Providing for your family from beyond the grave is an important part of any solid financial plan, with a cool Obi-Wan Kenobi vibe to boot. To do it, though, you'll have to venture into the confusing world of life insurance.
As your life changes, so do your insurance needs. You may no longer need life insurance, or you might need more. Plus, you might have bought a policy years ago because you were told it was a good investment that would provide income in retirement. How does that fit into your current plan?
Do you still need life insurance?
How would your family get by if you died? Or if your spouse died? If your family members would be financially fine on their own, then you may no longer need life insurance. Generally, there are two important milestones that mark the end of needing life insurance: (1) when your kids are out of the house and you're either single or your spouse's income can support the empty nest, or (2) when you retire.
Do you have enough life insurance?
On the other hand, if you haven't thought about life insurance in several years, your financial needs may have changed. Even if you already have life insurance, your current policy may not provide enough coverage. In that case, you may be able to add to your current policy, buy an additional policy, or replace your old policy with a new, larger one. If you have developed health problems since you last bought a policy, the cost of new coverage may be prohibitively expensive. In that case, you may be able to add to your current insurance or buy additional coverage through a group policy offered by your employer or a professional association.
There are lots of complicated methods out there to calculate how much life insurance you need. However, the simplest formula is to multiply your post-tax income by the number of years your family will need to replace your income.
Tackling term life insurance
If you own term life insurance, you pay an annual premium for insurance that pays a benefit when you die. If you're sure you no longer need the insurance, then the simplest solution is to save money by no longer paying the premiums.
Most policies are sold for five-, 10-, or 20-year terms, and once the term is up, the coverage ends. Generally, once the policy is issued, the term can't be extended at the original rate. However, you may be able to get a new term policy once the current one ends, or convert the term policy to cash-value insurance (keep reading for more). Both will result in higher premiums, but they may be attractive options if the policies don't require a new medical exam.
Cashing in the cash value
Cash-value insurance is a broad label for a breed with names such as whole life, universal life, and variable life insurance. However, they all have one thing in common: They pair life insurance with an investment account, known as the "cash value." If you own one of these policies, chances are you were attracted to the investment component and the fact that it grows tax-deferred -- attracted enough to pay eight to 10 times more than the cost of a term policy with the same death benefit.
If your family would still need the full benefit if you died, keep paying those premiums. However, if the time has come to see the policy as a source of income, here are your options:
- Surrender the policy: The insurer will send you a check for the cash value.
- Take out a loan: You can borrow against the cash value, and it doesn't have to be paid back; the amount will be deducted from the benefit when you die.
- Transfer it to an annuity: An annuity can provide an income stream or continued tax-deferred growth.
- Sell it: An investor might buy the policy from you, paying you to become the beneficiary of the policy.
- Buy a smaller policy: If you want to leave money to your spouse or other heirs but want to stop paying premiums, you can use your cash value to buy a "paid-up" policy, which won't require any more payments but also will result in a smaller death benefit than the original policy.
In most cases, life-insurance proceeds, surrender values, and loans are tax-free. However, there are plenty of exceptions, so talk to an expert before making any moves.
May the insurance be with you
Not having enough life insurance can add hardship to heartache, and not taking advantage of the cash value could waste of all the premiums you've paid. Instead, use it wisely to provide your family security for decades. Obi-Wan would be proud.
Robert Brokamp, CFP, is the advisor of Motley Fool Rule Your Retirement, from which this article has been repurposed.