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Understanding Term Life Insurance
Published Date : June 3, 2015
If you died tomorrow, can you guarantee the financial security of your surviving dependents?
For those currently in the asset accumulation stage of life, the untimely death of an income earner can have significant financial impact on the family. And while there are no guarantees in life, Term Life Insurance is an effective tool to help families achieve financial security in the event of a death. This article will explain how term life insurance works, when owning such a policy makes sense, and some tips on how to proceed.
How Does Term Life Insurance Work?
Term life insurance is often referred to as pure insurance – in other words, it provides a financial benefit upon the death of the insured. The purchaser specifies the desired benefit and the term or years of coverage, and pays a static premium for the term or life of the policy. If the insured dies during the policy term, the death benefit is paid to the named beneficiary(ies). If the insured lives beyond the term, the owner would most likely need to pay significant premiums to retain the policy or the policy would simply expire, leaving no cash value. Policy terms can be as short as 5 years and as long as 30 or more years. Death benefits can range up to several millions of dollars. Both the term and the benefit can be set to match specific liabilities or desired outcomes. Finally, because these policies play a very specific and limited role, they are considerably less expensive to purchase than other life insurance products. In order to purchase a policy of material size, the insured will need to “pass” a medical examination.
When Is Term Life Insurance Appropriate?
Determining the appropriateness of term life insurance is a straightforward exercise, and should be explored if any of the following apply:
- Is there mortgage debt on the family home?
- Is there significant business debt for which the family would be responsible?
- Would estate taxes at the insured’s death represent too great a burden on the family?
- Would the family’s asset base be insufficient to provide for the survivors if his or her income is lost?
If an insurance payment is used to retire debt or pay estate taxes, the family’s security is immediately improved. Proceeds can also provide an income bridge to support the family, perhaps providing the beneficiary time before returning to or, in some cases, joining the workforce. While there is no restriction on how the death benefit is used, it makes good financial sense to match the benefit to actual risks (i.e. debt amount or spending need).
Important Considerations
Timeline: Probably the first consideration is when to buy term insurance. Since the cost of the policy (the premium) is directly correlated to the age and health of the insured, buying earlier or younger, is generally better than buying later. But the key is identifying when family obligations create the need for coverage, whether to cover debts or provide resources to support the family. It is also wise to consider the timeframe during which coverage is needed and as closely as possible “match” the policy to that period.
Tax Treatment: One clear benefit of life insurance is that no income taxes are assessed on the benefit paid to the beneficiary at the insured’s death. However, it takes effective planning to assure that the death benefit is not included in the insured’s gross estate for estate tax calculation purposes. For strategies to avoid such an outcome see Sand Hill’s blog article Avoid a Commonly Overlooked Estate Tax Blunder: Life Insurance Policy Ownership.
Purchasing Power Risk: There is no inflation adjustment to the death benefit during the term of the policy, so thinking about and projecting what coverage will be needed in the future is part of the exercise. Debts often pay down over time while other living expenses increase at least by some inflation rate. Once again, tying the amount of coverage to particular risks (debts vs. income replacement) is helpful in determining the optimal coverage.
Term life insurance is a powerful risk management tool that can provide relatively inexpensive peace of mind if used appropriately. As with any financial decision, carefully consider what you want to achieve and talk with your Wealth Manager to assess your need.
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