Last week, we began our discussion of life insurance by building an understanding of what goes into a life insurance policy and the different types of insurance there are. This week we are going to start making our discussion a bit more personal by going into the benefits of having life insurance, who needs it, and the things you should consider before buying a policy. Let’s start with the benefits.
Benefits of Life Insurance
There are many benefits to having life insurance. Let’s talk about some of the most important features and protections offered by life insurance policies. Most people use life insurance to provide money to beneficiaries who would suffer financial hardship when they pass. However, for wealthy individuals, the tax advantages of life insurance, including the tax-deferred growth of cash value, tax-free dividends, and tax-free death benefits, can provide additional strategic opportunities.
Avoiding Taxes
According to the IRS, the death benefit of a life insurance policy is usually tax-free.1 Wealthy individuals sometimes buy permanent life insurance within a trust to help pay the estate taxes due upon their death. This strategy helps to preserve the value of the estate for their heirs. Believe it or not, tax avoidance is a law-abiding strategy for minimizing your tax liability and should not be confused with tax evasion, which is illegal!
Who Needs Life Insurance?
So who needs life insurance anyway? We talked about this a bit, but life insurance provides financial support to surviving dependents or other beneficiaries after the death of an insured policyholder. Here are some examples of people who may need life insurance:
Parents with minor children - If a parent dies, the loss of their income or caregiving skills could create financial hardship. Life insurance can make sure the kids will have the financial resources they need until they can support themselves.
Parents with special-needs adult children - For children who require lifelong care and may never be self-sufficient, life insurance can make sure their needs will be met after their parents pass away. According to the Social Security Administration, a policy’s death benefit can be used to fund a special needs trust that a fiduciary will manage for the adult child’s benefit.2
Adults who own property together - Married or not, if the death of one adult would mean that the other could no longer afford loan payments, upkeep, and taxes on the property, life insurance may be a good idea. One example would be an engaged couple who take out a joint mortgage to buy their first house.
Seniors who want to leave money to adult children who provide their care - Many adult children sacrifice time at work to care for an elderly parent who needs help. This help may also include direct financial support. Life insurance can help reimburse the adult child’s costs when the parent passes away.
Young adults whose parents incurred private student loan debt or cosigned a loan for them - Young adults without dependents rarely need life insurance, but if a parent will be on the hook for a child’s debt after their death, the child may want to carry enough life insurance to pay off that debt.
Children or young adults who want to lock in low rates - The younger and healthier you are, the lower your insurance premiums. A 20-something adult might buy a policy even without having dependents if there is an expectation to have them in the future.
Stay-at-home spouses - Stay-at-home spouses should have life insurance as they have significant economic value based on the work they do in the home. According to Salary.com, the economic value of a stay-at-home parent would have been equivalent to an annual salary of $162,581 in 2018, and it’s only gone up from there.
Wealthy families who expect to owe estate taxes - Life insurance can provide funds to cover the taxes and keep the full value of the estate intact.
Families who can’t afford burial and funeral expenses - A small life insurance policy can provide funds to honor a loved one’s passing.
Businesses with key employees - If the death of a key employee, such as a CEO, would create severe financial hardship for a company, that firm may have an insurable interest that will allow it to purchase a life insurance policy for that employee.
Married pensioners - Instead of choosing between a pension payout that offers a spousal benefit and one that doesn’t, pensioners can choose to accept their full pension and use some of the money to buy life insurance to benefit their spouse. This strategy is called pension maximization.
Those with preexisting conditions - If you have cancer or diabetes, are a smoker, or are in a similar situation, it may be beneficial to make sure you have life insurance to cover additional expenses your loved ones could incur for your care. However, some insurers may deny coverage for such individuals or charge very high rates in these cases.
Considerations Before Buying Life Insurance
Because life insurance policies are a major expense and commitment, it's critical to do proper due diligence to make sure the company you choose has a solid track record and financial strength, given that your heirs may not receive any death benefit for many decades into the future.
Life insurance can be a great financial tool to hedge your bets and provide protection for your loved ones in case of death, should you die while the policy is in force. However, there are situations in which it makes less sense—such as buying too much or insuring those whose income doesn't need to be replaced. So it's important to consider a few different things. Let’s go over those now.
Who Doesn’t Need Life Insurance?
What expenses couldn't be met if you died? If your spouse has a high income and you don't have any children, maybe life insurance is not warranted. It is still essential to consider the impact of your potential death on a spouse and consider how much financial support they would need to grieve without worrying about returning to work before they’re ready. However, if both spouses' income is necessary to maintain a desired lifestyle or meet financial commitments, then both spouses may need separate life insurance coverage.
If you're buying a policy on another family member's life, it's important to ask—what are you trying to insure? Children and seniors really don't have any meaningful income to replace, but burial expenses may need to be covered in the event of their death. Beyond burial expenses, a parent may also want to protect their child’s future insurability by purchasing a moderate-sized policy when they are young. Doing so allows that parent to ensure that their child can financially protect their future family. However, you should know that parents are only allowed to purchase life insurance for their children up to 25% of the in-force policy on their own lives.
Could investing the money that would be paid in premiums for permanent insurance throughout a policy earn a better return over time? As a hedge against uncertainty, consistent saving and investing—for example, self-insuring—might make more sense in some cases if a significant income doesn't need to be replaced or if policy investment returns on cash value are overly conservative.
Next week we will continue building on your knowledge about life insurance with a discussion on how to apply for a life insurance policy in the most advantageous way.
Until next time…
One last thought, I believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share.
Sources
1 Internal Revenue Service. "Life Insurance & Disability Insurance Proceeds." Accessed October 19, 2022.
2 Social Security Administration. "Liens, Adjustments and Recoveries, and Transfers of Assets." Accessed October 19, 2022.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.