Answers About Life

Matt Trogdon

I REALIZE MOST FOLKS don’t find personal finance as enthralling as I do, so I apologize in advance—this article’s topic is the least thrilling of all. It’s time to talk about life insurance.

I’ve been trying to come up with a good analogy for life insurance. The best I can think of: Life insurance is like the airbags in your car. No one ever gets excited about airbags. No one ever shows off the airbags in their new car. But if you ever need your airbags, you’ll be glad as heck you have them.

Life insurance can be tough to understand. There’s a boatload of different types. There are lots of weird terms. There are pushy salespeople whose incentives aren’t aligned with your best interests. And there’s a lack of unbiased guidance out there.

I’m writing in hopes of providing some basic understanding of how life insurance works, who needs it, how to estimate how much you need and how to understand the different types that are sold. To begin with, all types of insurance are designed to transfer the financial risk of something bad happening from you to the insurance company. With life insurance, you transfer the financial risk that comes from the possibility of untimely death.

If you die, you won’t be able to financially support your loved ones. By buying life insurance, you transfer part of that risk to the insurance company. You pay a small amount—the premium—to secure the coverage. In exchange, the insurance company guarantees to pay your beneficiaries if you die, reducing your family’s financial loss.

Each life insurance policy contains a death benefit. This is the amount that would be paid to the beneficiaries upon the death of the insured. Let’s use a hypothetical couple, Zack and Kelly. Let’s say Zack buys a life insurance policy with a $1 million death benefit. Zack lists himself as the insured and Kelly as the beneficiary. Zack pays $100 a month as his insurance premium. If Zack dies, the insurance company would pay Kelly $1 million.

If others depend on you financially, you should think about obtaining life insurance. There are many sorts of people who might need life insurance and, while some are obvious, some aren’t:

  • Parents with young children.
  • Married or partnered adults who own a home and have a mortgage.
  • Adults who financially support other adults.
  • Adults who have debts they don’t want to leave to their estate.
  • Small business owners who’d want to buy out a partner’s interest if she died.
  • Adults whose assets exceed the federal estate tax exemption, which is $12 million per person currently and is scheduled to drop to $5 million in 2026.

Although you might not get this impression from an insurance agent, not everyone needs life insurance. You don’t need coverage if your death wouldn’t cause anyone else financial distress. In other words, if you’re a child or a single adult with no debts or dependents, you probably don’t need life insurance.

If you do need insurance, however, there are two main types: term insurance and permanent insurance. Term insurance is the most basic kind and has the cheapest monthly premiums. Think of it as an insurance rental.

A term insurance policy pays out a death benefit if the insured dies within the specified period—the term—that’s listed when it’s purchased. The insurance coverage stops at the end of the term. This insurance is the most suitable and cost-effective form of insurance for most people.

Let’s say that Zack and Kelly have two children, ages four and two. They might each purchase a life insurance policy with a 20-year term. By the time their policies end, their children will be 24 and 22, respectively, and presumably won’t need financial support. If Zack or Kelly die during the 20-year period, their death benefit would replace the income they otherwise would have provided.

Permanent insurance is designed to cover someone forever, no matter how long he or she lives. In addition to paying out a death benefit, permanent insurance policies also contain a cash value component that allows policyholders to access some of the money they’ve paid in premiums over the years.

Permanent insurance is usually much more expensive than term insurance. Still, it can be useful for people who foresee the need for insurance for as long as they live. This can be those with large estates. Parents with children who need lifelong support could also be candidates for permanent insurance, which is sometimes called whole life.

There are numerous calculators to help determine how large a death benefit you might need. But here’s a back-of-the-napkin method you can use at home:

  • Figure out your annual take-home pay. That’s your gross salary minus deductions for things like taxes, Social Security, Medicare and retirement savings.
  • Subtract from your annual take-home pay how much you spend on yourself in any given year.
  • What’s left is the amount of support you provide your family annually. This is the sum your family will need to replace each year to maintain its standard of living.
  • Multiply this family support amount by the number of years you’d like the insurance to cover. That number is the death benefit you’d want from an insurance policy.

Let’s say Zack makes $100,000 in take-home salary and spends $25,000 on himself alone. His family would need to replace $75,000 in lost earnings each year to maintain its current lifestyle if Zack were to die. Over 20 years, Zack’s family would need to replace as much as $1.5 million of lost earnings. In this case, having Zack take out a $1.5 million term policy for 20 years might be a good idea.

Unfortunately, insurance is often sold rather than bought. The salesperson’s commission is tied to the size of the policy that gets sold and the type of coverage. For a policy of the same size, permanent insurance would pay a bigger commission than term. As a result, there is an incentive to oversell policies that clients don’t need.

Watch out for a salesperson who tells you that an insurance policy is a good investment or suggests that you can afford more insurance coverage by diverting savings from other areas. It’s also a red flag if someone uses scare tactics in the sales process, or tries to sell you permanent insurance right out of medical school or law school.

Rather than going through an insurance agent, you can now shop for insurance online through sites like Policy Genius, Nerd Wallet and Bestow. If you have questions, contact a fee-only financial planner. That’s a good way to get an unbiased opinion.

Matt Trogdon is a financial planner with Craftwork Capital, LLC. He’s based in Washington, D.C., and has a special interest in helping Gen X and Gen Y families. He also serves as a workshop instructor for the Babson College Financial Literacy Project. Matt’s previous articles were Preservation Mode and What It Really Costs. Follow him on Twitter @Matt_Trogdon.

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