t receive greater interest than cap rate, regardless of how strong the market is
- Flexible payment options
Now that you understand the basic types of life insurance plans, here are some tips to help choose the right life insurance policy type and coverage.
How to choose a policy?
Benefits to term life
- Cover income during the time you have dependents
- Pay off a mortgage
- Affordable
- As an alternative if you can’t afford permanent life insurance premiums
- It can often be converted later
Benefits to permanent life
- If you want to leave behind an inheritance
- As a way to continually cover estate taxes
- Life long dependent care
- If you don’t expect to have much in retirement savings but you want to leave something behind
- Even out inheritance between children, for example one child gets the house and the other gets the cash payout
How much should you buy?
The basic calculation to determine how much life insurance coverage you need:
Insurance policy = (Long term financial obligations) – (Assets)
Questions to consider when determining how much life insurance you need:
- Does anyone depend on you financially?
- How much money is needed annually to replace your income?
- How many years would they depend on you?
- How much debt do you have?
- What is your remaining mortgage to be paid?
- How much money do you want to provide for children’s education?
- What are estimated funeral and memorial expenses?
- How much after-tax income does your family have without considering your income contribution?
- Are there any pre-existing insurance policies in place?
- How much do you have in assets?
Example
Let’s look at an example using Joe and Rebecca. Joe is an attorney and Rebecca is a nurse, they have two young children, ages 5 and 7.
Joe wants to purchase a simple term life insurance policy to ensure that if he were to die unexpectedly, Rebecca would be able to cover all the expenses as well as stay home with the kids during the difficult years following his death. His annual income is $160,000.
Using the above questions, we can determine a rough estimate of how much life insurance he will want to consider.
Does anyone depend on you financially?
Yes, Rebecca and the kids
How much money is needed annually to replace your income?
$160,000 in annual income
How many years would they depend on you?
The youngest child will depend on Rebecca for another 13 years
How much debt do you have?
Car #1: $20,000
Car #2: #12,000
Credit card debt: 10,000
Total: $42,000
What is your remaining mortgage to be paid?
Remaining mortgage: $600,000
How much money do you want to provide for children’s education?
Each child should have $200,000 for 4 years of college (using the Vanguard College Cost Projector online tool)
Total of $400,000 for two kids
What are estimated funeral and memorial expenses?
The average cost of cremation funeral expenses is around $6,000, according to the National Funeral Directors Association.
How much after-tax income does your family have without considering your income contribution?
Rebecca works as a nurse and makes $90,000 annually. After taxes and saving for retirement, her take-home contribution is roughly $60,000.
Are there any pre-existing insurance policies in place?
Joe has an inexpensive life insurance policy through his employer which covers his full income for two years, or a total of $320,000.
How much do you have in assets?
401k: $500,000
Emergency savings: $45,000
Other investments/assets: $200,000
Total: $745,000
We can now use the DIME method to calculate and estimate of how much life insurance Joe should consider for his family.
The DIME method stands for:
D – Debt
I – Income to be replaced
M – Mortgage
E – Education
Debt: $42,000
Income: $160,000 x 13 years or a total of $2,080,000
Mortgage: $600,000
Education: $400,000
Total: $3.12 million
Factoring in the total assets that would contribute to this amount:
Insurance policy = (Long term financial obligations) – (Assets)
$3.12 million – $745,000 = 2.37 million in coverage
Since Joe also has life insurance through his employer, we can subtract this amount from the total.
$2.37 million – $320,000 = $2 million
Life insurance on the path to FI
If the plan is early retirement or financial independence, permanent life insurance doesn’t make a lot of sense. The premiums are higher, the cash value grows at a capped interest rate and the overall cash value and payout increases with time. As you save and invest and plan for FI, your assets and investments are growing, at least up to the point that you no longer require an income. Since the whole point to life insurance is to cover your income and any expenses upon your death, once you reach FI this should be redundant and unnecessary.
One solution is to stack term policies. The assumption is that you will need more coverage early on, when you are working and investing for FI. As the years go by and you work your way closer to FI, you won’t need as much coverage.
Instead of purchasing a large 30-year term life policy for $40 a month, you could purchase three separate policies of varying time lengths. For instance, if you want $500,000 coverage you could purchase a $200,000 10 year policy, a 200,000 20 year policy and one $100,000 30-year policy for a combined cost of $35/month. This way you pay less, have the full coverage during the early working years, before accumulating assets, then less and less over time.
There is a great tool on Quotacy that allows you to enter your zip code, gender and age then play with different types of term life policies, and an estimate of the premium monthly payment for each. This is how I calculated out the total cost of stacking the three plans.
Recap
Life insurance is, more often than not, part of a solid financial plan. It provides peace of mind, at a relatively low cost.
Like most every aspect of personal finance, what type of life insurance policy you choose, and how much coverage you need, is personal. The main question to ask yourself is this: If I were to suddenly pass away tomorrow, how much money does my family need each year, and how many years will they need to rely of that income? From there you can calculate out a general idea of how much coverage you need. What type of policy you need will depend on your long term goals. Since I am all about wisely managing your money today and investing for a secure future, term life insurance is the way to go.
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