Life Insurance 101

Life Insurance 101

There are so many ways to be a good spouse and parent: washing the dishes unasked, supporting your family's ambitions and dreams, throwing a surprise birthday party complete with red velvet cake (your 11-year-old's favorite!) ... and getting life insurance.

Yup, life insurance is a key aspect of a couple or family's financial plan. It's not necessarily something you want to think about, but we think you'll want to read this guide--it could be one of your biggest regrets if you don't.

Life Insurance in a Nutshell

Life insurance is like other types of insurance--car, home, health--in that you pay a monthly premium in case something bad or unexpected happens, in this case a death of an income earner and/or spouse.

In short, it means that if you or your spouse dies, you or your children won't have to deal with financial uncertainty and drastic changes while also dealing with the emotional loss. Your life insurance policy isn't for you; it's for other people in your life who depend on you.

Clearly, life insurance can't "replace" a deceased loved one, like car insurance can replace a car. But it can replace—at least partially—the income he or she was contributing to the household, the income you or your children depend on to stay financially secure and enable your family to continue to live a lifestyle close to what you have now.

Why Life Insurance Matters

Compared to health insurance, which you use every time you pick up a prescription, you rarely have a reason to think about life insurance. But it's arguably the most important kind.

Life insurance is especially important right now, as more families have been forced into living on a single income due to the recession. In a 2010 survey by insurance research firm LIMRA, 40% of households with children under 18 said they would have trouble meeting financial obligations if a primary breadwinner passed away. But unfortunately, LIMRA's research shows that individual life insurance ownership is at a 50-year low.

How Life Insurance Works

To get life insurance, you take out a policy on yourself (or someone else, with their permission), either through your work or privately, choosing the amount and/or type of coverage your family would need if you were to pass away. You pay a monthly premium (a payment to the insurance company) to keep the policy active and keep yourself covered. The more valuable the policy--meaning the more paid out if you were to pass away--the higher the monthly premium you pay. The cost is also dependent on your health, age and other factors, such as family medical history and smoking. The younger and healthier you are, the less you pay. For "term" policies (the most common type of life insurance), you also need to select the length of time for which you want the policy premiums to stay the same; usually this ranges from 15 to 30 years.

In the event of your death, your beneficiary (the person you designated to receive the benefit) makes a claim, and the insurance company writes him or her a check for the amount of the policy (called a "benefit"), either in a lump sum or in regular payments. The cash benefit is almost never subject to federal income taxes.

Who Needs Life Insurance

    • Couples in which one is working and the other isn't. If one spouse isn't working, it will take some time for her to get back into the workforce if she suddenly needs income to live on, and it may be at a lower salary. Life insurance can replace the income of the earner, and at the least ease the transition back into working life. This is especially important if the non-working spouse is disabled and can't work.
    • Families in which one parent stays at home. This is the traditional reason for life insurance: If one spouse is taking care of the children and the earner passes away, the transition back into working life will be difficult, and complicated by the fact that she might have to pay for child care, an enormous expense. And policies should actually be taken out for both parents. If the non-working spouse dies, the earner will also need additional money for child care and outsourcing tasks, from house cleaning to ordering takeout instead of cooking.
    • Families and couples where both parents work. While this may seem counterintuitive, even if one spouse is still earning an income, there are immediate and long-term extra expenses that come with the death of a spouse. First, there is the funeral. The surviving spouse might also have mortgage payments, school or college tuition, car payments and remaining credit card debt that were only feasible on a dual income. Life insurance is a way of ensuring that your lifestyle won't suffer should you suffer the premature death of a spouse.
  • Singles supporting family members. If you are supporting a parent or other family member, life insurance would replace your support in the event of your death.
  • Singles with co-signed or large debts. If you have any loans that wouldn't be written off if you were to pass away, such as co-signed federal student loans, most private student loans, auto loans or a mortgage, life insurance can take care of the debt so your family or friends aren't stuck holding the bag. (Federal student loans with no co-signer are generally written off upon the borrower's death.)
  • Business partners without sufficient assets to buy out the other partner(s). If you own or co-own a business, or have signed an agreement under which you would take over a business upon a partner's death, you should take life insurance on your business partner to make sure that the business stays open and you don't have to sell it quickly, which could mean taking a huge hit on the value of the business or on your own finances if you have to come up with the cash.

The only people who don't need life insurance? Singles who have no one depending on them for income and no major liabilities outstanding.

What Life Insurance Could Cover

The death of a family member can bring costs that you might not have considered. With life insurance giving out a lump sum or payments, you can choose to put it to one or all of these expenses:

Immediate Costs

  • Funeral costs
  • Estate settlement costs (lawyer fees)
  • Outstanding credit card, car or other personal debt
  • Medical bills
  • Taxes
  • Business overhead costs

Long-Term Costs

  • Living expenses
  • Mortgage payments
  • Car payments
  • Private school tuition
  • College tuition
  • Retirement

Premium: The monthly payment you make to the life insurance company.

Benefit: The cash payout or regular payments that result when the holder of a life insurance policy dies.

Beneficiary: The recipient of a life insurance benefit. This could be a child, spouse, business partner or even a non-profit organization.

How Much Life Insurance You Need

How much coverage you should get is entirely up to you and your family's needs. It also will be affected by your budget and what you can afford. But these basic guidelines can help you decide.

A simple rule some experts offer is to buy a policy that gives you seven to ten times your yearly income if cashed in. But that doesn't take fully into account your own specific situation and needs. For a more accurate figure, you can calculate how much life insurance you need by adding up the value of the financial obligations your family or spouse would need to meet if you passed away, then subtracting the amount you have in savings, retirement funds, investments and other life insurance policies you already have in your name that would pass to your family or spouse. We offer a more detailed approach here.

What You Should Do Now

Even if you already have a policy through your work, you should check to make sure it's adequate. Some policies through employers only offer a small sum, like $30,000. This may seem like a lot, but we can easily demonstrate why this isn't enough. Let's say you have decided to stay home with the kids. Your spouse brings home a comfortable $90,000 a year but you're working on paying off your student loans. He gets a terminal illness, incurring large medical debts before he passes away. Now you have only $30,000 to pay off those debts and support your family while you try to reenter the workforce. See what we mean? Make sure you calculate your coverage needs and compare them to what you have.

And if you don't have life insurance at all ... well, obviously it's time to look into getting some. You can start with our checklist on getting coverage, which will explain the different types and how to determine which one is best for you.

Remember ...

It's easy to procrastinate on life insurance, especially if you're healthy, young and invincible. But you owe it to the people who depend on you to get coverage as soon as possible—it could be the best thing you leave behind, besides the memories.

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