Life insurance can provide for the people and things that you care about if you died and could no longer provide for them yourself. If you don’t have any dependents, don’t want to leave money to family or charity, don’t own a business (or don’t care if it dies when you do), and don’t need to pay off your debts when you die; or if you already have enough assets to take care of those things, then you don’t need life insurance.
Sometimes it makes sense to purchase life insurance prior to the need for it arising. For example, if you’re trying to become pregnant, you may want to purchase a life policy now, as the physiological changes brought on by pregnancy could result in a higher rate class if you wait until after you are pregnant to apply. Some parents purchase life insurance policies for their young children, locking in coverage while they’re healthy, in case some future accident or sickness makes them uninsurable. Policies built for this purpose often include provisions allowing the insurance amount to be regularly increased regardless of health at the time of increase.
There are many, many different life insurance products available, but all of them fall into one of two broad categories: term and permanent.
Term life insurance is designed to provide affordable life insurance protection for a fixed number of years, known as the term length. The rate you pay is usually fixed for the entire term; if you keep the policy after the term, the rates jump up significantly and then increase every year, ultimately becoming unaffordable (at which point the policy lapses due to non-payment). Term life policies are ideal for financial obligations you will only have for a fixed period of time, like raising a child to adulthood or paying off a mortgage.
Permanent life insurance is ideal for financial obligations with no fixed end date, such as providing for a spouse, leaving an inheritance to your children or a bequest to a charity, or buying out a business partner if they die. Since nobody lives forever, the likelihood of dying, and therefore the cost of insurance, increases as you age. Permanent life policies remain affordable over the long term by having you pay significantly more premium than the underlying cost of insurance in the early years of the policy; this surplus premium creates a cash value that earns interest and grows. When you’re older and the cost of insurance exceeds your monthly premium payment, the difference is paid from the accumulated cash value. This mechanism allows you to pay a fixed amount for insurance designed to last for as long as you live.
The huge variety of permanent life policies basically differ in the manner by which interest is credited to the policy cash value. The interest rate varies from a fixed amount (whole life), to an amount that the insurer may periodically adjust but with a guaranteed minimum (universal life), to rates based on a benchmark like the ten-year US treasury bill interest rate or the increase in the S&P 500 stock market index with a guaranteed minimum (indexed universal life), to rates based on the performance of an underlying investment subaccount (variable universal life). Variable universal life (VUL) subaccounts do not have a minimum guaranteed interest rate; if the investments lose money your cash value will decrease.†
It’s important to note that, except for whole life, the monthly premium amount you pay is based on an assumption of what the interest crediting rate will be. If the assumption is higher than the policy’s guaranteed minimum interest rate, then there’s a risk that the actual interest rate is less than projected, which would require you to eventually pay additional premium to keep the policy from lapsing. On the other hand, if the policy earns more interest than projected, the cash value will exceed that which is needed to sustain the policy and you can borrow against or even withdraw the surplus cash value to supplement your income in your retirement years.
Purchasing life insurance in case you die is as practical as buying homeowners insurance in case your house burns down. In each instance, by paying a manageable yearly or monthly premium, you’re arranging for a large sum of money to be available in case you suddenly lose one of your largest assets. For homeowners insurance, the large asset is your house; for life insurance, the large asset is the income you generate year after year. For stay-at-home spouses, the large asset may be the cost of child care that would be required if the spouse couldn’t care for the family. Note that life insurance does not protect against loss of income when a family member’s income stops due to disability instead of death; disability insurance does that.
Here are some examples of using life insurance to prevent the emotional trauma of death from also becoming a financial trauma:
You take out a $400,000 thirty year mortgage, buying a term life insurance policy with a death benefit (also known as face amount) of $400,000 and a term length of thirty years. If you die during the thirty year term, the policy will provide the resources to pay off the mortgage rather than leaving your family in debt or having to sell the property to pay off the obligation. A few times over the course of the thirty years you reduce the policy face amount to reflect the lower mortgage balance.
