The majority of American households do have some variety of life insurance. But some of us understand how to get the most out of it. Five of the most damaging myths that lead to costly life insurance mistakes…
Myth 1: I just need enough life insurance to cover my family’s future expenses.
Fact: If you really want to provide for your family’s well-being, you’ll need more than that. The good news is that this extra coverage won’t set you back as much as you might think.
A typical family should combine the remaining portion of its mortgage … projected inflation-adjusted annual living expenses for the remainder of the spouse’s life … and college costs if they are a factor (assuming that costs will rise by 3% to 5% per year) to determine the amount the family needs to get by. Subtract the amount the surviving spouse will earn if he/she expects to return to the workforce at some point.
Example: A 40-year-old man who’s in good health would pay about $875 a year for a simple 20-year level-term life insurance policy that provides $1 million in coverage, and this would be enough to cover all his family’s future expenses.
And, for about $1,750, he could get a $2 million policy, enough to fully replace his lifetime earnings if his salary would have averaged $80,000 per year for the remaining 25 years of his career. An extra $875 per year (about $73 a month) is a small price to pay to ensure that his family won’t suffer financially after his death.
To compare life insurance costs, contact your insurance professional.
Myth 2: Term life insurance is always a better deal than whole life.
Fact: Term life insurance policies will usually provide lower premiums than a permanent cash-value policy like whole life, which combines the pure insurance of a term policy with a tax-favored investment account. But under particular circumstances – if you plan to keep the policy for more than 20 years … can afford the premiums … and have maxed out other tax-deferred investments, such as a 401(k) plan and an IRA-whole life insurance makes more sense.
Assuming that you don’t dip into your investment for at least 20 years, your total return from a whole life policy, including the death benefit and investment return, is likely to be higher than what you would earn by purchasing a similar amount of term coverage and investing the cost difference in municipal bonds – which is a comparable investment in terms of both risk and tax treatment.
Other permanent insurance options include variable universal life, which might be appropriate for younger couples in their 20s or early 30s, since the investment component could be put in high-growth mutual funds … and universal life, which can be appropriate for those whose income can fluctuate significantly from year to year, such as sales professionals, since it allows the insured to determine the premium paid in any year.
*Rates subject to change.
Other benefits of permanent (casb-value) insurance: You can borrow against the cash value of your policy at reasonable interest rates. Also, withdrawals up to the amount of your investment are tax-free.
Of course, permanent insurance loses its appeal if you need access to your money before two decades or more pass. Life insurance companies front-load their fees, so if you withdraw the money before then, your investment return will suffer disproportionately.
Myth 3: My wife does not work, so she doesn’t need her own life insurance policy.
Fact: Stay-at-home spouses might not produce income, but they often provide important services that are expensive to replace, such as cleaning, cooking and child care. Some spouses also find that their own ability to earn is temporarily reduced after the loss of a partner.
Example: A lawyer in private practice spent the year after his wife’s death walking around in a daze, causing his income to plummet.
Couples with children should have at least $1 million in coverage for the nonworking spouse, more if the family is large or lives in an expensive area. You can consider decreasing that figure if the kids are in their teens and reducing it again once the kids are out of the house. A 40-year-old nonsmoking woman in good health should be able to get a $1 million 20-year level-term policy for about $730 a year.
Myth 4: My term-life policy can be converted to whole life, so I don’t have to worry about losing coverage if I ever become chronically ill.
Fact: While it is true that more than two-thirds of term policies allow policyholders to convert over to whole life regardless of health problems, many “convertible” term policies can be converted only within a five or 10-year window – and insurance companies may not warn you when that window is about to close. If you don’t convert and the policy lapses, the insurance company gets to keep all the money you paid in premiums and won’t have to pay out a dime on the policy.
It is not uncommon for policyholders who have developed serious health problems to unwittingly miss their opportunity to convert to whole life and then find themselves uninsured and essentially uninsurable.
Self-defense: Make a habit of reviewing your policy at least once a year so that you won’t miss your chance to convert – or any other deadline.
Myth 5: I’m retiring soon, so I don’t need life insurance anymore.
Fact: This might be true in some cases, but life insurance can be useful for retirement planning and/or estate planning.
*If your employer offers a defined-benefit pension plan, it probably has two payout options – a single life annuity, which provides income only during your lifetime, and a joint life annuity, which provides a smaller monthly payment until you and your spouse both die. In spite of these smaller payments per month, most married people choose joint life for the sake of their spouses.
Assuming that you are in good health, single life is a better choice if you also hold a life insurance policy with your spouse as the beneficiary. Should you die first, your spouse could live on the proceeds. It’s best to purchase the insurance a decade or more before you retire to lock in an attractive age-based rate.
*If you expect to have a large estate – $ 3 million or more – it may be wise to use life insurance to pay the estate tax. Too often, people don’t buy the proper insurance for this purpose. The usual choice is a “second-to-die” policy – one that pays out when the surviving spouse passes away. But when you crunch the numbers, second-to-die policies can be inferior deals for most couples younger than 60 … and any couple in which the husband is more than five years older than his wife or the wife is more than 10 years older than her husband, since women live an average of five years longer than men. In such cases, it’s better for each spouse to buy a separate policy.
Scenario: A husband and wife, each 45 years old and healthy, would pay an annual premium of about $11,000 for a $1 million second-to-die whole life policy. If they had bought separate $500,000 whole life policies, they would pay a total of about $17,500 in annual premiums. (The high cost reflects the lifetime coverage with this type of policy.)
At first glance, the second-to-die policy looks great; saving about $6,500 a year, but the insurer pays nothing until both spouses die. With separate policies, the insurer must pay out $500,000 upon the death of the first spouse. If the surviving spouse were to invest that $500,000, he/she could turn it into more than $800,000 in a decade, even at a 5% after-tax return.
Bonus: Once the first spouse has died, the premiums must be paid only on the remaining spouse’s policy, reducing costs.
Second-to-die policies do make sense if both spouses are over age 60 and close in age. In this case, the odds are lower that they will die many years apart.