Life Insurance: Where And How To Invest Your Money

Life insurance is a financial product that can help secure your family's future in the unfortunate event of your death. It is a complex investment with its own pros and cons and can be a smart addition to your financial arsenal. There are two main types of life insurance: whole (or permanent) life insurance and term life insurance. Whole life insurance covers the insured for their entire life and includes a cash value that the policyholder can access. On the other hand, term life insurance is tied to a specific length of time and does not have a cash value component. While term life insurance is generally more affordable, whole life insurance offers the advantage of a cash payout. This money can be used to pay premiums, take out a loan, or withdraw cash. However, it is important to carefully consider the potential consequences of accessing the cash value, as it can impact the amount available, your death benefit, and the growth of your account.

Understanding the types of life insurance

There are several types of life insurance policies available, each with its own unique features, benefits, and drawbacks. Here's a detailed overview of the different types of life insurance to help you make an informed decision:

Term Life Insurance

Term life insurance is a simple and cost-effective policy designed to provide coverage for a specific number of years. It is typically sold in lengths of 1, 5, 10, 15, 20, 25, or 30 years. This type of insurance is ideal for most people as it offers sufficient coverage at a lower cost compared to other options. The main purpose of term life insurance is to replace your income in the event of your death during the policy term. While it is affordable, one of the drawbacks is that if you outlive the policy term, your beneficiaries will not receive a payout.

Whole Life Insurance

Whole life insurance, as the name suggests, provides coverage for your entire lifetime, as long as you keep up with the premiums. It is a permanent coverage type that offers a guaranteed payout to your beneficiaries whenever you pass away. Whole life insurance also includes a savings component, known as the cash value, which accumulates over time. The premiums for whole life insurance tend to be higher than term life insurance due to the lifelong coverage and the cash value component. This type of insurance may be ideal for those seeking guaranteed support for their loved ones and for long-term financial planning.

Universal Life Insurance

Universal life insurance is a flexible permanent coverage option that allows you to adjust your premiums and death benefit within certain limits. It also includes a savings component that grows over time, similar to whole life insurance. However, the interest rate for universal life insurance is not fixed and can change based on market conditions. This type of insurance may be suitable for those who want permanent coverage but desire more flexibility in their policy.

Variable Life Insurance

Variable life insurance is a riskier type of permanent life insurance. It consists of a fixed death benefit and a variable cash value component that rises and falls based on the performance of your selected investments. This type of insurance offers the potential for considerable gains if your investments perform well, but it also comes with higher risk, fees, and costs compared to whole life or universal life insurance. Variable life insurance may appeal to those with a higher risk tolerance who want more control over their investments.

Final Expense Life Insurance

Final expense life insurance, also known as burial or funeral insurance, is a type of whole life insurance with a smaller death benefit designed to cover end-of-life expenses such as funeral costs, medical bills, and outstanding debt. It is easier for older individuals or those with pre-existing health conditions to qualify for this type of insurance. Final expense life insurance typically has a lower coverage amount, and the full death benefit may not be paid out if the insured person dies within the first few years of the policy.

Other Types of Life Insurance

In addition to the main types mentioned above, there are a few other life insurance options available:

• Indexed Universal Life Insurance—This type of permanent life insurance links the cash value growth to a stock market index like the S&P 500 or NASDAQ.
• Simplified Issue Life Insurance—This type of insurance does not require a medical exam, making the approval process faster. However, it may be more expensive and have lower coverage amounts due to the increased risk for the insurer.
• Instant Life Insurance—This is a specific type of simplified issue policy that offers a quick online application process and faster approval.
• Guaranteed Life Insurance—This policy does not require medical questions or exams, and your application cannot be turned down.
• Supplemental Life Insurance—This provides additional coverage beyond what a group life policy offers, and can be purchased from an employer or a private insurance company.
• Survivorship Life Insurance—This type of joint life insurance covers two people on a single policy and pays a death benefit once both policyholders have passed away.
• Decreasing Term Life Insurance—This coverage option provides a death benefit that decreases over time, making the policy more affordable.
• Accidental Death and Dismemberment (AD&D) Insurance—This type of insurance only pays out if the insured person dies in an accident or suffers serious injuries such as the loss of limbs or sight.

