Most people have heard of life insurance before, but many have no idea how a life insurance policy works. Life insurance is an integral part of financial and estate planning for most people.
It helps to protect loved ones after someone’s death by providing a financial payout to help with funeral costs and other expenses.
While almost everyone could benefit from life insurance, not everyone purchases it. This could be because they think it is more expensive than it really is or because they don’t fully understand how it works.
Some people do not realize that there are many different types of life insurance policies, so finding the one that is right for their situation is critical to protecting their family.
Keep reading as we explain what life insurance is and how it works.
What Is Life Insurance?
Life insurance is a contract between the policyholder and the insurance company that provides a death benefit upon the insured’s death.
While that might sound complicated on the surface, it is pretty simple. Now, some policy types can become more complex, but at its most basic level, life insurance works like this.
- The policyholder pays the insurance company a premium, usually every month. In exchange for these premium payments, the insurance company promises to pay the beneficiary a financial payment when the policyholder dies.
The death benefit and premium payments are based on the insured’s age and health.
- Obviously, it will cost more to insure someone who is not in good health or is older simply because the odds are higher that the person will die while the contract is in existence.
- Insurance companies use complex mathematical formulas to determine applicants’ life expectancies so that they can appropriately set the premium rates and payments that will be due.
There is a fine balance between the company remaining profitable and insurance getting too expensive to be affordable.
This is the basic information about life insurance. However, we will discuss the different types of policies in more detail in the next section.
KEY TAKEAWAYS
- Life insurance is a contract between the policyholder and the insurance company that will provide a death benefit to beneficiaries upon the insured’s death.
- Different types of life insurance policies are available, and it’s important to choose a policy that is right for your circumstances.
- You may get a payout on the policy after only a few weeks. However, it generally will take longer since the insurance company needs to confirm the cause of death.
Types Of Life Insurance Policies
There are many different types of policies, and we will discuss a few of the most common types here. Different policy types have different rules, prices, and regulations.
There are also differences in the period for which they are active. You should select the type that works best for you and your family.
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Choosing The Policy Type That Is Right For You
Most people find that over time, their life insurance needs change. So, the type of policy that is right for you is the one that is right for you based on your current needs.
People typically start by deciding between a term life policy or a permanent policy.
- A term policy is right for you if you need coverage for a specific time period.
Many young professionals choose this option. They select a policy that will cover them during their working years or until their children reach an age where they are likely to be able to take care of themselves.
A policy like this can help replace your income, pay a mortgage, and maybe even pay for college tuition for your kids in the event of your death.
*Term policies are usually much cheaper than permanent policies.
- If you prefer a policy that will cover you for your lifetime and build cash value, then a permanent policy might be for you.
You should know that permanent policies usually do not provide both a death benefit and the policy’s cash value. In the event of your death, your beneficiaries will receive the death benefit, not the cash value of the policy.
*These policies are usually much more expensive, and the higher premiums are often not worth the investment.
Selecting The Right Coverage Amount
When applying for life insurance coverage, selecting a coverage amount is a big decision.
Your life insurance agent should be able to help you decide how much is right for you.
- You will want to consider how much you need from the policy’s death benefit to provide peace of mind for you and your family.
- The more coverage you get, the higher your premium payments will be. However, you need to make sure that you get enough coverage to take care of your family after your death.
- You should also know that the IRS typically exempts life insurance proceeds from taxes.
On average, most experts believe you need somewhere between 10 to 12 times your annual income in coverage. This helps ensure that your family can pay all your debts and continue the same level of lifestyle to which they are accustomed.
While you might be able to get away with less insurance than this, it may put more of a financial strain on your family after your death.
- You should take into account the amount of money you owe on your house, the amount owed on cars, any additional debts, potential college expenses, and any other financial needs that might arise.
You want to ensure that you provide plenty of financial protection for your family, and the right insurance products are one way to do that.
A financial planner can also assist with choosing how much life insurance you need when assessing your options.
TIP
Life Insurance can be a great way to transfer wealth, as life insurance proceeds are generally not taxable income for the beneficiary.
How To Choose Life Insurance Beneficiaries
Most people choose an immediate family member, such as a spouse or child, as the beneficiary of their policy.
However, this does not always have to be the case. A beneficiary might be a business partner, a company, or even a trust or estate.
- If you name a person as the beneficiary, your life insurance proceeds will generally not be taxable.
- However, if your payout goes into your estate, you might be forced to pay estate taxes on the amount received from the insurance company.
Creating an irrevocable life insurance trust is another way to avoid paying taxes on your insurance payout. This allows the insured to control the manner in which the beneficiaries receive the money.
They can use this type of trust to financially support their beneficiaries for many years. They may direct that the final expenses of their death be paid first, and then the trustee can manage the remaining funds for the beneficiaries’ benefit.
Cost Of Life Insurance
Life insurance rates vary by state, and many factors affect the rate you might pay for your policy.
- The most significant factors are the health and age of the potential insured.
- Health issues will cause the premiums to be higher.
- Non-smokers can also expect to pay less than tobacco users. In some cases, using tobacco might cause you not to be able to qualify for some of the main types of life insurance.
