Life Insurance: Understanding Basis And Its Importance

Life insurance is a contract between an insurance company and a policy owner, where the insurer guarantees to pay a sum of money to the insured person's beneficiaries when they die, in exchange for the policyholder paying premiums during their lifetime. The death benefit is usually tax-free, but there are some exceptions. Life insurance can be a useful tool for financial planning, as it can replace lost income for dependents, pay final expenses, create an inheritance for heirs, and more. There are two main types of life insurance: term life insurance, which is usually simpler and more affordable, and whole life insurance, which offers more benefits but is significantly more expensive.

Life insurance can replace income for dependents

The death benefit from a life insurance policy can be used by beneficiaries to cover ongoing expenses, such as mortgage payments, car payments, utilities, groceries, and gas. It can also be used to pay for college tuition and room and board, as well as healthcare and insurance costs.

When calculating how much life insurance you need to replace your income, it is recommended to multiply your annual salary by the number of years you want to cover. For example, if you want to provide five years' worth of income replacement for your dependents, you would multiply your annual salary by five.

In addition to income replacement, life insurance can also help cover funeral and burial expenses, pay off remaining debts, and create an inheritance for heirs. It can also provide a source of savings, as some types of life insurance policies accumulate cash value over time, which can be borrowed or withdrawn by the policyholder.

Life insurance can pay final expenses

Life insurance is a contract between an insurance company and a policy owner, in which the insurer guarantees to pay a sum of money to the named beneficiaries when the insured person dies. There are two main types of life insurance: term life insurance and whole life insurance. Term life insurance is designed to last a certain number of years, then end, whereas whole life insurance remains active until the insured person dies, stops paying premiums, or surrenders the policy.

Final expense insurance is a type of whole life insurance policy that pays medical bills and funeral expenses when the insured person dies. It is also known as burial or funeral insurance and is a popular choice among seniors due to its affordable price, smaller benefit amounts, and emphasis on covering funeral costs. Final expense insurance can also cover other end-of-life expenses, such as nursing home expenses and legal matters.

Most final expense plans have the following features:

• Whole life insurance with no expiration if premiums are paid
• Cash value—the insured may be able to take out a policy loan
• Fixed premiums as long as they are paid
• Simplified issue—usually no medical exam is required, just health questions on the application
• Easy application process
• Fast approvals—coverage can often be issued within days

The average final expense policy costs between $30 and $70 a month and depends on the insured person's age, sex, health, coverage amount, and life insurance company. Final expense insurance can be a way to ease the financial burden on loved ones and allow them to focus on healing during a difficult time.

Life insurance can create an inheritance for heirs

Life insurance can be an effective way to create an inheritance for your heirs. The death benefit from a life insurance policy goes directly to the policy's beneficiaries and is typically tax-free. This means that your beneficiaries will receive the payout regardless of how your estate is handled.

There are two main types of life insurance: term life and permanent life. Term life insurance lasts for a set number of years, such as 10, 20 or 30 years, while permanent life insurance can last your entire life. If you want a long-term policy that may last your entire life, consider permanent life insurance. On the other hand, if you need temporary coverage, term life insurance may be a better option.

Term life insurance is the most inexpensive type of life insurance and is designed to last for a specific period. It is similar to other types of insurance, such as fire, auto and medical insurance, in that you pay purely for protection with no cash value accumulation. While term life insurance can leave an inheritance, a longer-term solution should be considered if this is your primary goal.

Permanent life insurance can be designed to last your entire life, ensuring an inheritance for the next generation. It often includes a cash value element that accumulates on a tax-deferred basis. The insured can access this cash value through loans or withdrawals. Alternatively, if the cash value is left to accumulate within the policy, the death benefit may increase, leaving a larger inheritance for heirs.

In addition to creating an inheritance, life insurance can also be used to replace income for dependents, pay final expenses, pay federal and state "death" taxes, make significant charitable contributions, and create a source of savings. It is a cornerstone of sound financial planning and can provide financial security for your loved ones after you're gone.

Life insurance can pay federal and state death taxes

Life insurance is a contract between an insurance company and a policy owner in which the insurer guarantees to pay a sum of money to one or more named beneficiaries when the insured person dies. The death benefit of a life insurance policy is usually tax-free. However, it may be subject to estate taxes.

In the United States, life insurance benefits can pay for federal and state estate taxes so that heirs will not have to liquidate other assets or take a smaller inheritance. While most life insurance payouts are tax-free, there are exceptions. If the death benefit is paid out in installments and the remaining portion earns interest, that interest is taxable.

The main purpose of life insurance is to provide financial support to loved ones after death. It is important to know what tax liability beneficiaries might face, especially when the death benefit is a large amount.

In general, the Internal Revenue Service (IRS) does not consider death benefit proceeds as taxable income, and the beneficiary does not need to report the payout on their taxes. However, there are a few circumstances where the money is taxable.

For example, if the beneficiary receives interest, the lump-sum proceeds of the life insurance policy are typically not considered taxable income, but any interest earned is taxable. Additionally, if the money is paid to the insured's estate rather than a particular beneficiary, it may be taxable. Finally, if the owner and the insured are different, the payout to the beneficiary could be considered a taxable gift.

Life insurance can be used to make significant charitable contributions

Naming a Charity as the Beneficiary

Naming a charity as the beneficiary of your life insurance policy is a simple way to provide a charity with the death benefit proceeds. This method doesn't offer income tax advantages, but it reduces the donor's estate by the amount of the death benefit. Donors who are unsure about how they want to distribute their assets can list a charity as a revocable beneficiary, giving them flexibility if their financial situation changes. However, this method requires the donor to continue paying premiums, and the charity has no guarantee of receiving the payout as the donor can change the beneficiary at any time.

Transferring Ownership of a Policy to a Charity

Instead of simply naming a charity as the beneficiary, you can transfer ownership of an existing policy to a charity. This gives the charity immediate control of the contract, and they can name themselves as the beneficiary of a tax-free payout upon your death. The charity can also surrender the policy for the cash value if it is a permanent life insurance policy. This method offers an immediate charitable contribution tax deduction for the donor and removes the policy from their estate for estate tax purposes. However, this decision is irrevocable, and the donor no longer has access to the cash value of the policy.

Gifting Policy Dividends

If you have a permanent life insurance policy, you may receive dividends from the insurance company. You can choose to donate these dividends to a charity and claim a charitable contribution tax deduction. This method allows you to maintain ownership of your policy, but the dividend pool is usually tied to the death benefit, so donating dividends will reduce the death benefit. Additionally, insurance policy dividends are not guaranteed and can vary from year to year, which may impact the charity's ability to count on a consistent contribution.

Charitable Giving Riders

Charitable giving riders are addendums to a life insurance policy that pay a specific percentage of the policy's face value to a qualified charity of the policyholder's choice. These riders usually come at no additional cost and do not reduce the value of the death benefit. They eliminate the need to create and administer separate gift trusts. However, they often require a high amount of protection to be purchased, and there may be limitations on the maximum allowable gift amount.

Donating an Existing Policy

You can donate an existing life insurance policy to a charity by assigning all incidents of ownership and naming the charity as the beneficiary. This method can qualify for an income tax charitable deduction, but it is important to assign all rights to the charity, including the right to borrow cash values and change the beneficiary. The amount of the charitable contribution is deemed to be the lesser of the value of the policy or the donor's basis in the policy. Donating an existing policy is a simple and effective way to increase your charitable giving while enjoying attractive tax advantages.

Frequently asked questions