Most young Americans are not thinking about life insurance policies, but they should. Life insurance is the ultimate financial tool for those big "what if" moments. It can be useful even when the death benefit is not triggered, as long as it is used appropriately. Life insurance is not a panacea, and some younger Americans may not have the resources to devote to large policies. But it is a mistake to assume that only older couples with children and homes need life insurance.
All else being equal, it is always cheaper, and sometimes substantially less expensive, for a younger person to buy insurance than an older person. This means the potential benefits of insurance can be just as large and cost much less or may be much larger and cost about the same. Without other considerations, life insurance for a 22-year-old is a better proposition than life insurance for a 55-year-old.
Reasons to Buy Life Insurance
The most obvious reason to buy life insurance is when you have clear insurable interests and want to be financially protected from a catastrophic accident. For example, you may have large debt obligations from student loans or a mortgage that you do not want to be passed on to someone else. You might also have a spouse or children who rely on your income, parties who could depend on insurance claims to survive if something unfortunate happened to you.
Insurance can have other features besides a death benefit, however, which means there might be other good reasons to buy a policy. Some policies provide support for certain medical problems, such as cancer or paralysis. Permanent life insurance policies can serve as tax-advantaged savings vehicles through the accumulation of cash value.
Federal law prohibits insurance providers from selling policies on the basis of their cash value, although this almost certainly happens. This does not mean it is always a bad idea to buy insurance for its possible cash value accumulation. In some circumstances, cash value might accumulate money at a faster rate than other investments with less risk and more favorable legal ramifications.
Types of Life Insurance
Insurance is typically divided into two categories: term and whole life. This undersells the diversity of insurance products available to consumers since there are many different kinds of term insurance and many different kinds of permanent insurance.
Term insurance is designed to cover a specific set of possible events over a defined period. For example, a level term life insurance policy might offer $200,000 worth of coverage over 20 years and cost $20 per month until the end of the term. A beneficiary is named on the policy, and he receives the $200,000 if the insured party dies or is critically injured. For a 25-year-old individual with little debt and no dependent family, this kind of term life insurance is often unnecessary.
Some term insurance policies allow a return of premiums, fewer fees, and expenses if the insured outlives the policy. This is called "return of premium" term insurance, and it tends to be more expensive than level term policies.
Decreasing term insurance is a useful option to cover a specific kind of financial liability, such as a mortgage. The face value of a decreasing term insurance policy declines over time, usually because the liability is expected to shrink over time, such as the mortgage being paid down. Even some individuals in their 20s can have insurable liabilities, which means there might be an argument for a decreasing term policy.
Unlike term insurance, permanent life insurance offers more than just a death benefit. Permanent life insurance policies offer the chance to accumulate cash value, and cash value works better for people in their 20s than people in their 50s.
Different kinds of permanent life insurance include whole life, universal life, variable life and indexed universal life. The differences mostly center around how aggressively the policy's cash value grows; whole life insurance tends to be the safest and most conservative, and variable life insurance tends to be the riskiest and most aggressive.
Any type of permanent life insurance could pay off for an individual in his 20s, assuming he can afford the policy, which is often hundreds of dollars per month. The policy still offers a death benefit, but the cash value can be very useful even if the death benefit is not triggered for decades.
Understanding Cash Value
Cash value is an interesting and important feature of permanent policies; many insurance providers refer to cash value as part of a "living benefits" package as opposed to a death benefit. As money is paid in by the insured, a percentage of the premiums is kept in the policy and accumulates interest. This money may be accessed later to pay for other life events such as weddings, home purchases, children's schooling and even vacations. Most critically, this money usually grows and is usually withdrawn without creating a tax liability.
Even low-interest whole life policies can provide a healthy dividend on the cash value. This dividend can be collected or used to increase the cash value. It is conceivable, although not guaranteed, that a permanent life insurance policy could significantly increase retirement income, again tax-free, or even allow you to retire early.
How Insurance Can Pay Off
A cash value that builds for decades can amount to hundreds of thousands of dollars in future tax-free income. This can be an important aspect of a comprehensive retirement plan, especially if you already plan on maxing out an IRA. This strategy only works if premiums are paid consistently; permanent life insurance policies lapse if the cash value gets too low, which leaves the policyholder without coverage.
Even if you cannot afford a permanent life insurance policy, most 20-somethings can receive very good term policies for very low costs, such as $200,000 to $300,000 in coverage for $15 to $20 a month in some cases. More importantly, some term policies can last for 20, 30 or 40 years; you could be covered at a very low cost throughout your entire working life.