Life Insurance: What is It, How to Get It and More

Highlights:

• Life insurance provides tax-free cash benefits to certain beneficiaries following the death of the insured person.
• Life insurance premiums vary but are typically calculated based on factors like your age, gender, health and family medical history.
• You’ll typically choose between two types of life insurance: term life insurance, which offers temporary coverage, and permanent life insurance, which offers lifetime coverage.

The sudden loss of a loved one can be devastating, both emotionally and financially. A life insurance policy is one tool you can use to help ease the financial burden on those you leave behind. Life insurance provides tax-free funds to your beneficiaries when you pass away — creating a valuable safety net for your loved ones, even in your absence.

How does life insurance work?

When you purchase a life insurance policy, you make a series of regular payments, known as premiums, to your insurer. In exchange, the insurer agrees to provide a death benefit — a sum paid to your beneficiaries following your death. A death benefit may be paid out gradually or all at once, and policyholders may name multiple beneficiaries. In certain circumstances, a life insurance policy may also pay out while the policyholder is still alive, such as following the diagnosis of a terminal illness.

Life insurance premiums vary from person to person. They're typically calculated based on factors like your age, your gender, your health, your family medical history, your exercise habits and even your driving record. For instance, a young person with an active lifestyle will likely pay less than an older person with heart problems and a smoking habit.

What does life insurance cover?

Your exact coverage will depend on your policy, but life insurance typically covers most causes of death, including accidents, illness, homicide and age. Some life insurance policies may also cover death by suicide, though many do not.

Beneficiaries can generally use their death benefit as they please. Many use money from a life insurance policy to cover costs associated with the loved one's death, such as funeral and burial expenses. If the deceased was still working, beneficiaries often use their death benefit to offset lost income and cover rent or mortgage payments, groceries, utilities and other household expenses. Still others apply their death benefit toward large expenses such as debt or college tuition.

Are life insurance benefits taxable?

Death benefits are generally not considered taxable income, so beneficiaries won't have to report these funds as income when filing their taxes.

However, some insurance policies include a cash value feature that may be taxable. With cash value insurance, a portion of each premium is set aside to build up a cash reserve. These funds may accrue interest over time and may be accessible for withdrawals prior to the policyholder's death. However, certain actions, such as withdrawing money from or borrowing against your life insurance cash value, may qualify as taxable events.

What different types of life insurance are there?

You'll typically choose between two types of life insurance: term life insurance, which offers temporary coverage, and permanent life insurance, which offers lifetime coverage.

Term life insurance provides coverage within a limited window of time, typically between 10 and 30 years. If the policyholder dies within this period, their beneficiaries receive a death benefit. After that coverage window has ended, the policy is inactive and there will be no payout. Term life insurance premiums are typically more affordable than permanent life insurance premiums.

Permanent life insurance policies don't expire but instead provide coverage for your entire life. As a result, they generally cost more than term life insurance. Permanent life insurance policies often offer a cash value option, which allows you to earn interest on a portion of your premiums. There are several different types of permanent life insurance:

• Whole life insurance policies include both a death benefit and a cash value component, where your premium payments accumulate and earn interest tax-free over a long period of time. Under certain circumstances, you may be able to access the cash value of your policy during your lifetime.
• Universal life insurance is a more adaptable type of permanent life insurance that also provides a death benefit and a cash value component. Universal life insurance allows you to adjust or halt your premiums using funds from your policy's cash value. You may also have the flexibility to increase your death benefit (provided you pass a medical exam) or reduce it to bring down the cost of your premiums.
• Variable life insurance policies offer many of the same benefits as a universal life insurance policy. The main difference is that the cash value portion of your policy can be placed in mutual funds or other higher-yield investment options. Just be aware that those bigger gains come with greater risk.

What type of life insurance is right for me?

The perfect life insurance policy should meet each of your most important needs. To decide between policies, consider the following:

• Amount of coverage. Estimate how much money you contribute to your household and your loved ones on a yearly basis, including your income and the cost of employer-sponsored benefits such as health insurance. Use this figure to help estimate the size of your death benefit.
• Length of coverage. Decide how long your coverage should last. If you want to provide a safety net for your children until they reach adulthood and become financially independent, term life insurance may be adequate. However, if your goal is to leave your beneficiaries an inheritance, a permanent policy is likely the right fit.
• Size of your budget. How much can you afford to spend each month? If you have limited income, consider a policy with lower premiums, like term life insurance. If you have cash to spare, you can opt for higher-cost permanent life insurance.
• Policy features. What do you want from your policy? Some permanent life insurance includes a savings component with the option to borrow from your policy's cash value while you're still alive. You might want to take advantage of the premium flexibility offered by universal and variable life insurance. Certain policies also allow you to customize your coverage with riders, which are add-ons that provide additional flexibility and benefits, usually for an additional fee.

Where do I get life insurance? You can often secure a policy through your employer as a part of your benefits package. You can also purchase life insurance directly from an insurer. Regardless of the source, do your research and choose your policy wisely. Having the right life insurance can provide your family with peace of mind and much-needed financial security.