Life insurance is a valuable financial planning tool, but make sure the type of insurance you choose matches your needs.
When deciding if you need life insurance, it's important to first understand what purpose the insurance would be serving. The most common use of life insurance is to provide an immediate pool of assets that can replace the insured's income or savings potential to meet the needs of the survivors. These needs could be living expenses, outstanding debts like mortgages, education expenses and any other financial needs or goals. The bottom line is, if you aren't here tomorrow, will your family's quality of life continue or grind to a halt?
If you decide you do have a need for life insurance, here are some simple rules-of-thumb to use as a starting point.
- How much should I get? A common starting point is 10 times your annual income. If you want to get more comprehensive, you can add the items listed above like mortgage balances, college education costs and other expenses you would want to take care of for your family. There are also circumstances where it makes sense to insure the life of a spouse who does not earn income, but provides critical support for the family and household.
- How long will I need it? You may want coverage until your projected date of financial independence or when the needs listed above no longer exist. For many, this will line up fairly closely with retirement.
I think I need life insurance, but what is the difference between term and whole life?
Term Life is a life insurance contract with a pre-defined expiration date. Designed to serve a temporary need, these policies typically cover a period between 5 and 30 years, which creates a lot of flexibility for their use within your financial plan. The concept is relatively straightforward. The insurance company agrees to pay a death benefit for a certain length of time (the "term"), as long as you pay the premiums. The amount of the premium will be based on your age, health and the term. Similar to home and auto insurance, when you cancel the policy or stop paying the premiums, the contract ends.
Whole Life is a type of permanent insurance that will pay a death benefit regardless of your age as long as the policy is in-force. The premiums are usually much higher with this type of policy because the premiums paid during early years are used to build cash value and subsidize the cost of insurance for the later years. When you are young, the cost of insurance is very cheap. When you are old, the cost of insurance is very expensive. If you average out the cost over your "whole life", you get the cost of permanent insurance. The benefits of these types of policies include a permanent death benefit and access to the cash value that is built up within the policy.
Which type of insurance is right for me?
Focus on the why! Are the reasons you need insurance temporary or permanent in nature? Temporary needs would be expenses that are expected to be reduced or go away completely over time, such as replacement of income to cover debts, living expenses or education costs. Permanent needs would include potential future health issues that would prevent insurability, estate tax/liquidity needs (less so now that the combined estate tax exemption is over $22M!) or legal agreements that require insurance that never goes away. The purpose that the insurance is serving will determine the type of insurance that should be purchased. A person's life insurance needs will typically diminish over time, so it often makes sense to purchase an inexpensive term policy while directing more of your savings to building your army of dollar bills. This is especially true during your precious early years of savings where your Wealth Multiplier is so powerful!
Here is a clip that goes into detail on the differences between term and whole life.
Term Insurance vs. Whole Life Insurance (Full Episode - 10:38)
Check out this clip where Brian and Bo discuss some of the fundamental concepts about life insurance.