Your spouse is changing careers, which after about two years of schooling and another three years of on-the-job training should have them earning about twice what they currently do. You’ve saved enough to get by on your salary alone during this transition, but if you died they’d have to abandon school and go back to their old job. You buy a policy with a term length of five years and a face amount that will match five years of your after-tax income to help ensure your spouse can complete their career change.
You are adopting a one year old child and want to pay for their upbringing all the way through college, buying a term life insurance policy with a twenty year term length. How much should the face amount be? See How Much Insurance Should You Buy, below.
Between a successful business and wise investments, you’ve amassed an estate of twenty five million dollars to pass on to your children after you and your spouse have died. That’s the good news: The bad news is that almost five million of that will be lost to estate taxes. Your attorney helps you establish an irrevocable life insurance trust that purchases a five million dollar second-to-die whole life insurance policy. The policy cost ($185,000/year for twelve years) is a fair price to pay for a five million dollar tax free death benefit that will offset your estate tax obligation after you and your spouse die so that your children receive the full value of your estate.
You and your business partner are a great team; but if one of you dies, that partner’s family will end up owning their half of the business while the surviving partner does all the work. You and your partner execute a buy/sell agreement in the event of one of your deaths, and you each purchase a life insurance policy on the other in the amount of the agreed upon purchase price to provide the funds for the buyout.
For life insurance purchased to pay off a loan, start with a policy face amount equal to the loan amount. If you stay current on your mortgage payments and don’t increase the loan term or face amount by refinancing, your mortgage balance will go down over time. When the loan’s principal balance is much lower (which takes years), you might be able to reduce the face amount of the life insurance policy to match the lower principal balance, reducing the policy cost.
While it’s easy to pick the policy face amount for a loan, what face amount should you choose for difficult-to-calculate needs like the cost of raising a child? While you can probably find published benchmarks for this, your costs may vary dramatically from the average based upon your specific needs and manner of living (some examples: paid child care vs. relatives helping out, home schooling versus public or private school, camping locally versus exotic vacations). We recommend not stressing out trying to perfectly calculate long term costs (a needs-based approach) and instead buying enough life insurance to replace the income you currently bring home (an income replacement approach). After all, you’ve already tailored your lifestyle to match your available income. If you die and your family gets a death benefit that matches your take-home pay, they should be able to live in the manner to which they are accustomed. But just to be sure, and to accommodate future increases in your earnings, buy a little more coverage than you currently need. Remember, nobody ever has said, I wish my loved one had died with less life insurance coverage in place.
An annuity is an insurance product where the buyer, in exchange for a premium that is paid all at once (an immediate annuity) or over time (a deferred annuity), then receives regular monthly or yearly payments for a fixed period of time, or for the remainder of the buyer’s life or the buyer and their spouse’s lives. This should sound familiar, as pensions and Social Security operate in a similar fashion. A pension is essentially a deferred annuity, with the premiums paid by the employer over the course of the employee’s career. Similarly, Social Security is like a deferred annuity, with the premiums paid by the employer and employee over the course of the employee’s career in the form of Social Security taxes.
Lifetime annuities, including pensions and Social Security, are invaluable retirement tools because they provide a base income that is guaranteed to last throughout your retirement, reducing the risk of you outliving your savings. In essence, they are the opposite of life insurance, protecting you if you live too long (that is, after your savings have run out) instead of dying too soon (that is, before you’ve amassed enough savings). However, there are two risks that can prevent an annuity from doing its job:
Inflation and default risk is why an annuity should only be one part of your retirement income, with your own savings and investments providing the balance.
Unlike immediate annuities, deferred annuities have a multiple year accumulation phase during which premium payments are made and interest is earned and credited to the annuity’s value. The available methods of interest crediting are analogous to those available for permanent life insurance cash values:
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If you die during the accumulation phase, the annuity’s value is paid to your beneficiary; the value is included in your estate for the purpose of estate taxes. Given the tax-deferred growth of deferred annuities (see taxation of annuities, below) they can be used with certain wealth transfer strategies. It is especially useful for high net-worth individuals in poorer health for whom permanent life insurance, another wealth transfer tool, may not be available or affordable.
