Life Insurance: When And How To Use It

Life insurance is a financial safety net for your loved ones after you die. It provides a tax-free lump-sum payment, known as a death benefit, to your chosen beneficiaries, which can be used to maintain their standard of living, cover debts and expenses, or be donated to charity. While term life insurance covers a specific period, permanent life insurance offers lifelong coverage and can build cash value over time, allowing you to access funds while you're alive. This cash value can be used for loans, paying premiums, or supplementing retirement income. However, it's important to carefully consider your financial situation, goals, and long-term needs before selecting a life insurance policy.

Life insurance can be used to pay for funeral and final expenses

Burial insurance is often more affordable than other types of life insurance due to its lower coverage amounts. Final expense life insurance rates start at $63 a month, with coverage amounts ranging from $5,000 to $40,000. This type of insurance is usually purchased to cover final arrangements but can also be used to pay off the deceased's debts, including medical bills, credit card bills, mortgage loans, and personal loans.

There are generally three types of burial insurance: simplified issue, guaranteed issue, and pre-need insurance. Simplified issue insurance evaluates your health based on a series of medical history questions but does not require a medical exam. Guaranteed issue insurance does not require any medical questions or exams, but the cost is typically higher. Pre-need insurance involves a contract with a funeral service provider, and the payout goes directly to them rather than individual beneficiaries.

In addition to burial insurance, there are other types of life insurance that can cover funeral expenses, such as whole life insurance and universal life insurance. Whole life insurance is a permanent policy that covers you for your entire life and pays out to your beneficiaries regardless of when you die. Universal life insurance offers more flexibility, allowing you to adjust the death benefit and premium at any time.

When deciding on a burial or funeral insurance policy, it is important to consider factors such as the coverage amount needed, the cost of premiums, and whether the insurance provider offers support services for your family. Planning ahead for your final expenses can help ease the financial burden on your loved ones and ensure that your wishes are carried out.

It can help pay off credit card bills, medical bills, mortgages or car loan balances

Life insurance is often used to ensure financial stability for loved ones after the policyholder's death. It can also be used to pay off debts, which is one of the main reasons people take out a life insurance policy. This is especially useful for debts that cannot be inherited, such as credit card debt or loans taken out solely by the deceased.

A life insurance payout can be used to pay off credit card debt, medical bills, mortgages, or car loan balances. While credit card debt and medical bills are considered unsecured debt, mortgages and car loans are secured debt, requiring an asset as collateral. If the policyholder defaults on a secured loan, the lender can seize the asset to recoup costs.

For example, if you have a mortgage and pass away, your surviving partner and family will need to settle the debt to keep the house. A life insurance payout can be used to pay off the remaining balance. Similarly, if you have a car loan, your heirs can use the life insurance money to take over the loan and keep the vehicle.

It's important to note that not all life insurance policies are the same. Whole life or universal life insurance policies accrue a cash value over time, allowing policyholders to borrow against this cash value to pay off debts. On the other hand, term life insurance policies do not accrue a cash value, so policyholders cannot withdraw any money from the policy.

When considering using life insurance to pay off debts, it's essential to weigh the pros and cons and seek advice from a financial adviser or insurance expert.

It can be used to fund children's college tuition and expenses

Life insurance can be used to fund children's college tuition and expenses. Here's how:

Life Insurance as a College Savings Fund

Life insurance, particularly permanent life insurance, can be used as a savings vehicle for your child's college education. It offers a tax-deferred savings component, allowing the cash value of the policy to grow over time. This savings feature is separate from the death benefit and can be accessed to cover college costs.

Withdrawing from Cash Value

The cash value of a whole life insurance policy can be withdrawn to pay for college expenses. This provides flexibility, as there are no restrictions on how the money is used, unlike 529 plans, which are limited to qualified educational expenses. Withdrawals are generally tax-free up to the amount of premiums paid, and educational expenses, except for room and board, are typically tax-deductible.

Taking Out a Loan Against the Policy

Another option is to take out a loan against the value of the policy. This approach offers tax-free access to the money without the need for a loan application process. While the loan accumulates interest, there is no requirement to make payments, although repaying the loan should be planned to maintain the life insurance benefit.

