Life Insurance: What Do You Really Need?

Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on WCCO 830 AM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com. Advisory services offered through Wealth Enhancement Advisory Services LLC, a registered investment adviser and affiliate of Wealth Enhancement Group.

Life insurance is widely misunderstood. People generally don’t like it. They look down upon it — don’t want to talk about it. They negatively judge the people who sell it. Fundamentally, they don’t want to hear anything about it.

Yet, as much as it can be maligned, life insurance can be a critical part of a comprehensive financial plan. The best place to begin isn’t by trying to decide which policy fits your budget. It’s by asking a more basic question: What financial risk are you trying to protect against?

Start With The Need

Life insurance is fundamentally about transferring risk. If you died tomorrow, who would be financially affected, how much money would they need, and how long would they need it?

For a young family, the answers may include replacing income, paying a mortgage, funding college expenses, or allowing a surviving spouse and children to remain in your home. Business owners might need insurance to fund a buy-sell agreement. Parents of a child with special needs may want to provide financial support that lasts a lifetime.

Don’t overlook a spouse simply because he or she earns less. Childcare, household management and other responsibilities have economic value and can be costly to replace.

That’s also why guidelines such as buying coverage equal to 10 times your salary can be misleading. Rather than simply replacing a paycheck, you need to consider the financial consequences of losing the person.

Your need may also change dramatically over time. A couple in their 40s with children and a mortgage may need substantial coverage to protect against the losses we just outlined above. Thirty years later, however, with the mortgage paid, children financially independent and significant retirement assets accumulated, that need could be much smaller.

When Life Insurance Becomes A Want

Once you’ve addressed the basic protection need, life insurance can potentially serve other purposes.

Life insurance death benefits are generally excluded from a beneficiary’s federal taxable income, although exceptions apply. Certain permanent policies also accumulate cash value, which generally grows tax-deferred.

Depending on the type of policy, owners may be able to access that cash value through withdrawals or policy loans. With a properly structured policy, withdrawals generally come first from the policyholder’s basis (essentially, the premiums you’ve paid) before taxable gains (this is called “first in, first out,” or “FIFO” in industry parlance).

Policy loans can also provide access to cash without generally being treated as taxable income when the policy is properly structured and maintained. But loans aren’t free money. Interest is charged, loans can reduce the cash value and death benefit, and a heavily borrowed policy that lapses or is surrendered can create unexpected tax consequences.

Permanent insurance may also be useful in legacy and estate planning. Suppose parents own a business that one of three children will eventually inherit. Life insurance could potentially provide an inheritance for the other two without requiring the family to divide or sell the business.

The parents may no longer need insurance for income replacement. They may nevertheless want it because it efficiently addresses another important planning objective.

Term Or Permanent?

Term insurance provides coverage for a specified period, such as 10, 20 or 30 years. It generally costs considerably less initially than comparable permanent insurance and can be well suited to temporary needs such as replacing income while children are young, covering a mortgage, or protecting the family until retirement assets have grown.

If you buy a 20-year term policy and survive those 20 years, the insurance didn’t fail. It protected you against a financial risk during the period when that risk existed — much as homeowners insurance provides valuable protection even if your house never burns down.

Permanent insurance is designed to potentially remain in force throughout your life, assuming premiums are paid and the policy is adequately funded. It can combine a death benefit with cash-value accumulation, tax-deferred growth, and potential estate-planning applications.

That additional functionality comes at a price. But the question you should ask isn’t whether permanent insurance costs more. Ask what you receive for that additional premium and whether those features solve a problem you actually have.

What About ‘Buy Term And Invest The Difference’?

Buying lower-cost term coverage and investing the difference can be a perfectly reasonable strategy. But comparing that approach with permanent insurance isn’t always apples to apples.

An investment portfolio may offer greater liquidity, lower costs, a wider range of investments, and greater upside potential. Permanent insurance can provide a death benefit, cash value, tax-deferred accumulation, and potentially lifetime coverage.

Neither is automatically superior, because each asset serves a different purpose.

And the answer doesn’t necessarily have to be one or the other. A family that needs $2 million of coverage today might decide that $1.5 million represents temporary needs that will disappear as children become independent and the mortgage declines. The remaining $500,000 might represent a permanent legacy objective. A larger term policy combined with a smaller permanent policy could address both.

Your Insurance Should Evolve As Life Happens

Life insurance shouldn’t be a “set it and forget it” decision. Marriage, divorce, children, retirement, an inheritance or the purchase or sale of a business can all change your needs. Periodically review your coverage, beneficiaries, ownership, premiums and, for permanent insurance, policy performance.

Before asking which policy to buy, ask what financial risk you’re insuring. Term insurance can be an excellent solution to a temporary problem. Permanent insurance can potentially address lifelong protection, estate, and legacy goals.

Ultimately, the decision about what insurance you need comes down to a simple but profound realization: If something happens to you, the people and priorities you care about shouldn’t be forced to change because the money isn’t there.

The original was published in Pioneer Press. 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

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