Deferred annuities grow on a tax-deferred basis: No taxes are paid until monies are taken out of the annuity. If withdrawals are taken from the annuity during the accumulation phase (which may incur a surrender charge) the amounts withdrawn are considered to come from any gains in the annuity value, if any. Gains are taxed as ordinary income, plus an additional 10% penalty tax if the withdrawal is made prior to age 59 ½. After all gains have been withdrawn, any remaining withdrawals are considered a return of principal with no tax due.
Once periodic payments have begun (the annuitization phase), each payment is considered to be part gain and part return of principal, with only the gain subject to tax. The calculation of the gain is based on IRS life expectancy tables; payments made beyond your life expectancy are considered to be entirely gains. Gains are taxed as ordinary income, and if the annuity is a deferred annuity an additional 10% penalty tax applies on payments made prior to age 59 ½.
The above discussion is for non-qualified annuities, which are not held within a tax-deferred retirement account. For qualified annuities purchased with pre-tax dollars, all distributions are fully taxable as ordinary income. For annuities purchased with Roth IRA or Roth 401(k) funds, all earnings are tax free if the annuity was owned for at least five years and distribution is made after age 59 ½.
The purpose of an immediate annuity is to convert a lump sum into a guaranteed monthly income that you can’t outlive. If you have enough savings to comfortably live out your life, even if you live to age 100 or longer, then you don’t need an immediate annuity. If you’re many years away from retirement, then you should start saving and investing now so that you will have enough funds to live on without needing an annuity. If, however, you’re at or near retirement and i) have some retirement savings and ii) aren’t confident in your ability to invest your savings wisely or make it last, then an annuity may be an appropriate solution for you.
As for deferred annuities, they are complex financial products with fees that are much higher than investment products such as mutual funds. We only recommend fixed and index annuities for individuals who have no tolerance for loss of principal or for high net-worth individuals who have exhausted other avenues for tax-deferred growth (like IRAs or company retirement plans). While variable annuities may be appropriate for high net-worth individuals with a medium-high risk tolerance, we do not sell variable products.
Here are some examples of using annuities to meet a variety of financial objectives:
You’re 65 years old and received a $125,000 inheritance. After spending $25,000 of it on some needed home and auto repairs, you have $100,000 remaining. You realize you’re not very good with money and will probably spend the remainder in a few years time. Instead, you purchase a $100,000 single premium immediate annuity and, after taxes are withheld, will receive $522 every month for the rest of your life to supplement your Social Security.
You’re 42 years old and received an $80,000 lump sum divorce settlement but no alimony or child support. Your child is 13 and you want to use the settlement over the next 8 years while they’re still living with you. That’s not enough time to invest the money and ride out the ups and downs of the stock market. You purchase a single premium immediate annuity which will make monthly payments of $975 for the next eight years.
You are the 70 year old parent of a special needs child and want to ensure that the financial support you’ve been providing for their care continues for the rest of their life, even after your death. You set up a special needs trust to hold an immediate annuity on their life; the trustee (you initially) will disburse the monthly income for allowable expenses. This arrangement won't disrupt any government benefits your child receives, which would happen if the child received the monthly payments or an inheritance from you directly.
You earn a good living and want to set aside money for retirement but can’t stomach the possibility of losing money when investing. You purchase a deferred indexed annuity that credits interest at 60% of the gain of the S&P 500, but with a floor of 0% so that you won’t lose money during market downturns.
You are a very high net worth individual looking for a tax-efficient way to transfer wealth to future generations of your family. Your child and their spouse each opens a deferred annuity on their life with your grandchild as beneficiary. You and your spouse each pay the maximum gift exclusion amount ($17,000 x 2 = $34,000 in 2023) into each annuity each year. All of the money you contribute grows tax-deferred for the life of your child; when they die, your grandchild will be able to receive the accumulated funds up through their 85th birthday. Following this plan over the course of several decades allows you to pass millions of dollars of appreciated assets to the second generation, with taxes deferred until the funds are withdrawn by your grandchild, and without incurring the generation skipping transfer tax.