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Do I Need Term or Whole Life Insurance?

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The old life insurance question! Do I need it? The answer is most likely yes. But what kind of life insurance do I need? There are basically two types of life insurance: whole (also called permanent) and term. There is a different purpose between the two. The type you need depends on your goals with life insurance.

First, let's talk about whole life insurance. Whole life insurance is a policy written on a person that lasts until their death and then pays out to a designated beneficiary. Whole life insurance policies can be taken out on a husband and wife together, called a second to die policy, and these policies do not pay out until the second person dies. Premiums for a whole life insurance policy are substantially higher than term because there is the definite payout at death. As premiums are paid, the cash surrender value of the policy increases. The cash surrender value is what you would receive if you chose to surrender or terminate the policy early. This cash surrender value is substantially less than the policy amount, the amount that would be paid to the beneficiary upon death, and the policy ends when that money is taken out. However, you can usually borrow against the cash surrender value without terminating the policy but it lowers the amount paid out at death. Taking out the cash surrender value and terminating the policy is not the goal of a whole life policy. It should not be viewed as a retirement type account. Whole life insurance is not for everyone. It is generally used as an estate planning tool for people with a high net worth or a lot of assets that will be passed on.

For example, if someone dies and their estate holds a lot of assets but not a lot of cash, they may have a whole life insurance policy so that the beneficiary has cash to pay any estate taxes. Let's say William has one child, Sally, and William's wife has already passed away. William owns a lot of real estate. William also has a whole life insurance policy of $10,000,000 and Sally is the beneficiary. William owns so much real estate that when he dies, $15,000,000 will be subjected to estate tax. Assuming an estate tax rate of 40%, that would be $6,000,000 due in taxes. We've all heard sad stories about children having to sell the family farm because they needed money to pay the estate taxes. Well, in this example, Sally has $10,000,000 from the whole life insurance policy to pay the $6,000,000 in taxes and still has another $4,000,000 to maintain the properties and pay the annual property taxes. Since the life insurance proceeds are not taxable, it is a great way to get cash to your children (or designated beneficiary) without that amount of money being part of the estate and subject to estate tax.

As you can see, not everyone falls into William's category. Whole life insurance is not for everyone but it can be a great estate planning tool if you have a lot of assets or a large estate.

Term life insurance works in a different way. Term life insurance is exactly as it's name implies, insurance coverage for a specified term. Term life insurance does not have a guaranteed death benefit. Term life insurance only pays out if the person dies during that specified term. For example, if you have a $1,000,000 term life insurance policy up to age 55 and you die at age 52 then the $1,000,000 benefit will be paid. On the other hand, when you turn 56 the policy will terminate. The main purpose for term life insurance is to financially provide for your family in the event of your premature death.

Let's say Maggie and Bill are married with two kids. Both Maggie and Bill work. They each make $100,000 per year. Their budget and their lifestyle is based around income of $200,000 per year. However, if Bill unexpectedly died then there would only be $100,000 of income for Maggie and the two kids to live on. Maggie would not be able to maintain her current lifestyle, and probably her current home, with half the amount of income to live off of. However, if Bill had a term life insurance policy then it would give Maggie the peace of mind of not having to worry about finances as she mourns the loss of her husband and supporting her family going forward.

The general rule of thumb is to have term life insurance that is at least ten times your annual income. In our prior example, if Bill had a $1,000,000 term life insurance policy then Maggie would receive that at the time of his death. You may be thinking, that's great she would have 10 years worth of income BUT if Maggie invests that money at say 7% and withdraws $100,000 per year then it will last about 15 years! A premature death is difficult enough to deal with, the last thing needed is financial concerns.

It is usually a good idea to obtain term life insurance when you get married but definitely once you have kids. And have a policy on both spouses. Even if one spouse stays home with the kids and technically doesn't have income, if that spouse were to die then the surviving spouse would then have to pay for childcare, etc. You want the term life insurance term to go until a time that you are debt free and have enough in savings to live off of.

Term life insurance is relatively cheap. If a 30 year old husband and wife each wanted a $1,000,000 policy with a 20 year term, meaning it terminates when they are 50, the average annual premium would be about $450 for the husband and $400 for the wife. Age, gender, health, etc do affect your rates. While one hopes to never need the term life insurance, it is definitely peace of mind in the event of a premature death.

On the other hand, whole life insurance premiums are much more expensive because they have the guaranteed death benefit. The premiums for that $1,000,000 would be more like $4,500-$5,000 a year and would continue until death.

Remember, choosing term or whole depends on your goals. Term is a great option for peace of mind for families and whole is a great estate planning tool.

Information contained in this post is for educational purposes only and is not considered financial advice.


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