Using the Child's Policy

You can also insure your child at a young age and access the policy's cash value later when they are ready for college. Insuring a child is relatively inexpensive, and starting early allows the policy to accumulate value over time. This approach also locks in protection for the child's entire life.

Advantages Over 529 Plans

Life insurance offers several advantages over 529 plans as a college savings option. It provides greater flexibility, as the funds are not limited to specific types of expenses. Additionally, life insurance is typically excluded from college financial aid calculations, so it won't reduce the amount of financial aid your child may be eligible for.

However, it's important to consider the potential drawbacks of using life insurance for college savings, including high costs, complex withdrawal processes, and the potential for rising premiums that can erode cash accumulations.

It can be used to pay for living expenses that were previously covered by the insured person's income

Life insurance can be used to pay for living expenses that were previously covered by the insured person's income. This is one of the most common reasons for buying life insurance. The death benefit from a life insurance policy can be used to replace the income of the insured person, ensuring that their loved ones can maintain their standard of living. This is especially important if the insured person was the primary breadwinner or if their income was necessary to maintain a desired lifestyle.

The death benefit can help cover regular household expenses such as grocery bills, utility bills, and childcare costs. It can also help pay off any debts, such as mortgages, car loans, or credit card bills, that the insured person may have left behind. This can be a significant help to the beneficiaries, as many types of debt are not forgiven upon the death of the insured person.

In addition, the death benefit can be used to fund children's education, cover end-of-life expenses, or leave a financial gift to loved ones. Life insurance can also play a crucial role in business planning, providing financial protection in the event of the death of a key employee or funding buy/sell agreements between business partners.

Overall, life insurance provides financial security and peace of mind for the insured person's loved ones, ensuring that they can maintain their standard of living and cover any necessary expenses.

You can borrow from your policy

You can borrow against your life insurance policy if it has a cash value component. This is known as a "life insurance loan". Borrowing against your life insurance policy can be a quick and easy way to get cash when you need it. However, it is important to understand the risks and potential downsides before taking out a life insurance loan.

Life insurance loans are only available on permanent life insurance policies, such as whole life or universal life insurance, that have a cash value component. Term life insurance policies do not have a cash value and therefore cannot be borrowed against. With a life insurance loan, you are essentially borrowing from yourself, with the policy's cash value serving as collateral. There is no formal approval process, credit check, or income requirement, and the funds can be accessed within a few days.

Pros

Life insurance loans offer several advantages over traditional loans:

• No red tape: There are no lengthy applications or approvals, and you don't need to justify your spending.
• Flexible repayment: There is no fixed repayment schedule, and you can pay back the loan at your own pace.
• Low interest: Interest rates on life insurance loans are typically lower than those for personal loans or credit cards.
• No credit impact: The loan does not affect your credit score, and your credit score does not affect the loan's interest rate.
• Tax-free: The loan is generally not recognised as income by the IRS, making it a tax-free source of funding.

Cons

However, there are also some significant disadvantages and risks associated with life insurance loans:

• Reduced death benefit: If the loan is not repaid before the policyholder's death, the outstanding balance, including interest, will be deducted from the death benefit, reducing the amount received by beneficiaries.
• Risk of lapse: If the loan balance and interest exceed the policy's cash value, the policy may lapse, resulting in a loss of coverage and potential tax penalties.
• Interest accumulation: Interest accumulates over time and can deplete the policy's cash value, affecting its growth and increasing the risk of lapse.
• Impact on guarantees: Borrowing from a permanent policy may deplete the cash required to ensure the policy's guarantees.
• Higher costs: Some permanent policies may require higher premium payments to maintain guarantees when cash is withdrawn.

The amount you can borrow depends on the cash value of your policy and the rules set by your insurer. Most insurers allow you to borrow up to 90% of the policy's cash value, but this may vary. It is important to review the terms and conditions of your policy and discuss any questions with your insurance agent or financial advisor.

Frequently asked questions