It is often said that there are two certainties in life—death and taxes. Life insurance is an important tool to mitigate the financial impact of a death. But the “need” for life insurance is not so straight-forward.
What is life insurance, and how does it work?
Life insurance is a contract with an insurance company wherein the owner pays premiums in exchange for a promise that the insurance company will pay out certain benefits to a beneficiary upon the death of the insured. The owner, payor, beneficiary, and insured can all be different people or entities (except the insured must be a natural person, not a non-person entity such as a company), but there is often some overlap—they can all even be the same, if the policy pays out the death benefit to the estate of the deceased.
For example, at my previous employer I owned a policy insuring my life where the employer and I both paid a share of the premiums, and Xa would have received the proceeds had I died while the policy was in force. I was the owner of the policy, my employer and I were co-payors, I was the insured (since my death would have triggered the payout), and Xa was the beneficiary. I have also owned policies on others’ lives where I paid the premiums and was the beneficiary.
Term life insurance is the most straightforward. A term policy is for a set period of time, and only pays out benefits if the insured dies during the term of the policy. If the insured is still alive at the end of the term, the policy simply lapses. (Some policies let you renew for an additional term or convert to a permanent policy.) This is the least expensive option.
Permanent life insurance lasts for the life of the insured. Permanent life insurance policies typically combine a death benefit with a cash-value savings portion that the policy owner can access while the policy remains in force. Permanent life insurance policies are much more expensive than term policies, but do not expire as long as premiums are paid. (There are two types of permanent life insurance—universal life and whole life—based on the policy’s parameters for premium payments and cash-value growth.)
Life insurance premiums are not tax deductible, but death benefits are not taxable income. While you may grumble at not getting a deduction for those monthly premiums, you will not be subject to taxes on the death benefit cash payout. If you save or invest those funds after receiving them, you will pay taxes on the earnings, but not the principal portion.
Do I need it?
While permanent life policies can be used as investment vehicles, there are better investment options available. Keep in mind the purpose of insurance generally: to make you whole in the event of a loss—not to provide a windfall.
In that lens, the primary question to ask is whether others depend on your income for support. If you were to die tomorrow, what impact would your lost income have on others? If the answer is none, then you do not need life insurance.
This assumes you have sufficient savings or investments to pay your burial expenses and satisfy any outstanding debts. Death is expensive! Funeral costs in the United States average $7,000 to $12,000, but this can easily be higher, and does not include a cemetery plot of headstone. Cremation or aquamation is generally cheaper than burial, but there are still funeral costs involved.
While your beneficiaries cannot be held liable for your personal debts, assets must be used to pay any outstanding debts before going to beneficiaries. Creditors can seek reimbursement from beneficiaries that receive assets before debts are paid.
If your answer is more along the lines of “my children would be in a powerful world of hurt without my income for the next fifteen years,” then you need life insurance—but only for the length of time you expect to support your dependents. Once there is no longer anybody who depends on your income, you no longer need life insurance.
Because the need for life insurance typically expires (for example, when children become self-sufficient adults), I recommend term life insurance over permanent life insurance. You do not need to pay extra just to keep a policy in force beyond its efficacy. Additionally, if you live a normal lifespan, you will be able to accumulate more money by investing what you would otherwise pay for permanent life insurance, you are unlikely to have to pay estate tax, and your beneficiaries will inherit those funds tax-free anyway.
If you are on the FIRE path, you only need term life insurance until your investments reach a point that the surviving members of your household could survive off of your current investments in perpetuity. Besides a small life insurance policy that Xa has through her job—an employee benefit for which she does not pay any extra money—neither Xa nor I own life insurance policies on ourselves or one another. If either of us were to pass away, we have sufficient investments to pay off our mortgage, and the survivor would remain on track to FIRE with the remaining assets and their income. This is the case even though we have not reached our FI Number yet since the funds needed to support one person are less than those needed to support both of us.
Tax tip: A beneficiary can access retirement accounts at any time after the death of the account owner without incurring an early-withdrawal penalty. If you want to leave a gift to someone after your death, consider adding them as a pay-on-death beneficiary of your IRA rather than maintaining a permanent life insurance policy.
Okay, I need it—but for how long, and how much?
When picking a term life insurance policy, you need to select a term length and death benefit.
Assume that you make $80,000 per year ($60,000 after federal and state taxes) and you are responsible for supporting an eight-year-old and a five-year-old in addition to yourself. If you were to die today, you would probably need to be able to replace your after-tax income for the next 13 to 17 years (depending on whether you want to include the first four years of postsecondary education) based on the age of the younger child.
As a result, 15 or 20 years would be a sufficient term length. As for the size of the policy (i.e., its death benefit), the easy math would be to multiply your $60,000 after-tax income by the number of years needed. But you do not actually need that much. For example, a $500,000 payout that grows by 7% each year would provide a stream of $60,000 payments for 12.94 years. (The average rate of return in the stock market is approximately 10% per year before accounting for inflation, which is typically 2%–3% annually.) Various annuity calculators are available to help you select the policy size. Of course, if you want to provide your beneficiary with an extra cushion, you can always go with the “easy math” option, but weigh the costs of doing so because the difference can be significant. (After all, $60,000 × 13 = $780,000.) Your insurance agent can provide you with quotes for all sorts of terms and payout options.
If you have significant investments that you also plan to leave your beneficiaries, you may be able to reduce the death benefit slightly. If you pass away earlier than expected, you will not be using that 401(k) balance and can leave it to support your surviving dependents. You can also opt to change the size of the death benefit over time, reducing it as you accumulate wealth. Since most of us are working to accumulate wealth as we go, revisiting your life insurance plan and reducing your death benefit as you accumulate wealth should be done periodically.
What about life insurance on others?
Yes, you can own life insurance policies on people besides yourself. I owned a life insurance policy on my father before he died. I also own a term life insurance policy on my youngest brother (a Marine infantry officer) that I purchased just before his first deployment; I chose a term that will last the length of his military career.
You typically need permission when purchasing a life insurance policy on someone other than yourself. I remember asking my brother if he would be okay with me purchasing a policy on his life. His response? “You would be stupid not to.”
I also have an account where that same brother and I have set aside funds to pay for the cremation and funeral of our mother when the time comes. (As far as we know, our mother has no life insurance, which is fine because nobody depends on her for support.) It is okay to plan for these expenses with funds other than life insurance—just have a plan. Hopefully we will not need to access this account for a long time, but it is comforting to know we will not have financial stress during a time of family grieving!
I want to buy life insurance. Now what?
If you have a trusted insurance agent, simply reach out to them for assistance. (This may be the same person who assists you with car and/or home insurance, or you might seek out someone who specializes in life insurance.) You can also ask friends and family for recommendations. Finally, there are several online insurance brokerages that will allow you to compare costs for various options and to purchase a policy. Just be sure that you are working with a reputable company that will be around for the long haul.
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