- Another thing that people often do not consider is their hobbies. Your premiums will be higher if you engage in dangerous hobbies like motorcycle riding or rock climbing.
Your life insurance company will look into your medical records and perform background checks to verify the information you provide on your application.
- Most insurers also require a medical exam to take place to verify your health.
- Your application will also need to go through full underwriting.
A healthy individual in his or her 20s might be able to get a 15-year term policy of $1 million for less than $500 per year.
However, that same policy might cost a 35-year-old over $1,000 per year.
If you switch to a permanent policy, the premiums may rise to $5,000 or more for the year. If you want to pay a lower premium, you will need to reduce the benefit amount or the number of years for which the term is active.
Some states, like New York, have many rules and regulations regarding insurance companies, so the state in which you live can also affect the premium amount you will pay.
Getting life insurance quotes is relatively easy today. Many companies offer free online quotes by providing basic personal details.
- To get a more specific quote, you should contact an insurance company so that they can tell you precisely what they need to get you a quote.
- Once getting a quote, you can then decide whether you wish to purchase the coverage or not.
So, what is an insurance premium? That is simply the amount you must pay to keep the policy active. You might make monthly, quarterly, or yearly payments to maintain your policy.
Filing A Life Insurance Claim
When it comes time to file a claim, the process is generally the same regardless of your insurance company or policy type.
You must notify the company and provide proof of death to begin the claims process. Here are the steps you must take when a loved one dies, and you want to file a life insurance claim.
Notify Insurance Carrier
The claims process starts with notifying the insurance company. Most policies list a phone number to call when you need to report a claim.
You can find their general contact information on their website if you are unsure how to contact your insurance company.
You will need to provide the company with some documentation, such as the name of the deceased, policy number (if known), death certificate, and other information.
Most insurance companies require specific documentation and claim forms to be completed once a claim is started.
Payout Options
In some cases, you might be able to choose the type of payout you receive. In other situations, the policy may specify the type of payouts available.
The most common payout is a lump sum payment, which means the beneficiary receives the entire death benefit in a single lump sum.
You might also choose annuity payments or other payouts like a retained asset account. This means that the insurer might retain the death benefit in a special account and pay you interest and payments from the account.
Since you typically do not pay taxes on life insurance payouts, most people opt for the lump sum to get all the money at once and get it tax-free.
Potential Payout Delays
So, how quickly will you receive the payout from an insurance policy? In some cases, you might be able to get the money in as little as a couple of weeks.
However, you need to be aware of potential delays. These delays could happen for several reasons.
- First, if there are any suspicious circumstances surrounding the death, you can almost rest assured that the payment will be delayed.
- In addition, it depends on what your life insurance covers. If the event that caused the death is not covered under the policy, then no payout may occur at all. The policy will specifically list the causes of death that are covered under the policy and those that are not.
- Anything that raises suspicion will likely delay your insurance payout.
The Bottom Line
Almost everyone should consider purchasing life insurance as it is a powerful financial planning tool.
Knowing what type of policy and how much coverage is right for you is critical to deciding on the best policy.
Your insurance agent or financial planner should be able to help you with these decisions. Over time, your life insurance needs may change, so you should continually assess your coverage and policies.
Frequently Asked Questions
It depends on your specific policy. For a term policy, if you do not die during the term of the policy, then the contract ends, and no death benefit is received upon your eventual death.
Other policy types grow a cash balance. You might cash in the policy and receive the surrender value in exchange for canceling the death benefit.
It is difficult to find data on average life insurance payouts, although the average in the United States seems to be around $100,000.
Some policies pay much less than this. Sometimes, you might find that a policy has a death benefit as low as a few hundred dollars.
However, you also have the other end of the spectrum. Some policies might pay several million dollars upon the insured’s death. It just all depends on the specifics of your policy.
Not always. While a lump sum payment is a standard option, you might also find payouts in the form of annuities or retained asset accounts.
This typically gives the beneficiary a set amount each month or year for the rest of their lifetime. In some cases, this can be an excellent option to help the beneficiary avoid running out of money because they spent it all upfront.
Many will ask, “Do I have to file taxes on insurance payments?” The answer is usually no, although there might be some situations where taxes are due.
Term life insurance is only valid for a certain period. Policies may be available for a term of 5 years, 10 years, 20 years, 30 years, or any period for which the insurance company is willing to offer a policy.
The death benefit will be payable if the insured dies during this term. If the insured lives past the expiration of the term, then the policy expires, and no benefit will be payable.
Whole life insurance is valid for your entire life if you pay the premiums. Whole life is usually much more expensive, and some companies might not even issue a whole life policy, depending on your age.
That depends on your personal financial situation. Most experts state that you need to carry coverage for 10 to 12 times your annual salary.
Your salary, level of debt, and expected lifestyle all play a role in determining how much coverage you need to select. You will want your family to be able to pay your debts and have plenty of money left over to maintain their current lifestyle and pay for future expenses.
Almost everyone should buy life insurance in some amount.
Some people need more than others. If you have minor children and a family, then you certainly need to purchase life insurance to protect them in the event of your death.
If you are older or more wealthy, you might need less life insurance; however, that does not mean that you should not purchase insurance at all.
If you have any questions, consult your financial advisor to determine how much insurance you need.
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