A CFP's Guide to Life Insurance

WRITTEN BY: Gideon Drucker, CFP® AIF® ECA

Let's start here:

“What are the different types of life insurance and when is each appropriate (and NOT appropriate?)”

Fundamentally, there are two types:

Term Life insurance
Permanent Life Insurance

“Term” life insurance is life insurance that you purchase for a specific period of time.

So if you buy a 20-year term insurance policy with a $1mm death benefit, and if you pass away at any point over that 20 year period, your beneficiary will receive $1mm tax free. But, if you pass away in year 22 when you no longer have the insurance coverage (and are no longer paying the insurance premiums, naturally) they will receive nothing.

It is insurance in its purest form: there is no cash build up or savings component…so if you outlive the term period that you’ve elected, you do not receive any money back (which, is, obviously best case scenario as it means you’re still alive!)

Because of this limited form of protection, the coverage is inexpensive relative to other, permanent types of insurance….that is it’s best attribute. Most people can (and should) get an amount of term life insurance that will adequately protect their family without it breaking their budget.

Term insurance is most suitable when you’re young and are worried about how your family would replace your lack of income if you were to pass away prematurely.

Let’s say that you’re 38 years old, making $400k annually and supporting your family. Imagine what would happen if you were to pass away next year: your family would be losing out on another 20+ years of your $400k salary as well as 20+ years of you being able to max out your 401k, add money to the kids 529 plans, investments, savings etc. How much is all that future income worth to your family TODAY? That is why you get term insurance, to make sure that your family has enough money to get through what would have been your next 15, 20 or 25 years of earning and saving money.

Ok, given that baseline, when does term insurance make the most sense?

You have (or will have soon) a young/growing family Getting $2million or 5million of permanent life insurance would not be practical (as it would be way too expensive for most people at this stage of life) and besides, we are fundamentally concerned with protecting your family for the next 20 years ie: your working/child raising years! As you get older and your net worth climbs (and the kids move out of the house) you will have less of a need for quite as much death benefit protection as you need when you’re young. Term insurance therefore fills the insurance need at a low cost for the SPECIFIC period of time that you are most vulnerable & most need life insurance.
You have a mortgage & student loans Most people, upon buying a home and getting a mortgage, look to get term insurance to cover the outstanding balance of the mortgage so that if something were to happen to them, their family could pay off the mortgage no problem. While this obviously is a great play, it is typically not anywhere close to adequate! Ok, so your family now doesn’t have a mortgage payment, but how will they pay their bills, pay for the kids’ college, vacation, retirement etc. without those 30 income-earning years ahead of you.
You are responsible for older family members If you know that It will one day be your responsibility to care for your elderly uncle, grandma etc. and they will rely upon your savings/accumulated assets in 20 years, we want to make sure that even if you are UNABLE to provide that by the time that you pass away, they will still be adequately taken care of.
Why not. Quite frankly, term insurance is so inexpensive and so flexible that I think it is worthwhile to set up (in some amount) once you start making significant income even if you don’t have an immediate need or aren’t sure the amount to get.

Personally, I have a $2mm 20 year term policy and I am single with no children (my sister is currently the beneficiary on my policy.) Why’d I get it? Life insurance cost is based on age/health. The younger and healthier you are when you get insurance, the less it will cost you. So, for $30 per month (the price of two drinks in NYC per month) I have locked in 18 more years of a $2mm death benefit at the top health rating class.

So when I get married and have a family, I will make my spouse my beneficiary and they will be immediately protected and I won’t have to worry about still being insurable in 3 years or 5 years because this is locked in. I will also be able to convert this coverage into the permanent type of insurance at any point over the next 20 years without having to go through additional medical underwriting!

Money affords you freedom, opportunity, and security. For the price of 2 cocktails per month, I am more than happy to ensure that the people closest to me are in better financial position if I were to pass away. Again, I say, why wouldn't I do this?

As I hope I made it clear, I don’t think getting term insurance is ever a bad thing (provided you have an emergency reserve, no credit card debt, adequate retirement savings etc.) it’s just that in some cases it may not be “enough” nor, by itself, appropriate for the specific goal that you are targeting.

I will end this piece by saying that MOST people will absolutely be adequately protected by only buying term life insurance (as much as life insurance agents don’t want to hear this!)

So does permanent insurance ever make sense? Sure, and specifically in the following scenarios:

You want life insurance for the entirety of your life & are interested in legacy planning. Setting up a permanent insurance policy that guarantees your family a tax-free death benefit whether you pass away at 50 or 85 can be a powerful thing & a way of creating generational wealth. We've worked with families that LOVE the idea of having a policy that pays out a few million dollars upon the death of the second spouse for their kids/grandkids as it allows them the freedom/comfort of knowing that they can spend down all of their investments and retirement assets while alive and still leave behind enough money for their family to create a meaningful legacy.
As an estate planning tool for high net worth families. Life insurance proceeds are both tax-free and estate-tax free and so exist outside of federal income/gift tax laws. As a result, permanent life insurance affords high net worth family fantastic leverage. If you can pay $1 today (which you don’t need and are not spending) to create an additional $4 (tax free) upon your demise, why wouldn’t you? You can earmark that money to your family, a trust, your favorite charity etc.

Here’s a more specific example: Let’s say your mom has $1million inside of a Traditional IRA/401k that she is never going to spend down and will eventually be inherited by you. Receiving a “beneficiary IRA” means you will have to pay income tax on the proceeds (because it’s a Pre-tax account and was never taxed) and you will, most likely, have to distribute all of the funds over 10 years according to Inherited IRA distribution rules. Simply put, you are about to get crushed with taxes & unwanted income whenever you inherit that IRA…it will be a hassle!

Instead, let’s say that your mom buys a life insurance policy and pays for it with $200k that she takes out of the IRA while alive….and this amount of premium buys a permanent policy with a $1.5mm death benefit. Now, when mom passes away, you will receive $1.5mm tax & estate-tax free and you can distribute the funds however you’d like and whenever you'd like. Your mom just turned $200k that you would have paid 40% in taxes on (minimum) into $1.5 million dollars tax free. If she’s not spending down the money anyway, why not create more leverage??

Permanent life insurance policies usually come with a long term care rider that will allow you to access portions of the death benefit if you were to need long term care later in life…this could be a cost-effective way to build a level of long term care protection with your desire to provide your family with life insurance coverage

Of course, this is all just a high level overview of how insurance works...it's not meant to be definitive or conclusive....These examples & use cases should help you think about your financial goals and how life insurance might fit (or not fit!) into your financial plan.

As always, if you have any questions about your current insurance policies or best course of action, reach out to schedule your 15 minute "Right Fit" call here so we can figure out together if there's more you can be doing now in your financial world.