Life Insurance Refresher Course

Life insurance is one of the most complicated of financial products for consumers.  Should I buy a policy that builds cash value?  Should I stick with term insurance?  Should I buy insurance on my spouse?  How about my children?  What follows is an excerpt from my (co-authored) recently published book, J.K. Lasser’s New Rules for Estate, Retirement and Tax Planning– Fifth Edition”.

If your primary purpose is to provide your family with a source of income should you die prematurely, then level term insurance is your best bet. This assumes that you have a wealth accumulation plan (retirement plan) in place. In working with our clients, we normally recommend either 15-year or 20-year level term policies. This is because we have implemented a wealth accumulation plan that is expected to achieve total financial independence by the end of that period. For example, let’s say that you determined that you need to accumulate $3,000,000 of investment capital to be financially independent. Once you have accumulated that sum, you no longer need life insurance as a source of income protection for your family. It is possible that you might need permanent (cash value) life insurance for other reasons, such as estate liquidity. Remember, because you can convert term insurance to permanent insurance without having to pass a new physical exam, you have left your options open.

Insurance on a Homemaker

If you have young children, replacing the services of a homemaker can be quite expensive. Ask yourself this question: If my homemaker spouse were to die, could I afford to pay someone to perform those services out of my current income? You may be lucky enough to have a family member who could step in and provide childcare services. In this case, no life insurance would be necessary. On the other hand, if you decide life insurance on a homemaker is necessary, a $150,000 to $500,000 term policy should provide adequate coverage. By buying a 10- to 15-year level term insurance policy, you will provide coverage until the children are old enough to assist with their own care.

Insurance on adult children

If you have adult children who have started their own families, you might consider buying insurance on their lives to provide protection for their families. We are sure you can remember how tight cash flow was when you first started your family. This is a situation where you have the cash and they have the need. From a selfish point of view, if you had a breadwinner son-in-law die without enough life insurance, you might feel compelled to step in with financial support for your daughter and grandchildren. Believe us, paying the premiums on a large term life policy for your son-in-law is a lot more palatable than financially supporting a second family! The latter could have a serious negative impact on your own estate and retirement plan.

How to Get the Best Deal

Fortunately for the consumer, term insurance is a very competitive product. In terms of planning and budgeting, 10-, 15-, or 20-year level term is advised. That way, you have a predictable premium for a fixed period of time. To access competitive quotes on-line click here: “Life Insurance Quotes.”

To get the best deal, first decide how much life insurance you need and what kind of term insurance best fits your circumstances. For example, if you decide that you need $750,000 of 15-year level term life insurance, first, go online to get a quote. Then, if you have a local agent, ask him or her for a quote. A simple comparison will ensure that you get the best deal. Personally, we prefer to work with a local agent because you will receive a more personal level of service.

I have suggested level term life insurance as the best choice for the family bread winner with the emphasis on being sure that you have plenty of life insurance while keeping your monthly premiums low.  Most people underestimate just how much life insurance is needed to replace the income of a family member and therefore are often underinsured.  A simplistic way to think about it is to decide for how many years you will need how much income and then do some simple math.  For example, you decide that if you died suddenly, you’d need to replace $50,000 of income for the next twenty years.  $50,000 times twenty years equals $1,000,000.  Ok, I understand that we could discount the amount of insurance we will need by what we expect to earn on the proceeds, but let’s keep it simple.  Consider the earnings portion as part of emergency reserves or to help offset future inflation.  And let’s remember that in many cases this is just the bare minimum of insurance you’ll need.  You may need a larger policy to cover future college costs or money to fund continuing income if your homemaker-spouse does not intend to return to work after raising your children.  At age thirty, a $1 million twenty-year level term policy costs less than $500 per year for a male in excellent health (females are much less).  If you chose to purchase a cash value policy, your premiums would likely be at least four times that much.  As you can see, trying to solve a big insurance problem with cash value insurance can be very taxing on your personal finances.

So when is buying a cash value policy a good idea?  Not too long ago we saw lots of situations where permanent (cash value) life insurance was needed to pay estate taxes for many middle income Americans.  However, the most recent changes to the death tax laws provides that there are no death taxes if your estate is less than $5,430,000 (double that for married couples) so this does not come into play for the vast majority of people today.  The other reason for buying a cash value policy is for the savings or investment feature.  It is true that life insurance policy cash values grow tax deferred and escape income taxation if the policy pays out as a death benefit but the cash value returns tend to be negative in the early years and very modest over the long term.  I’m not against using cash value life insurance as a savings vehicle but would strongly prefer investing first through your company 401k plan, an IRA, a Roth IRA or in stocks or low-cost no-load stock mutual funds.  You’re going to need the higher long-term returns of the stock market in order to build enough wealth for retirement.

Term insurance conversion trap

The big advantage to term insurance over cash value insurance is low cost.  But what happens if at the end of the term period (twenty years in my example above), you decide you still need the insurance but you are now uninsurable?  Most term policies allow you to ‘convert’ your term policy to a cash value policy with your same insurance company and you don’t have to prove you’re still in good health.  You simply sign a conversion form and you now own a ‘permanent’ cash value policy.  While this sounds simple enough, there are two problems of which you need to be aware:

  1. Conversion to lousy policy. If you’re converting your term policy, the insurance company is guessing that you may be in poor health and therefore a higher risk.  To discourage you, many companies don’t allow you to convert to their best policy…in fact they write a special policy that is very expensive and a lousy deal compared to their other policies.
  2. Conversion option expires before the end of the term insurance period. Most companies allow you to convert for the entire time you own the policy (20 years on a twenty-year term policy, for example).  However, some companies drop the conversion privilege two to three years before the policy ends.  Why?  I can only surmise they hope you’ll ‘forget’ and when you need to convert at the end of the policy, it’ll be too late.

Protect yourself in both of these cases by asking your agent to confirm that you can convert to a competitive policy and that the conversion right extends for the full term of the policy

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