Here’s what life insurance is and how it works

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Life insurance is an important part of financial planning. Although people may feel as if they don’t need it, it provides protection for their loved ones if the policyholder dies.

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Still, only 52% of Americans own life insurance and 41% of adults — both insured and uninsured — believe they don’t have an adequate amount of life insurance, according to Annuity.org.

“Life insurance is like a financial safety net,” said Noel Kimball McEntee, co-founder of estate planning firm Legado. “The hope is that you don’t need it; but if you die unexpectedly, it provides payment to your loved ones while the policy is active. Like most subscriptions, like Netflix or HelloFresh, as long as you pay your monthly or annual premium, your policy will be active.”

Also check out Dave Ramsey’s life insurance advice.

What is life insurance?

Jennifer Mann, vice president of wealth management and insurance consulting firm Lenox Advisors, explained that life insurance helps people in four phases of life and can achieve the following if your insurance portfolio is set up correctly:

  • If something happens to you, it can ensure that any organization you care about will be fine financially.

  • If you earn more money and are concerned about tax and creditor protection, this can provide tax-advantaged savings.

  • In retirement, this can be a buffer asset providing tax-free income.

  • It can be used for inheritance purposes to make sure that when you die, more of what you left goes to whichever organization you care about, rather than Uncle Sam.

Life insurance can also be used for business purposes to fund buy/sell agreements, help retain key employees, etc.

Mann added that life insurance should not be compared to investments in the market because it is not the same risk profile – unless it is a variable product. This is your safety net.

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Types of insurance

There are two main types of life insurance: term life insurance and whole life. The main differences are the duration of the coverage and the price.

Ciara Lister, co-founder of Legado, said: “Think of term life insurance as a 10-, 20- or 30-year lease. If you die during the policy period, your beneficiaries receive a payout,” Lister said. “At the end of the set period, your beneficiaries won’t get paid and you get nothing.”

As for whole life insurance. Lister said it’s like owning a home instead of renting it.

“Basically, you pay a higher monthly fee than term life, but you have permanent coverage,” she said. “A lifetime also accumulates cash value that you can access through loans or withdrawals.”

While any type of life insurance can benefit your family, term insurance is often surprisingly affordable — monthly premiums average around $16 to $19 for a 40-year-old with a 20-year policy and $250,000 payout. That makes it especially useful for those with dependents or a mortgage, Lister said.

“In terms of estate planning,” she said, “a life insurance policy can be the quick cash a family needs to pay for funeral expenses that add up quickly. In fact, according to the National Funeral Directors Association, the average cost of a funeral in 2021 was $7,848.”

Another important point is that life insurance payouts are generally not subject to income tax and, assuming the estate plan is structured properly, they are also excluded from the deceased’s taxable estate, she said.

Why might it be hard for people to get it?

According to Kimble McEntee, procrastination and underinsurance are the two reasons why it is difficult to get approved for life insurance.

As she noted, the cost of life insurance is determined based on your age and health when you apply for coverage and the customer enters into a contractual agreement with a life insurance company.

“The older you are or the unhealthier you are, the higher the risk and the higher the monthly premium,” she said. “Do not wait! Applying for life insurance coverage when you are young and healthy is always the best time and always the lowest premium per month.”

Why are people reluctant to get one?

One of the main reasons is that many people avoid life insurance because they think it is too expensive.

“This is a common misconception, especially among younger people,” said Jeff Rose, CFP and founder of Good Financial Cents. “In fact, LIMRA research has highlighted that some young people believe the cost of life insurance is triple what it really is. This kind of overpricing can stop them from even considering it, thinking it’s out of their budget.

In fact, the 2023 Insurance Barometer survey conducted by LIMRA and Life Happens found that 38% of millennials and 29% of Gen Z think it’s too expensive and cite it as the main reason they don’t buy this coverage.

Another reason people are reluctant to buy life insurance is that thinking about it means facing their mortality, and that’s not a pleasant thought, Rose explained.

“It often leads to an attitude of, ‘I’ll think about it tomorrow,'” Rose said. “Especially when you’re young, there’s this sense of invincibility that makes it easy to push those kinds of decisions to the back burner. But the irony is that the younger and healthier you are, the better prices you can get.”

Finally, the daily financial pressures of life can make it difficult to think about the long game.

“For those juggling bills, debt and immediate living expenses, setting aside money for something that feels so far away like life insurance can seem less urgent,” Rose said. “It’s a classic battle between today’s needs and tomorrow’s security, with the present often winning.”

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This article originally appeared on GOBankingRates.com: I’m an Estate Planner: Here’s What Life Insurance Is and How It Works

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