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Smart Money

How Does Life Insurance Work?

Life insurance is an investment that many people include in their long-term financial plans. This type of insurance has evolved into a flexible and powerful fiscal product that can take care of your loved ones monetarily if someone passes away.

Rachel Velez • April 26, 2022

So you’ve got your home and car insurance policies ready to go. But what about life insurance? Having a life insurance policy is a good idea for anyone who wants to make sure the financial security of their family members and surviving loved ones is taken care of upon their death.

This might feel strange to think about, especially if you are just starting out, or maybe getting life insurance is already on your to-do list, but you just haven’t got around to it. Either way, if you have loved ones who depend on your income, it’s worth knowing how life insurance can protect them if anything were to happen to you. 

Buying life insurance can be an important aspect of any financial plan. The money from a life insurance policy can help your family continue their lifestyle, achieve their goals, replace your income, or simply pay for your funeral and burial expenses when you die. Another benefit of having life insurance is that you may be able to borrow money from your policy or earn interest on ones that build cash value.  

Here’s a breakdown of what you need to know about life insurance — how it works, what it costs, and the different types of policies available.

In This Article

  1. What Is Life Insurance?
  2. The 2 Main Types of Life Insurance
  3. Other Types of Life Insurance
  4. What Does a Life Insurance Beneficiary Do?
  5. What Does Life Insurance Cover?
  6. How Much Does Life Insurance Cost?
  7. Do I Need Life Insurance?
  8. FAQs
  9. Final Thoughts: Why Is Life Insurance Important?

What Is Life Insurance?

Life insurance is a contract between you and an insurance company that provides financial protection for your loved ones after you pass away. You pay a monthly or annual premium to the company, and in exchange, they pay a tax-free lump sum of money if you die, as long as the policy is active.

Depending on the type of policy you buy, life insurance typically covers natural deaths, accidental deaths, and/or death by illness. You can customize your life insurance policy to fit your family’s needs by choosing the level of coverage, the number of years you want it to last, and the dollar amount that would be paid out if the policy was cashed in. 

Once the money is paid out, your loved ones can use the money for whatever they choose. Often this includes paying monthly bills, like a mortgage or paying for a child’s education. Having the safety net of life insurance can ensure that your family can stay in their home and pay for the necessary things that they need during a difficult time. Life insurance is a way to protect the financial future of your family or business while also giving you peace of mind.

The 2 Main Types of Life Insurance

Insurance companies generally offer several types of life insurance policies. Choosing the right type of policy and the best level of coverage for your situation isn’t always simple. Understanding the different types of life insurance policies and how they work can help you decide which one is best for your needs.

Let’s start with the two most popular types of life insurance: term life and permanent life. Term life insurance covers you for a fixed amount of time, while permanent life insurance covers you until the end of your life. Now here’s a closer look.

How Does Term Life Insurance Work?

Term life insurance provides the most straightforward coverage. It’s active for a set period, usually 10 to 30 years, and pays out a death benefit to your beneficiaries if you die while the policy is still active. You choose the term when you take out the policy. That’s it — nothing more, just simple financial protection for the people you care about. 

Term is also typically the most affordable type of life insurance since the premium payments stay the same for the duration of the policy. In addition to being the most affordable, term life insurance is the most popular type of life insurance sold because it offers large payouts at a low cost.

How Does Permanent Life Insurance Work?

Permanent life insurance provides coverage for your entire life unless the policyholder stops paying the premiums or gives up the policy. It’s typically more expensive than term life insurance because it can last for the duration of your life and usually builds cash value as the policy ages.

A portion of the premium payments you make is added to a cash account, which can earn interest or be invested, depending on the type of policy you hold. You can then use the cash value of your life insurance while you’re still alive. You can borrow from it, make withdrawals, or just use the interest payments accrued to cover the premium later in life. 

You can even surrender the policy, trading your death benefit for the value currently in the account, minus some fees. These options can create complicated tax issues, so it’s a good idea to talk to a financial advisor before utilizing your cash value.

There are also a couple of different types of permanent life insurance.

  • How Does Whole Life Insurance Work? Whole life insurance is a type of permanent life insurance that has a guaranteed premium and a cash value that accumulates over time. 
  • How Does Universal Life Insurance Work? Universal life insurance also has a cash value component that earns interest and features flexible premiums. Unlike term and whole life insurance, the premiums can be adjusted over time.

