Dear Carrie: My husband and I are in our thirties and have a three-year-old. I’m thinking that we should have a life insurance policy, but the choices are overwhelming! How can I figure this out? — A Reader
Dear Reader: This is the perfect time to be asking this question. You and your husband not only have each other to protect, but perhaps even more importantly, your three-year-old child. While no one likes to think about an early demise, if you have dependents that rely on your income for support — and you don’t have a big chunk of money set aside — you should probably have some type of life insurance coverage.
And you’re right: wading through the policy choices can be a chore. But it doesn’t have to be. For instance, term insurance is a relatively straightforward and low-cost type of life insurance.
However, before you jump into a term policy, you should at least understand a bit about the other choices so you can feel confident in your decision. After that, it’s a question of determining how much insurance you need and doing some comparison-shopping.
Understand the Difference Between Term and Permanent Insurance
There are two basic types of insurance: term (or temporary) and permanent (or cash value). Here are the main differences:
–Term insurance is pure insurance. You purchase a policy for a set length of time (the term) at a pre-established premium. Unless you renew when the term is over, you’ll no longer have coverage when the policy expires. Term insurance is by far the least expensive choice. However, you need to realize that there’s only a payout if the insured dies during the term. The policy doesn’t have any monetary value itself.
–Permanent insurance gives you coverage for life as long as you pay the premiums on time. It’s generally much more expensive than term insurance, partly because a portion of your premium goes toward building cash value, but also because of embedded commissions and fees. Traditional permanent insurance builds up cash value on a tax-deferred basis. Depending on the policy, you may be able to borrow against the cash value or apply it to future premiums. In addition, you can even surrender the policy for its cash value (less any surrender charges) if you find you no longer need the coverage.
You may also hear references to whole life (permanent insurance with a level premium, guaranteed death benefit, and guaranteed rate of return on the cash value), variable life (permanent insurance with a fixed premium but a variable rate of return depending on the investment options you choose), or universal life (with adjustable premiums and a flexible death benefit). Unlike term insurance policies, which are fairly straight-forward, these types of permanent policies can be very complicated and difficult to evaluate. If you decide to go this route, make sure you do your homework!
Choose Between the Two
For many young families, a term policy is often the way to go. For one thing, it’s more affordable. And for another, you can choose the term — say 10 or 20 years — depending on the age of your children and the length of time you want to provide them with financial help. Once the kids are independent, you likely won’t need to continue coverage.
There are a couple of instances where permanent insurance can make sense. For example, if you have dependents with special needs that will need financial assistance indefinitely, permanent insurance might be the best option. Or in the rare case where someone’s estate is large enough to have to deal with estate taxes, permanent insurance can help handle some of that tax burden. But in general, I’d start with a term policy. You might then consider using the difference between your term life premium and what you would have paid for a permanent life policy, to invest in low-cost, tax-efficient mutual funds or ETFs. You may actually be able to achieve a better return on those funds as your investment performance will not be reduced by mortality and expense charges, administrative fees, and other insurance based charges.
Some food for thought: for both types of insurance, premiums are generally lower when you’re young and go up with age. Factor that in when choosing an initial term or in deciding if permanent coverage is the better initial choice.
Figure Out How Much You Need
An industry rule of thumb says you should have life insurance equal to six to eight times your annual salary, but I think it’s smarter to make a calculation based on your individual needs. For instance, do you want to cover only daily living expenses for a certain number of years? Or are there other big-ticket items such as a mortgage or college tuition that you want to include?
The amount you need also depends on your savings and any other income sources your family might have, as well as whether you have coverage through your employer (which you may or may not be able to keep if you change jobs). There are a number of online calculators that can also help you factor in things like the projected growth of current assets, future college costs, inflation, and more to give you a realistic figure.
Be sure to compare several different companies for the best cost and coverage. As an example, a $500,000 policy for a 20-year term could range between $25 and $35 per month for a 35-year-old nonsmoking male in excellent health, yet be less for a female. Standard provisions can also vary. Again, there are a number of online tools available where you can enter your zip code and answer a few questions to get a quote.
Talk to a Professional
I don’t mean to make life insurance sound simple; it isn’t. So the next step is to talk to a reputable insurance professional that can walk you through your choices in greater detail. But don’t let yourself be pressured into something you don’t need or want. With this basic understanding and a clearer idea of what you’re looking for, you should be able to get the type and amount of coverage that’s right for your family.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president
of the Charles Schwab Foundation and author of “It Pays to Talk.” You can e-mail Carrie at firstname.lastname@example.org.