Borrowing from your life insurance policy

Firstly, it's important to understand that you can only borrow against a permanent life insurance policy, such as a whole life insurance or universal life insurance policy. These policies are more expensive than term life insurance but have no predetermined expiration date. If sufficient premiums are paid, the policy will be in force for the lifetime of the insured. While the monthly premiums are higher than term life insurance, money paid into the policy that exceeds the cost of insurance builds up a cash value that is part of the policy. This cash value is designed to offset the rising cost of insurance as you age, allowing premiums to remain level throughout life and preventing them from becoming unaffordable in your later years.

The cash value of a permanent life insurance policy typically grows at a rate that depends on the type of policy. For example, in a regular universal life policy, it grows based on current interest rates, while in a variable universal life policy, the cash value is invested by the owner in the stock market. It usually takes a few years for the cash value to build up to a sufficient level to take out a loan.

When borrowing from your life insurance policy, there is no approval process or credit check since you are essentially borrowing from yourself. No explanation is required about how you plan to use the money, and it does not affect your credit score. The loan is also not recognised by the IRS as income and remains tax-free as long as the policy stays active. However, it's important to note that the loan is expected to be paid back with interest, and there is no mandatory monthly payment.

A policy loan reduces your available cash value and death benefit. If you pass away while still owing money on a life insurance loan, the outstanding balance, including any interest owed, will be deducted from the death benefit your beneficiaries receive. Therefore, it is crucial to pay back the loan in a timely manner, on top of your regular premium payments. If the loan is not paid back before the insured person's death, the loan amount and interest will be subtracted from the death benefit.

Additionally, if the loan remains unpaid, interest will be added to the balance and accrue over time. This could cause the loan to exceed the policy's cash value and result in a policy lapse. In such cases, you may owe taxes on the borrowed amount. Insurance companies usually provide opportunities to keep the loan current and prevent lapsing, but it is the policyholder's responsibility to ensure timely repayment.

It is important to carefully consider the pros and cons of borrowing from your life insurance policy and understand the potential financial implications. While it can provide quick access to cash, it may reduce the death benefit and potentially impact your beneficiaries. Consulting with a financial advisor can help you make an informed decision that aligns with your financial goals and needs.

Weighing the pros and cons of permanent life insurance

Permanent life insurance is a type of insurance that provides coverage for the policyholder's entire lifespan, as long as premiums are paid. It is more expensive than term life insurance but offers lifelong coverage and the opportunity to build cash value, which can be used to pay premiums or take out a loan from the insurer.

Pros:

• Permanent life insurance provides coverage for the entirety of the policyholder's life, whereas term life insurance only covers a fixed period.
• It offers a cash value component that grows over time and can be used to take out a loan or pay premiums.
• The cash value grows tax-deferred, and there is no income tax when receiving dividends or surrendering coverage, unless the amount received is greater than the premiums paid.
• The death benefit for beneficiaries is paid tax-free.
• There is flexibility in some permanent life insurance policies, such as universal life insurance, which allows for adjustments to premium payments and death benefits.
• It is a good option for those who want to ensure a death benefit payout for their loved ones no matter when they die.
• It can be used to fund a life insurance trust or leave a financial legacy to heirs.
• It can help cover final expenses and funeral costs.

Cons:

• Permanent life insurance is significantly more expensive than term life insurance due to lifelong coverage and investment opportunities.
• Universal and variable policies require careful monitoring to ensure the cash value performs well and the policy stays in force, making them riskier than term life policies.
• Borrowing from the cash value and not paying it back will typically result in a reduction of the death benefit by the same amount.
• The interest rate earned on the cash value is often lower than what could be achieved through other investment avenues.
• Whole life insurance policies lack the flexibility to alter premium payments or death benefits.
• It is likely not a good choice for those who only need life insurance for a specific period.
• Some policies charge high internal fees that eat into the potential cash value.
• It may not be suitable for those with a higher risk tolerance or those seeking higher investment returns.

Choosing a life insurance beneficiary

Who can be a life insurance beneficiary?

Almost anyone can be a life insurance beneficiary, including people, organisations and trusts. Some common examples are:

• A person, like your spouse.
• Multiple people, like your children.
• A charitable organisation.
• A legal entity, like your company.

Some insurers place limits on the number of beneficiaries you can name. If your policy has a limit, be selective when compiling your list.

The beneficiaries you choose when you purchase a policy must have an "insurable interest" in your life. This means they have more to lose than gain by your death, whether that's financial or otherwise.

Primary vs. contingent beneficiary

Primary life insurance beneficiaries are the first in line to receive the life insurance death benefit if you die.

Contingent life insurance beneficiaries, sometimes called secondary beneficiaries, receive the death benefit if the primary beneficiary dies before you do.