Learn More About Term Life Insurance

Haven Life provides term life insurance that’s actually simple. With an easy online application and coverage provided by Mass Mutual (a leading insurer), they are a great place to start your life insurance journey.

Other Types of Life Insurance

There are a couple of other types of life insurance that you may have heard of before. Here’s how they work.

How Does Group Term Life Insurance Work?

Group term life insurance is different from having an individual policy, and it’s usually issued through your employer. Many employers offer group life insurance in their benefits packages. Group plans typically provide term life insurance, but some employers also offer permanent life policies. 

A group life insurance policy may cap the death benefit at 1 to 2 times your annual salary, but usually doesn’t require a medical examination, making this form of coverage ideal for those who would otherwise not be able to obtain insurance on their own. If you’ve already signed up for a group life insurance plan through your work, there may not be an urgent need to purchase your own policy yet.

But remember, with group life insurance, your policy is generally only active while you’re employed with your company or organization. 

How Does Supplemental Life Insurance Work?

Supplemental life insurance adds extra coverage to an existing policy. It’s used when the current policy is insufficient and wouldn’t cover your family’s financial needs in the event of your death. Supplemental insurance may include coverage you purchase in addition to your basic policy, like life insurance for your spouse or child. You typically buy supplemental life insurance from your employer; however, policies are also available from private agents and insurers.

What Does a Life Insurance Beneficiary Do?

Once you pick what type of life insurance you want, you then need to consider your beneficiaries. Beneficiaries are the people that you want to receive the death benefit from your policy when you pass away. Choosing life insurance beneficiaries is an important step when purchasing a life insurance policy. Beneficiaries can be spouses, children, parents, relatives, or friends, but you can essentially choose anyone. 

However, not everyone names people as their beneficiaries — some name a trust or an estate. People can create a living trust and name it as their life insurance beneficiary so they can ensure that the money is used in line with their wishes. When doing this, it’s wise to work with a financial planner to guarantee everything is set up correctly.

Life insurance beneficiaries can also include:

  • A legal entity or business 
  • A nonprofit organization
  • An estate

Life Insurance Beneficiary Rules

When it comes to choosing beneficiaries, you have a couple of options. You can choose to name a single or primary beneficiary with one or more contingent beneficiaries for your policy. A contingent beneficiary would receive the benefits from your life insurance policy if the primary beneficiary was unable to accept them upon your death. Or you can name multiple beneficiaries as your primary beneficiaries and decide what percentage each will receive if you pass away. 

It’s also important to update and review your beneficiaries regularly. For example, life events such as a marriage or a divorce can impact your decision and affect who you choose. If you have a child, you may also want to update your primary or contingent beneficiaries. To update, contact your life insurance company and ask to submit a change of beneficiary form. 

What Does Life Insurance Cover?

You may be wondering what a life insurance payout can be used for in the event of a death. Once disbursed, beneficiaries can use the money from the life insurance policy for whatever they want. Examples may include:

  • Paying for everyday expenses (groceries, gas, or household essentials)
  • Paying off a mortgage 
  • Paying for outstanding debts
  • Covering burial and funeral costs
  • Paying for a child’s college tuition 

The payment from a life insurance policy can also function as a safety net by ensuring that a family can stay in their home and pay for the things that were planned before the policyholder’s death, such as a child’s education.

How Much Life Insurance Do You Need?

The amount of life insurance you need is dependent on what you’re personally looking for in a policy. If you’re just looking to have your end-of-life expenses covered, you won’t need as much coverage as if you were trying to replace your income for another person or your family once you’re gone.

When you purchase a policy, you’ll need to decide on a coverage amount, which is how much money your beneficiaries will receive upon your death. A good rule of thumb is to get about 10 to 30 times your annual income in coverage. However, this can be a personal choice based on age and family needs.

Life insurance quotes are free, so it doesn’t hurt to price out the coverage you need to see what it will cost you. If it turns out to be unaffordable, you can buy what you can pay for now to lock in a good rate. You can add more coverage later to both term and permanent life insurance — just be aware that down the road, your rate will be based on your age and any health conditions you’ve developed. So, as you get older or possibly acquire health issues, your premiums can become more expensive.

How Much Does Life Insurance Cost?

