Life Insurance: Understanding Your Financial Position

Life insurance is a legally binding contract between an insurance company and a policyholder, guaranteeing a death benefit to the policyholder's beneficiaries upon their death. The policyholder pays a premium, either as a single upfront payment or as regular payments, to keep the policy active. The two main types of life insurance are term life insurance and permanent life insurance, with the former being valid for a set period and the latter remaining in force for the policyholder's entire life. Permanent life insurance, including whole life and universal life insurance, can serve as a financial asset, allowing the policyholder to borrow against or withdraw the cash value of the policy.

Term vs. permanent life insurance

Term life insurance and permanent life insurance are two types of life insurance policies that cater to different needs. Both types of policies aim to protect the financial well-being of your loved ones in the event of your death. However, they differ in terms of the length of coverage, benefits offered, and premium structures.

Length of Coverage

Term life insurance provides temporary protection for a set period, often 10, 15, or 20 years. The coverage can be renewed, but only up to a specific age, and the premiums generally increase with each renewal. On the other hand, permanent life insurance is designed to provide long-term or lifelong coverage. As long as you continue to pay the premiums, your coverage remains in force.

Benefits

Term life insurance offers short-term death benefit protection, and your beneficiaries will receive a lump-sum payout if you pass away during the coverage period. Some term life policies also offer flexible features, such as allowing you to access benefits early if you become terminally ill or helping with premium payments if you become disabled. Permanent life insurance, on the other hand, offers long-term death benefit protection and additional features. One of the most significant benefits is the opportunity to build cash value, which can be accessed to cover unexpected emergencies, college expenses, or retirement.

Cost

The cost of life insurance depends on the type of coverage and the length of the coverage period. With term life insurance, your premiums are locked in for the selected coverage period but will increase if you choose to renew. Whole life insurance, a type of permanent life insurance, typically starts out more expensive than term life, but the premiums remain locked in at the time of purchase and do not increase over time.

The choice between term and permanent life insurance depends on your unique circumstances and needs. Consider term life insurance if you need short-term coverage, are on a budget, or want flexibility in case your circumstances change. Permanent life insurance may be more suitable if you require long-term financial protection, wish to create an inheritance for your heirs, or seek a tax-advantaged way to save for future expenses.

Whole life insurance

There are several types of whole life insurance policies, categorised based on how premiums are paid. Level payment policies, where premiums remain unchanged throughout the duration of the policy, are the most common type. Single premium policies involve a one-time large premium payment that funds the policy for life, while limited payment policies have higher premiums for a fixed number of years. Modified whole life insurance policies offer lower premiums in the initial years, followed by higher-than-standard premiums in the later years.

Universal life insurance

Compared to term life insurance, universal life insurance offers more flexibility in premium payments and the opportunity for cash value accumulation. However, it is important to note that universal life insurance may be more complex and challenging to understand due to the existence of different types with varying features.

Tax implications of life insurance

Life insurance death benefits are usually tax-free. However, there are some situations in which beneficiaries may be taxed on the payout.

Taxation on Interest

If the beneficiary chooses to receive the payout in installments, the life insurance company will hold the principal amount in an interest-bearing account. While the original death benefit is typically not taxed, the interest that accumulates on the benefit is subject to income tax.

Taxation on Estate

If the total taxable value of your assets, including the life insurance payout, exceeds the federal estate tax exemption limit of $13.61 million for individuals, the IRS will levy an estate tax. In this case, your heirs would have to pay an estate tax on any assets above the threshold within nine months of your death.

To avoid this, high net worth individuals can transfer ownership of their policy to an irrevocable life insurance trust (ILIT). This ensures that the policy and the disbursement of the payout are under the trust's control and excluded from the value of the estate.

Taxation on Gifts

If the insured, policy owner, and beneficiary are three separate people, the death benefit may be subject to gift tax. The IRS considers the death benefit a gift from the policy owner to the beneficiary, and the policy owner is considered the donor. However, the tax is only due if the donor's estate, including any gifts over $18,000 per recipient per year, is worth more than $13.61 million.

Taxation on Cash Value

Whole life insurance and most other permanent life insurance policies earn cash value over time, which can be withdrawn or borrowed against. This cash is tax-deferred, meaning you only pay income taxes on it if you withdraw more than the policy basis (the sum of what you've paid in premiums minus any dividends received).

If you surrender a permanent life insurance policy, the portion of the cash value that exceeds the policy basis is taxable as income.

Taxation on Dividends

Life insurance dividends are not typically taxed unless the amount received exceeds the amount paid in premiums over the course of the year.

Taxation on Group Term Life Insurance

If your employer subsidizes the cost of your group term life insurance policy, the premiums will be subject to income tax. This is because the IRS considers the premiums paid by your employer to be part of your compensation.

Taxation on Life Insurance Settlements

If you decide to sell your life insurance policy to a third party, the sale may be subject to income tax and capital gains tax. The portion taxed as income is the policy's cash value minus the amount paid in premiums. The portion taxed as capital gains is the total gain on the settlement (settlement amount minus premiums paid) minus the amount taxed as income.

Riders and customisations

Riders are additional benefits that can be purchased and added to a basic life insurance policy. They allow you to customise your policy and can provide several kinds of protection if you meet their conditions. While buying a rider means paying extra, the additional premium is usually low because relatively little underwriting is required. Here are some of the most common life insurance riders:

• Guaranteed Insurability Rider: This rider allows you to purchase additional insurance coverage within a stated period without the need for a further medical examination. This type of rider may also provide a renewal of your base policy at the end of its term without a medical check-up.
• Accidental Death Rider: This rider pays out an additional amount of the death benefit if the insured dies as a result of an accident. In the event of death due to accidental bodily injury, the insured's family receives twice the amount of the policy.
• Waiver of Premium Rider: Under this rider, future premiums are waived if the insured becomes permanently disabled or loses their income as a result of injury or illness prior to a specified age. In these circumstances, the rider exempts policyholders from paying the premium until they are ready to work again.
• Family Income Benefit Rider: In the case of the insured's death, this rider will provide a steady flow of income to family members. This rider is generally purchased by individuals who are the sole breadwinners of their families.
• Accelerated Death Benefit Rider: Under this rider, an insured person can use the death benefits if diagnosed with a terminal illness that will considerably shorten their lifespan. Insurers may subtract the amount received, plus interest, from what the beneficiaries receive upon the insured's death.
• Long-Term Care Rider: In the event that the insured has to stay at a nursing home or receive home care, this rider offers monthly payments. Although long-term care insurance can be bought individually, insurance companies also offer riders that take care of long-term care costs.
• Return of Premium Rider: Under this rider, you pay a marginal premium, and at the end of the term, your premiums are returned to you in full. In the event of death, your beneficiaries will receive the paid premium amount.

Frequently asked questions