Life Insurance: Foundation to a Solid Portfolio

Despite its sometimes maligned reputation, life insurance is a foundational piece of a solid financial portfolio. While some have a strong understanding of the need for life insurance, there are just as many who harbor misconceptions about the product.

In fact, according to a recent survey by Allianz Life Insurance Company of North America, more than half (51%) of respondents said they were either unsure or did not believe life insurance could provide living benefits such as access to potential cash value accumulation to help fund college education, supplement retirement or other financial needs. In addition, only 33% of respondents were aware that benefits paid from life insurance are generally not taxable income to the beneficiaries. (For more, see: Buying a Life Insurance Policy? Read This First.)

Dispelling Misconceptions

Armed with some additional information, many of these misconceptions on life insurance can be dispelled. The main reason to get life insurance is to provide a financial benefit to loved ones in the event of an early and/or unexpected death. The death benefit from a life insurance policy can be used for immediate needs such as paying for medical expenses and a funeral as well as longer term needs such as mortgage assistance, funding educational expenses, replacing lost income and potentially maintaining other investments. Importantly, the benefits received from a life insurance policy are generally income tax free. And as is the case with some policies, there is accumulation potential - meaning it is possible to potentially build cash value in addition to the death benefit.

Contrary to popular belief, life insurance is not for just one stage of life. For younger singles, unsettled debt at the time of death can become a burden to those left behind, particularly if they co-signed on the loans. The proceeds from a life insurance policy can be used to settle estate matters, including debt. For couples, protecting a spouse or significant other is an important part in establishing joint finances. Life insurance can help ensure that milestone goals such as buying a home and saving and investing for retirement remain on track in the event of the unexpected death of a partner/spouse. Not having life insurance in place not only has a short-term impact but a long-term impact as well as funds that would normally be used for investing might need to be redirected for more immediate financial needs.

For those with children, any available cash value that a life insurance policy may have accumulated can be accessed through policy loans and withdrawals to help fund a variety of expenses ranging from day care to supplementing college funding.* Importantly, life insurance also allows for the possibility of a surviving spouse or significant other to either leave or have added flexibility at work if they choose to care for children full time.

And for those in their golden years, life insurance fund proceeds can be used to help build a legacy through the death benefit, either through leaving money to a beneficiary or via a final donation to an organization. Also, in some cases, some policies will allow the policyholder to access any available cash value income tax free to help cover any financial needs and supplement retirement income.

These loans and withdrawals can be at any time as long as there is sufficient cash value in the policy. Those with a policy should carefully manage values when taking loans to ensure the policy does not lapse. (For more, see: Life Insurance: How To Get the Most Out Of Your Policy.)

The most well-known type of insurance is term. Term life insurance provides protection for a specified period of time. Once that time period is over, the policy terminates. Some term policies are also “convertible”, which means the policy owner can change the policy to a permanent one under certain conditions and within a certain time frame. With term life insurance, in the event of death, the beneficiary generally receives the death benefit income-tax free.

A permanent life insurance policy is a policy that does not expire during a set term. In addition to death benefit protection, this type of insurance policy also allows for a cash value accumulation potential. Any available cash can be withdrawn or loaned and used to cover unexpected expenses or used to help meet a financial goal such as helping to pay for college, buying a home or supplementing retirement income. These loans or withdrawals may be income-tax-free, which can be an appealing option for many. The two common types of permanent life insurance are whole life insurance and universal life insurance.

Whole life offers the predictability of level premium payments and interest rates are usually only adjusted annually. Universal life offers the flexibility to pay premiums at any time and in any amount (subject to some limits) as long as the policy expenses and cost of coverage are met. During times of high interest rates, those with universal life might see their cash values accumulate faster than those with whole life policies. In addition, there are different types of universal life insurance to consider.

For example, fixed index universal life insurance is a universal life insurance policy that allows for an opportunity to accumulate cash value based on positive changes in an external market index or a fixed interest allocation. This allows for the opportunity for greater accumulation potential as compared to traditional universal life insurance. There is also a built-in annual floor that ensures the cash value will not decrease due to market volatility as the cash value is not directly invested in the market - although certain fees and expenses will reduce cash value.

Other types of permanent life insurance policies include variable life and variable universal life.

Life insurance will likely never be a product that grabs the headlines or one that serves as a conversation starter at a party. However, there is no doubt that it is perhaps one of the most invaluable financial purchases one can make and it can be the foundation of an overall financial portfolio. Having the proper protection in place can be a critical part in ensuring financial goals are met both today and tomorrow for yourself and for those you love. (For more from this author, see: 3 Steps for Building Financial Stability This Year.)

*Policy loans and withdrawals will reduce the available cash value and death benefit and may cause the policy to lapse, or affect guarantees against lapse. Withdrawals in excess of premiums paid will be subject to ordinary income tax. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. If a policy is a modified endowment contract (MEC), policy loans and withdrawals will be taxable as ordinary income to the extent there are earnings in the policy. If any of these features are exercised prior to age 59½ on a MEC, a 10% federal additional tax may be imposed. Tax laws are subject to change and you should consult a tax professional.