Do You Need Life Insurance?
If so, what type and how much?
Most people use life insurance as a way to assure that their loved ones will be able to maintain their quality of life for years to come. To decide if you need life insurance, first ask yourself if your family is adequately protected should something happen to you.
If you're single with no children and no dependents, you probably don't need life insurance at all. If you have substantial assets, you may be able to self-insure. But the vast majority of people fall in between and may want to consider life insurance for a variety of possible reasons, including:
- Income replacement—It can be a vital resource for your loved ones to help replace your income, pay off the mortgage or fund your children's education in the event of your death.
- Terminal illness—Some policies allow you to access a percentage of your policy benefit over your lifetime if you become terminally ill. The proceeds from insurance can help cover unexpected expenses or medical costs at a time most critical to you and your family.
- Estate taxes—You may be able to use insurance proceeds to pay estate taxes, preserving your estate for your beneficiaries.
- Own business—If you own a business, life insurance can be used to cover outstanding business loans, ensure financial stability after the untimely death of a key employee, and to provide cash needed to fund a buyout by a surviving owner.
Types of life insurance
As mentioned in the general discussion of insurance, there are two basic types of life insurance, term and cash value. Here are some key differences to help you decide which type might be best for you:
Term insurance—the best low-cost insurance for a limited time
- Term life insurance is pure insurance. You buy a specific amount of coverage for a certain length of time, which can be from five to a maximum of 30 years.
- In general, premiums are guaranteed by the insurance company and can't be raised during the term you select. For this reason, you may want to consider buying an initial policy for the maximum number of years. You can always stop paying the premiums and cancel the coverage if your circumstances change.
- There is no cash value to the policy. If you don't use it during the term of the policy, there is no refund of your premiums.
- Term life is by far the least expensive and a good choice for young families wanting to make sure basic expenses are covered.
Cash value insurance—higher-cost, lifetime insurance with an investment component
- Cash value or permanent life insurance insures you for your lifetime. Unlike term life, there's no expiration date. As long as you pay your premiums, you should be covered.
- In addition to lifelong coverage, these policies also offer a savings component—a cash value. A sliding percentage of each premium is set aside—more at first, less as you age. The insurance company usually invests this money, which grows tax-deferred. You can then make withdrawals from or borrow against it.
- Cash value policies are generally far more costly than term life policies, but may be warranted if you have what you believe will be a long-term or "permanent" need for coverage. For example, if you have a dependent who will always need care, health concerns or other estate planning needs, this may be the wisest choice.
How much life insurance do you need?
A simple way to decide how much life insurance you need is to calculate how much it would cost to:
- Replace your income for a specific number of years
- Pay off major expenses including your mortgage and your children's college educations
- Provide an emergency fund
- Pay for any final expenses (e.g., estate settlement, funeral or final medical expenses)
An industry rule of thumb says you should have six to eight times your annual salary. However, in reality life insurance is a highly individualized need. Unless your needs are very straightforward, it is probably best to consult with an insurance specialist.
You'll find much more detailed information on life insurance as well as other types of insurance at the Insurance Information Institute.
A note on life insurance and taxes
Life insurance proceeds are not taxable to the beneficiaries for income tax purposes. However, the value of life insurance proceeds may be included in the gross estate and be subject to estate tax if the decedent retains any "incidents of ownership" on the policy at death (or makes a transfer of ownership within three years of death).
A common planning tool to avoid estate taxation of life insurance proceeds is the irrevocable life insurance trust (ILIT).