The cost of life insurance can vary depending on several different factors. A big cost factor will be the type of life insurance you buy. For example, a term life insurance policy is less expensive than a whole life insurance policy for the same amount of coverage because of the length of the policy. 

Here are some of the other most common factors that affect life insurance rates:

  • Age: The younger you are when you buy a policy, the less you’ll pay since your chance of death is smaller when you’re young.
  • Sex: According to the National Center for Health Statistics, females have a life expectancy that is nearly 5 years longer than males. This means that men can generally expect to pay more for life insurance than women (except in Montana, where insurers must provide gender-neutral life insurance rates).
  • Health: Your overall health can have a major impact on your life insurance rates. The insurer will usually look at your past and current medical conditions to help calculate your rate, but it ultimately depends on the type of policy or insurer.
  • Lifestyle: Things like your driving history, criminal record, and dangerous jobs and hobbies can all result in higher life insurance rates.

Also, many life insurance applications require a medical exam, where the insurer will check things like your weight, blood pressure, and cholesterol to determine your overall health. But, when all things are considered, a healthy young adult can expect to pay under $30 a month for a $250,000 policy

Getting life insurance as soon as possible is the best way to get the most affordable policy. Even though buying life insurance does get more expensive as you get older, there’s always a way to get coverage that fits your budget.

How Do I Buy Life Insurance?

The purchasing process can be different depending on the type of life insurance you buy. Typically, you can either get a life insurance policy through your employer or purchase it yourself using a life insurance agent.

If you only need a small amount of coverage, you might want to check and see if your employer offers life insurance as a perk. Employee life insurance can often cover basic end-of-life expenses and may even cover some — or all — of your annual salary. Basic coverage usually doesn’t require an exam and can be free.

If you privately buy a term or permanent life policy from an agent, the insurer typically requires you to complete an application that may require you to take a medical examination to determine your eligibility. If you do qualify for coverage, you’ll usually receive a conditional binding receipt. The underwriting process may take days or weeks to complete before the carrier will issue your policy.

Do I Need Life Insurance?

Like all insurance, life insurance was designed to solve a financial problem and give monetary aid in crisis situations. Life insurance can be a significant benefit to your loved ones because when you die, some or all of your income can disappear. If you have a spouse or kids who are dependent on you financially, they would be left without support if you didn’t have life insurance.

Even if no one depends on your income, there will still be costs associated with your death. Your spouse, children, or relatives would have to pay for your burial and other end-of-life expenses on their own if you haven’t left sufficient funds. People who should consider purchasing life insurance include:

  • Income-earning parents
  • Stay-at-home parents
  • Spouses or domestic partners
  • High-net-worth individuals
  • Individuals with a mortgage 

FAQs

What’s the average life insurance payout amount?

According to Haven Life, the average face value payout for a life term insurance policy is $618,000, which is the amount that would be paid if a claim was submitted due to the death of the policyholder. But, the amount paid out ultimately depends on the type of policy, the circumstances of your death, and the coverage you purchased.

Is life insurance tax deductible?

Life insurance premiums are generally not tax deductible. The Internal Revenue Service (IRS) views your premiums as a personal expense, so you can’t deduct them on your tax return. Life insurance isn’t a requirement by a state or federal government, so there aren’t tax breaks when purchasing a policy.

How long does it take to get life insurance money?

Life insurance companies pay out the death benefit when the insured dies after the beneficiary of the policy files a claim. A beneficiary should be able to collect the life insurance payout within 30 to 60 days after they have submitted the completed forms and supporting documents.

How does life insurance work as an investment?

If you’re a high earner who has maxed out your investments, it may make sense to also add whole life insurance to your portfolio. But for most people, it’s an insurance product first and foremost. But, either way you look at it, life insurance is a good investment monetarily and for your loved ones in the long run.

Final Thoughts: Why Is Life Insurance Important?

Most people don’t have enough savings to cover their family’s expenses for years to come after they die. That’s where life insurance comes in. You can protect your family, even if you don’t have a ton of money in the bank. 

Life insurance provides a plan you can rely on for sometimes as little as $30 a month, and it will ensure your family isn’t left scrambling for funds if something happens to you. Life insurance is a vital part of any financial plan, and over the course of a policy, it costs a lot less than the amount your loved ones would receive once you’re gone.

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