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How to Use Life Insurance and Protect Your Family

Investing Retirement Funding Insights Taxes

Imagine the worst day of your life. Your spouse, the person you love the most in this world (outside of our children) just passed away, unexpectedly. Not only will there be a great void in your personal life but financially as well. Thankfully, they were covered by a life insurance policy that paid a death benefit so you don't have to worry about money during a time that may well turn out to be the most difficult period of your life. 

The question isn't: Do I need life insurance? Rather, it's "What type of Life Insurance do I need?" And when it comes to life insurance, there are many choices:

  1. Whole life. 
  2. Variable universal life. 
  3. Term. 

But what do these descriptions really mean?

Every life insurance policy has two common components: They guarantee that the insurance company will pay a death benefit to a beneficiary after a policyholder dies (although the guarantee may be waived if the death is a suicide occurring within two years of the policy purchase). All require recurring payments known as premiums to keep the policy in place. This is where the similarities typically end.

Some life insurance coverage is permanent, but not all. Permanent life insurance is designed to cover you throughout your entire life, not just a portion, or "term," of it, and it can become an important element in your retirement planning. Whole life insurance is the most common form of permanent life insurance.

A whole life policy will accumulate cash value. What is it and how does that happen?

An insurer directs some of your premium payments into what is known as a reserve account and they will invest those dollars as they see fit, typically more conservative investments. The return on the investments influences the growth of the cash value, which builds up according to a formula set by the insurer.

A whole life policy's cash value grows tax deferred. 

After a while, assuming the investments perform as expected, you gain the ability to borrow against that cash value. If structured properly, that loan could be interest & tax-free. If you decide after many years that you no longer want the policy, you also have the option to cancel the entire policy and receive a surrender value. 

Premiums on whole life policies, though, are usually higher than premiums on term life policies, and they may rise with time. Beneficiaries would receive a death benefit and not the policy's cash value when a policyholder passes away.

Universal life insurance is whole life insurance with a twist. 

Like a whole life policy, universal life policies also build cash value, and taxes are deferred. Eventually, you may be able to pay the monthly premiums out of the policy's investment portion.

Little by little, some of your premium on a universal life policy gets credited to the cash reserve for the policy. Sooner or later, you could elect to pay premiums out of that cash reserve, so the policy can begin to pay for itself. Over time, if all goes well, a universal life policy could end up having a lower net cost than a whole life policy. However, if the investments the insurer chooses severely underperform, that can create issues with the sustainability of the policy and ultimately your payments. If the cash reserves dwindle low enough, your policy could end up being accidentally canceled if the premiums aren't paid.

What about variable life (VL) and variable universal life (VUL) policies? 

VL policies are just like whole life or universal life policies but again, with a twist and maybe a bit more risk. In VL and VUL policies, you as the policy owner can direct percentages of the cash reserve into investment subaccounts which are managed by the insurer. Assets allocated to these subaccounts can be invested into a host of options like equities or fixed-income investments. It's your choice. 

If you choose equity investments, typically this means you and the insurer assume greater risk in exchange for the possibility of greater reward. The performance of the subaccounts cannot be guaranteed and as an effect of this risk exposure, a VUL policy usually carries a higher annual cost than a comparable UL policy.

The stock market's performance may have a heavy impact on the performance of the subaccounts and policy premiums. In a bull market, you will most likely be ecstatic because this could mean better growth for the policy's cash value and ultimately lower premiums. A bear market may mean reduced cash value and higher monthly payments just to keep the policy going. In an absolute worst-case scenario, the cash value plummets, the insurer hikes the premiums to provide the guaranteed death benefit, the premiums become too expensive to pay, and the policy lapses.

Term life insurance is renting vs owning. 

It provides coverage for a set period of time, usually 10 - 30 years. Should you die within that period, your beneficiary will get the stated death benefit. Typically, the premium payments and death benefit on a term policy are fixed from the start and do not change during that period. The premiums are much lower than those of permanent life policies because there is a definite endpoint to the policy. When the term of coverage ends, you may be offered the option to renew the coverage for another term usually at a much higher premium, or to convert the policy to a form of permanent life insurance.

Term life is cheap, but the trade-off comes when the term is up. Just as you cannot build up home equity by renting, you cannot build up cash value by renting life insurance. When the term of coverage is over, you usually walk away with nothing for the premiums you have paid. In fact, 99% of term policyholders either outlive their policy or allow it to lapse before their beneficiaries can receive the benefit.1 

Do you need a life insurance policy in retirement? 

One school of thought says no. The kids are grown (usually doing better than you), and because you are retired, you don't have to replace the breadwinner.  If you are thinking about dropping your coverage for either or both of those reasons, you may also want to consider the excellent reasons to keep, get a new, or convert a life insurance policy after you retire. Take these factors into account and consult with your financial professional before making a decision.

Are you protected from the "Double Whammy?" 

The double whammy is what we call the income and tax consequence of losing a spouse. While you are both alive and well, you will often receive a higher income and pay lower taxes. This is due to the fact that you and your significant other are both receiving social security income while also benefiting from higher tax brackets. See the table below:


The problem arises when one spouse passes away. The surviving spouse only gets to keep one social security income and on top of that they now go from filing their taxes as "married filing jointly" to a "single filer." Now if we look at the again to the table above, you can see as a single filer, you jump into much higher tax brackets much faster. We often see the surviving spouse with less income and actually paying higher taxes. That is what we call the “double whammy”, and a life insurance policy can go a long way toward offsetting that burden and allowing them to live the life you both intended.

Could you make use of your policy's cash value? 

If you have a whole-life policy, you might want to utilize that cash in response to certain retirement needs. If you need extended care, for example, you could explore converting the cash in your whole life policy into a new policy with an extended care rider. If you need additional income, many insurers will let you surrender a whole life policy you have held for some years and arrange an income contract with the cash value. You can access the money, tax & interest-free, as a loan from the policy as long as the policy doesn't lapse. Remember that withdrawing money or taking a loan against a policy's cash value naturally reduces the policy's death benefit.

Do you receive a "single-life" pension? 

Having a pension-like income every month is great. But, if you're married, and that income will only continue as long as the sole beneficiary is alive, you might have an insurance need. If there is no joint-and-survivor option on that income stream, and you pass away before your spouse, that income will die with you. Even worse, if you pass away early in your retirement, this could present your spouse with a serious financial problem. 

If you or your spouse find yourself in this situation, think about trying to find a life insurance policy with a monthly premium equivalent to the difference between the amount of income your household would get from a joint-and-survivor pension vs a single-life pension.

Will your estate be taxed? 

Should the value of your estate end up surpassing federal or state estate tax thresholds, then life insurance proceeds may help pay the resulting taxes and prevent the need for your heirs to liquidate some assets. But again, this needs to be set up properly.

Are you carrying a mortgage? 

If you are carrying a mortgage whether it be from the purchase of your home or if you refinanced and are carrying a mortgage, a life insurance policy may make sense. It could mean the difference between your loved ones being able to stay in the house or not if you die with the mortgage still outstanding.

Which coverage is right for you? 

Many factors may come into play when you are deciding which type of life insurance will suit your needs. The best thing to do is to speak with a holistic financial planner who can help you examine these factors along with your entire financial situation so you can determine which type of coverage you should have.




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About the Author

James M. Comblo, CFF
is the President & CEO of FSC Wealth Advisors. His greatest passion in the financial services industry is helping clients live the life they want, not the life they are forced to. To learn more about him click here.




1. https://www.bankrate.com/insurance/life-insurance/term-life-insurance/  



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