You'd do anything to protect your family. Yet many heads-of-household neglect the most commonplace thing they can do: Get life insurance. Of course, buying a  policy may seem pretty daunting (adequately provide for your spouse and kids if you're gone? No pressure there), but the experience becomes much easier when you know some of the basic questions to ask. The following are some of the most important things to know before signing on with an insurer.

Term or Permanent Coverage?

Life insurance comes in two basic categories: term policies and permanent policies.

Term policies are the easiest to understand. You pay a premium at regular intervals and, in return, get a guarantee that, if you die within a certain period or term – say, 10 or 20 years – your beneficiaries will receive a predetermined death benefit. Conversely, permanent policies offer protection for an indefinite period – as long as the owner continues to pay premiums, basically.

But that’s not the only distinction. Unlike the more straightforward term coverage, permanent policies also include a savings component.The insurer essentially takes part of your premium payment and diverts it to a separate cash account. Once the value in your account builds, you can make withdrawals or even borrow against your policy. As you might have guessed, you pay higher premiums to receive this benefit.

The permanent life category itself consists of two major types: whole life and universal life (read more about the distinction in Permanent Life Policies: Whole Vs. Universal). And within those subcategories are several variations. For example, variable universal life policies allow you to put the investable portion of your premiums into professionally managed investments, rather than relying on the fairly conservative dividends and accruals afforded by a whole life policy.

What Do You Need?

But let's return to the first, fundamental question: whether to go with term or permanent coverage. Basically, the decision boils down to whether it’s better for you to build a nest egg within a life insurance plan (as a permanent policy offers) or to just pay for the bare-bones life coverage offered by a term policy, and make other savings plans.

A lot of advisors plump for the latter, quoting an old personal finance adage: “Buy term and invest the rest.” Here’s why. Permanent life insurance has significantly higher fees – and more restrictions – than your basic term coverage. The sales commission on a whole life policy can easily exceed half of your premiums for year one. So after paying into your policy for a year, you may find that its accrued cash value is still tiny. (See How Cash Value Builds In A Life Insurance Policy.)

What’s more, annual renewal fees can cost you around 7% over the next decade, further cutting into the savings portion of your policy. That makes no-load stock or bond funds look much more affordable by comparison, and their rates of return better too.

And what if you let the policy lapse within the first few years, as a sizable segment of consumers do? It's doubtful the cash surrender value will ever match the added premiums you've paid in.

Still, permanent life has its points. One of them is the fact that funds within your cash account grow tax-deferred. That's always a plus, especially if you’ve already maxed out your 401(k) plan and IRA contributions.  Lump-sum death benefit payouts are not subject to income tax or, in certain cases, to estate tax, either. In fact, well-heeled families sometimes use these policies as part of a complex estate-planning strategy to reduce the impact of taxes. See Cut Your Tax Bill With Permanent Life Insurance.

Another reason for sticking with a permanent life insurance policy: You'll never be left with a sudden lack of coverage, as you might be when a term policy expires at a time when you're in poor health.

 

Figure 1. Despite their higher cost, permanent policies are considerably more popular than term policies, according to a study by LIMRA, an insurance and financial services trade association. Source: LIMRA

How Much Do You Need?

Beyond the type of policy, you also have to figure out how much protection to buy. That can be a tricky task.

Some financial gurus suggest the face value of your policy be 10 times your annual salary, as a starting point. But keep in mind that there are a number of factors that could affect how much insurance your family needs. How much do you owe on your home? Do your kids go to private school? Does your spouse earn a substantial salary or have significant earnings potential if something happens to you? All of these could affect how much of a cushion you’d want to leave for your loved ones.

It may help to take an inventory of the main family expenses going forward. The resulting number should help tell you whether you need a $250,000 death benefit or a $750,000 one.

The family breadwinner isn’t necessarily the only one who needs coverage. If you’re a stay-at-home parent, your spouse may need help paying for things like childcare or housekeeping in the event of your untimely passing. Whoever is insured, you may also want to factor in the cost of a funeral or cremation services, which usually cost several thousand dollars at minimum.

‘Captive’ Agent or Independent Broker?

When it’s time to take out insurance, your first instinct might be to contact a salesperson for one of the major carriers. There are certain advantages to working with these “captive” agents, to be sure. For example, you might be able to keep multiple policies under one roof, and get a deal, if you get life insurance through the same company as your homeowners or auto insurance coverage.

But you might also think about talking to an independent agent, also known as a “broker,” who works with several different life insurance companies. By shopping your policy out to multiple providers at once, a broker can often help you find better pricing.

Going with a broker is particularly helpful if you have medical conditions such as high cholesterol or diabetes. Before offering you a policy, most carriers will have you go through medical underwriting. At the very least, that involves filling out a detailed health history form; in many cases, you’ll also have to undergo a health screening or full physical exam. While some insurers may charge you higher rates or deny your application if they consider you high-risk, an independent agent might be able to find a carrier willing to extend their standard rates.

And don’t think you have to pay more to use a broker, either. Like captive agents, they are compensated through sales commissions and policy renewal fees paid by the insurance company.  (Bear that in mind, though, if a broker seems to be pushing a particular policy hard: Perhaps that company pays more generous commissions.)

Yet another route is to buy life insurance through your employer. However, you may be able to find better terms elsewhere. Plus, you can’t take your group life coverage with you, should you end up leaving your job.

The Bottom Line

Deciding between term and life insurance doesn't have to be an either/or proposition. Some consumers carry both types of coverage (see chart). Plus, many term policies are convertible to whole life at a later date. So if your needs change and you decide that you want some protection after that period, you can transition all or part of the face value to whole life coverage without going through the medical underwriting a second time.

 

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