One decision you need to make when looking at life insurance to protect you and your family is choosing between permanent versus term life insurance. Each person’s situation is different. I will cover important aspects for each type of coverage to enable you to make the decision that is best for your situation.
Term Life Insurance
Term life insurance is a policy you can purchase that provides coverage over a specific time horizon. You can get coverage for 10, 20, or 30 years or to a specific age. Term coverage is cheap if you are in good health and relatively young. I was recently quoted the following for term coverage up to age 80. I could get $300k of coverage for $15/month, or I could get $1 million of coverage for $37/month. However, by year 20 of the policy, the premiums almost doubled. Finally, you do not build any equity in a term life policy and your coverage will eventually end (based on the time horizon you select to be covered for).
Permanent Life Insurance
Permanent life insurance (sometimes called whole or universal insurance) provides coverage for your entire life as long you continue to pay the premium. This is important to note because there are nice benefits to permanent insurance, but you need to be able to make your premium payments every year until you die. Permanent insurance will cost more than term, but the cost remains level. In addition, permanent insurance will build equity and can be a nice tax-free retirement bucket.
The most important consideration when determining which life insurance policy to go with is why do you need it in the first place? My perspective is you should provide enough coverage for your family in the event that something unfortunate happens to you. You may also want to consider life insurance if you are single and you have outstanding debt. That way you don’t stick your parents with the bill.
Here are some other considerations:
How much coverage is appropriate?
I have worked with different financial advisers and they recommended from 3 times your income to 7-10 times your income for the appropriate amount of coverage. This “ballpark” estimate is like throwing a piece of gum on the wall and hoping that it sticks. I would consider the following:
- How much will children cost? I used three different estimates (one, two, three) and found that the average cost to raise a kid until they turn 18 is $260,000. What is more difficult to estimate is the cost of college tuition in 18 – 20 years. According to the College Board, the average tuition costs are: in-state tuition is $9,410 ($37.6k four-year total), out-of-state tuition is $23,893 ($95k), and private school tuition is $32,405 ($130k).
- How much debt do you have: car loans, credit cards, student loans, and mortgages are the big items to consider.
- Funeral costs, which can be up to $10,000.
- Supplemental income.
Let’s take a look at a family of four that has two young kids, $10k in student debt, and $250k left on their mortgage. This totals up to a little over $600k to cover the cost to raise the children and put them through a public university, pay off the mortgage, and pay off the student debt. If the person that passed away was making $75,000, there is over $1.3 million (over 18 years) for lost income on top of the $600k.
Now, this calculation is a rough, brute-force approach to understanding what you should consider when estimating how much coverage you need. This is much more (26x the $75k salary) than what my financial advisers told me to get. My point is that you should look at your unique situation and make sure you are considering all of these factors so you can protect your family.
How much can you afford?
Term coverage costs much less than permanent life insurance. If your budget is tight but you want to provide a safety net for your family then term insurance is likely your best option. Permanent life insurance cost will depend on the amount of coverage you want to take out. With a permanent policy, you will begin to accumulate a cash value in the policy over time and you can also add more coverage to the policy at a later date. Therefore, if you cannot afford the coverage you need with a permanent policy you can either: start with a term life insurance policy and convert it to a permanent policy at a later date, or you can start with a combination of term and permanent life insurance.
There are no tax advantages for term life insurance. There are tax advantages to the cash value in a permanent life insurance policy because that money is not taxed as added income. This means the cash value that grows in a permanent life insurance policy can be used to:
- Pay for college for children
- Provide a tax-free bucket of money in retirement
- Cover any emergencies that occu