Takeaways
- Life insurance is a financial product that pays beneficiaries cash payments.
- Over 50% of Americans are covered by at least one life insurance policy.
- 50% of Millennials intend to purchase life insurance within the next 12 months.
- Life insurance is categorized as term life insurance or whole life insurance.
- Life insurance payments can replace lost income, pay off mortgages, car notes, or student loans, and provide a financial cushion to beneficiaries.
What Is Life Insurance?
Life insurance is a contract you buy from an insurance company that provides a death benefit to the policy’s beneficiaries. During the policy term, you pay insurance premiums for coverage. In return, the insurer promises to pay your designated beneficiaries a specified sum of money if you die while the policy is active. The lump sum payment is called the life insurance death benefit.
Life insurance beneficiaries can include your spouse, children, parents, or siblings—really, any person or entity you choose. Life insurance is intended to help cover the costs of losing a salary, pay off long-term debts like your mortgage, or pay for your children’s college.
Policyholders get life insurance mainly to support those who depend financially on them and cover their final expenses. Life insurance was initially designed to cover burial costs for grieving families. Today, life insurance has morphed into a crucial financial safety net that gives families financial stability.
According to a recent study by the Insurance Information Institute, roughly half of Americans have life insurance policies. And a record number of younger adults, Millennials and Gen Z, are looking to purchase life insurance within the next year. [1][2]
Let’s explore how this financial product actually works.
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How Life Insurance Works
Life insurance works like many other types of insurance. You research the best insurance provider and policy you can secure and enter into an agreement with the insurance company. From there, you pay premiums based on a range of factors like age, health, and coverage level. In exchange, your insurer will pay your beneficiaries a death benefit if you pass away while the policy is active.
The policyholder pays life insurance premiums to keep the policy active. If the insured person dies, the insurance company pays a cash payout to the beneficiaries.
Notably, the policyholder can be different from the beneficiary and the insured person. The person or entity that holds a life insurance policy and pays the insurance premium gets to designate the policy’s beneficiaries.
Life insurance policies will typically remain valid as long as you pay the premiums on time and meet any additional stipulations set in the policy. Some policies also include a cash component that builds in value over time. If you stop paying, the coverage could end, and no death benefit would be paid.
There are two main types of life insurance plans:
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Permanent Life Insurance
Permanent life insurance lasts for your entire life as long as premiums are paid. There are several types of permanent insurance, including:
- Whole Life Insurances
- Universal Life Insurance
- Variable Life Insurance
- Variable-Universal Life Insurance
The benefit of permanent life insurance is that each premium payment goes toward building up your policy’s cash value. And depending upon your policy, your cash value will earn interest at a fixed or variable interest rate. (Read more about how APR works).
After accumulating enough cash value in your permanent life insurance policy, you can tap into it. Many policies allow you to use it as a piggy bank. You can borrow from it, use your accumulated interest, or make withdrawals.
Tapping your life insurance policy could complicate your taxes. Talk to your tax advisor or professional about how accessing these funds could affect your annual tax filing.
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Term Life Insurance
Permanent life insurance lasts for your entire life as long as premiums are paid. There are several types of permanent insurance, including:
- Whole Life Insurances
- Universal Life Insurance
- Variable Life Insurance
- Variable-Universal Life Insurance
The benefit of permanent life insurance is that each premium payment goes toward building up your policy’s cash value. And depending upon your policy, your cash value will earn interest at a fixed or variable interest rate. (Read more about how APR works).
After accumulating enough cash value in your permanent life insurance policy, you can tap into it. Many policies allow you to use it as a piggy bank. You can borrow from it, use your accumulated interest, or make withdrawals.
Tapping your life insurance policy could complicate your taxes. Talk to your tax advisor or professional about how accessing these funds could affect your annual tax filing.
What Does Life Insurance Cover?
The monetary benefit paid by life insurance can be used for nearly anything your beneficiaries need. It helps close the financial gap created when you are no longer there to provide for your family and loved ones.
The funds can be used to pay for day-to-day expenses, like groceries or rent, to settle outstanding debts like a mortgage or auto loan, to help cover the final costs related to your funeral, to invest for your family’s future, or to be used in countless other ways. Proceeds from your life insurance policy can be used to pay for almost anything.
Ultimately, your beneficiary distributions should be a financial cushion for your family. That’s why it is essential to understand your coverage amount and ensure it accurately reflects your family’s needs if a death benefit is paid.
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Life Insurance Terms to Know
To effectively research your insurance policy, you should understand these terms:
1. Insurance Premiums
Insurance premiums are the periodic payments you make to your insurer to keep your life insurance policy active. You may be paying premiums monthly, quarterly, or even yearly.
Factors like general health, family history, age, sex, occupation, and more determine your premiums. If you develop a chronic illness after purchasing a policy, your premiums usually stay the same, but future policies will likely cost more.
2. Policy Benefits
Insurance benefits are the coverage and features that your policy will provide. These can include the monetary benefit paid on death, optional riders, and sometimes even a cash component.
Be sure to review your policy details to ensure that you understand exactly what you are getting and are aware of any applicable limits.
3. Death Benefit
The death benefit is the sum of money the insurer pays your beneficiaries when an insured person dies.
The policy’s death benefit can vary significantly based on your specific policy, ranging from thousands to millions of dollars. Most policies contemplate paying out a multiple of your annual compensation. For example, if you earn $250,000, your policy might pay out a 4X multiple, or $1,000,0000.
Your death benefit is usually tax-free, though you should verify this in the context of your finances with your trusted tax professional.[3]
4. Insurance Riders
Insurance riders are a la carte options that can be added to your life insurance policy to provide extra coverage, features, or benefits.
Popular insurance riders include accelerated death benefit riders, which allow you to access some money early if your condition is terminal, and a waiver of premium rider, which can cover your premiums if you become disabled or cannot work.
Read More: 6 Types of Life Insurance Plans to Know
When To Get Life Insurance
Many people sign up for life insurance when they have children, dependents, or other significant financial responsibilities.
You might consider getting coverage when you are:
- Getting Married
- Purchasing Your First Home
- Starting a Business
- Having Children
- Supporting Family Members
Remember, the earlier in life that you purchase life insurance, the lower your insurance premiums will be for the length of your policy.
How Much Does Life Insurance Cost?
The cost of your life insurance policy (corresponding monthly premiums) will vary wildly depending on your age, size of policy, and lifestyle choices. As you grow older, premiums generally increase as the probability of a claim rises.
- Smart Money Tip: A 20-year, $500,000 term life policy through Fidelity for a healthy 30-year-old male is $21.25 per month (terms apply and rates vary).[4]
When it comes to pricing your life insurance, many variables are at play. For example, you can also face higher premiums if you have lifestyle choices that are considered higher risk, like smoking or drinking alcohol.
It is always a smart money move to get quotes from multiple insurers to find the best one for you and your family.
Smart Summary
Life insurance is a financial product that pays beneficiaries cash when an insured person dies. Personal finance experts advocate getting life insurance policies independently or through employer-sponsored plans. Life insurance plans are an integral part of a well-balanced financial plan. Protecting your beneficiaries and giving yourself peace of mind is a smart money move.
Resources:
(1) LIMRA. Securing the Future. Last Accessed February 7, 2025.
(2) Insurance Information Institute. Facts + Statistics: Life insurance. Last Accessed March 7, 2025.
(3) Internal Revenue Service. Life insurance & disability insurance proceeds. Last Accessed February 7, 2025.
(4) Fidelity.Term life insurance – Insuring their future starts here. Last Accessed February 7, 2025.
