Life insurance basics, Part 1

Life insurance is the foundation of financial security for you and your family. It protects your financial resources against the uncertainties of life so you can plan for the future.

Choosing a life insurance product is an important decision, and it can be complicated. As with any major purchase, it is important that you understand your needs and the options available to you.

Getting Started

The main purpose of life insurance is to provide cash for your family after you die. The money your dependents will receive (the "death benefit") is an important financial resource: It can help pay the mortgage, run the household, and ensure that your dependents aren't burdened with debt.

The proceeds from a life insurance policy could mean that your family won't have to sell assets to pay outstanding bills or taxes. What's more, there is no federal income tax on life insurance benefits.

Where to Begin?

Start by evaluating your family's needs. Gather all your personal financial information and estimate what your family will need after you're gone. Include ongoing expenses (such as day care, tuition or retirement) and immediate expenses at the time of death (such as medical bills, burial costs and estate taxes). Also consider that your family also may need funds to help them finance a move or pay expenses while job hunting.

Remember that life insurance provides financial protection. If protection is not your primary goal, you should consider other financial products.

So, how much life insurance should you buy? While there's no substitute for evaluating needs, one rule of thumb is to buy life insurance equal to five to seven times your annual gross income.

Life Insurance Options

There are many kinds of insurance, but they generally fall into two categories:

    1. Term insurance. This type provides protection for a specific period of time. It pays a benefit only if you die during the term. Some term insurance policies can be renewed when you reach the end of the term, which can range from one year to 30 years. The premium rates increase at each renewal date. Many policies require that you present evidence of insurability at renewal to qualify for lower rates.

    2. Permanent insurance. This type provides lifelong protection. As long as you pay the premiums, the death benefit will be paid. These policies are designed and priced for you to keep over a long period. If you don't intend to keep the policy for the long term, this may be the wrong type of insurance for you.

Permanent policies are known by a variety of names: whole, ordinary, universal, adjustable and variable life. Most have a feature known as "cash value" or "cash surrender value." This feature, not found in most term insurance policies, provides you with some options. You can cancel or "surrender" the policy—in total or in part—and receive the cash value as a lump sum. But if you surrender your policy in the early years, there may be little or no cash value. If you need to stop paying premiums, you can use the cash value to continue your current insurance protection for a specified time or to provide a lesser amount of protection covering you for your lifetime.

You can usually borrow from the insurance company using the cash value in your life insurance as collateral. Unlike loans from most financial institutions, the loan is not dependent on credit checks or other restrictions. You ultimately must repay any loan with interest or your beneficiaries will receive a reduced death benefit.

With all types of permanent policies, the cash value of a policy is different from the policy's face amount. The face amount is the money that will be paid at death or policy maturity. Cash value is the amount available if you surrender a policy before its maturity or your death. Moreover, the cash value may be affected by your insurance company's financial results or "experience," which can be influenced by mortality rates, expenses and investment earnings.

Part 2, Next Week

Next week, I'll delve more deeply into the types of life insurance and discuss the advantages and disadvantages of each.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at miltzall@starpower.net.

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