Multiple beneficiaries

If you name multiple beneficiaries, you can choose how much of the payout each party receives. For example, you might allocate 50% to your spouse, 30% to your child and 20% to a charity. No matter how you divide a life insurance payout among beneficiaries, the percentages must add up to 100%. If you don’t list the percentages, the insurer may grant equal shares to each beneficiary.

Irrevocable vs. revocable beneficiaries

You cannot change an irrevocable life insurance beneficiary designation without the beneficiary’s approval. For this reason, irrevocable designations aren't common. However, they can be useful if you want to make sure the death benefit reaches a specific person, such as your child.

In contrast, a revocable life insurance beneficiary designation is flexible. You can change, update, add or remove a revocable beneficiary at any time.

This decision isn't always a simple one. The right choice may not be the most obvious choice. Start by asking yourself why you have life insurance in the first place:

• Who relies on you financially and would need help paying ongoing bills if you die?
• Who would need financial support to cover costs incurred by your death, such as funeral expenses?
• Who would you like to leave money to regardless of whether they rely on you, such as a charity or a trust for your children?

You can avoid simple mistakes when designating a life insurance beneficiary by being as specific as you can. Make sure to include any identifying factors, such as each beneficiary’s full name, Social Security number, relationship to you, date of birth and address, so the insurer can locate your beneficiaries quickly. Consult with a legal professional to ensure you use the correct language.

Once you narrow down your options, ask yourself how much money each beneficiary would need, and divide the death benefit accordingly.

Naming children as your beneficiaries

Naming your children as life insurance beneficiaries might seem like a sensible decision. But if you die while they’re still minors, the payout can be complicated.

These are your options:

• Many states allow legal guardians to receive payouts on behalf of minors. You can appoint a legal guardian prior to your death, or the guardian can petition for rights after you die. In either case, the state must grant the guardian legal rights to manage the child’s finances. Appointing a guardian can be a lengthy and expensive process, so consult with a lawyer before proceeding.
• Trusts can be effective solutions for leaving money to children. You can set up a life insurance trust for your children and have the trustee oversee the funds and distribute the money according to your wishes. However, there are costs involved, and the trust must be valid and active at the time of your death.

Naming your estate as your beneficiary

Although life insurance proceeds typically aren't taxable, the payout may be subject to estate tax if left as part of a large inheritance.

Even if you have a will, your estate—including the death benefit—can get held up in probate court, delaying the payout and costing your estate money. If you name a specific beneficiary on your life insurance policy instead, the funds go directly to the beneficiary without being wrapped up in your estate.

If you don’t name a beneficiary, the insurer typically issues the death benefit to your estate. However, in some cases, insurers distribute the death benefit according to a specific order outlined in the policy. This order can vary, so make sure you know who’s first in line before you leave the beneficiary box blank.

Deciding how your death benefit will be paid out

Lump-sum Payment

This is the most common and traditional method of paying out a death benefit. The beneficiary receives the full amount of the benefit in one payment. This option is often the default choice for many policies. While it can provide a significant financial cushion for your loved ones, it's important to consider the tax implications, especially if the benefit is substantial.

Installment Payments

With this option, the beneficiary receives the death benefit in regular installments over a fixed period or for the life of the beneficiary. This can provide a steady income stream for a predetermined number of years, ranging from 5 to 40 years. However, it's important to note that any interest income received on these installments may be subject to taxation.

Annuities

Annuities are similar to installment payments, but the proceeds and accumulated interest are paid out over the life of the beneficiary. This option provides a guaranteed income stream for the beneficiary. However, any interest income received will be subject to taxation.

Retained Asset Account

In this case, the insurance company acts as a bank and holds the payout in an account. The beneficiary can then make withdrawals as needed. Interest will accumulate on the account balance, and the beneficiary can write checks against it. This option provides flexibility and easy access to funds.

Combination of Options

In some cases, you may choose to combine different options to meet your specific needs. For example, you could opt for a partial lump-sum payment and use the remaining benefit to purchase an annuity or set up a retained asset account. This allows you to provide an immediate financial cushion while also ensuring a steady income stream for your beneficiary.

When deciding on the payout option, it's essential to consider your beneficiaries' financial needs, tax implications, and the potential impact on the total benefit amount. Consulting with a financial advisor or insurance professional can help you make an informed decision that aligns with your goals and ensures your beneficiaries are taken care of in the way you intend.

Frequently asked questions