How Does Life Insurance Work? [Complete Guide]

life insurance

If you’re struggling with your finances, any form of insurance may seem like a waste of money. However, there are certain types of insurance that may be absolutely necessary.

Life insurance, for example, is a form of insurance that is not mandatory. Because of this, many people avoid spending extra money on life insurance to save money. However, is this the best place you should cut back on your spending?

Table Of Contents show

What To Expect:

This post is an in depth analysis of how life insurance works and the different types of life insurance available to you. It will cover:

  • How Life Insurance Works
  • What Happens To Your Term Life Insurance If You Outlive It
  • Life Insurance Payouts And Taxes
  • Should You Get Life Insurance
  • If You Want Life Insurance, How Do You Get It
  • Medical Issues Life Insurance Does Not Cover
  • How To Decide What Insurance To Buy
  • The Type Of Life Insurance I Have For My Family

Life Insurance: An Overview

Auto and health insurance have been mandated, on some level, by either state or federal governments. Life insurance, however, is optional. Even though this type of insurance is optional, if you have people who depend on you, I highly recommend you have some level of life insurance coverage.

Life insurance is a unique type of insurance because it doesn’t necessarily protect you as the policyholder. It is more beneficial to your loved ones in the event of your death.

However, there are certain types of insurance you can benefit from while you are alive if you’re willing to pay extra. Features such as living benefits, the return on premium or cash values can be beneficial to you while you are still living.

In cases where you have an investment feature attached to the policy, such as a universal indexed policy or a variable universal life policy, you can use cash from the investment piece of the policy while you are still alive.

Life Insurance Basics

Life insurance is an agreement between you and the insurance company that states in the event of your death, they will provide death benefits to your designated beneficiary. This contractual agreement stipulates that as long as you make the monthly payments, known as premiums, your designated beneficiary will receive a lump-sum, tax-free payment in the event of your death.

Life insurance is obtained by individuals based on specific needs. Ultimately, the goal is to provide for loved ones long after you leave this earth. Individual needs vary from person to person, and the types of policies that are purchased come in different forms.

There are term insurance policies (coverage for a certain amount of time) and policies that cover you for your whole life. Also, generally, any benefits received by a beneficiary are not taxed upon disbursement.

How Life Insurance Works

life insurance infographic

As mentioned earlier, life insurance is a contractual agreement between the insured and the life insurance company. The agreement stipulates that the insured pays regular monthly premiums in exchange for the insurer paying a lump sum of money to a designated beneficiary if the policyholder dies during the contract.

Term Life Insurance

There are different types of life insurance policies. One type of life insurance policy is a term life policy. The other kind of policy is a whole life policy that covers the insured for their entire life.

With a term insurance policy, if the insured dies within the term limits agreed upon in the contract, the beneficiary is entitled to the amount of the insurance policy or the face value. For example, if you take out a 20-year term life insurance policy and die after 18 years, your beneficiary is entitled to the full payout.

If, however, you die one day after the 20-year contract expires, your beneficiary would not be entitled to a payout if the term policy was not extended. There are alternative types of term life insurance policies that we’ll cover later.

Term life insurance is, by far, the cheapest type of life insurance available.

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Whole Life Insurance

For a whole life insurance policy, an individual covered under this type of insurance policy is covered for their entire life as long as they are current on their payments. Going back to the term life example, if a person purchases a whole life insurance policy at the age of 25 and due to an unfortunate event this person dies at the age of 65, they are still covered.

In this example, 40 years have elapsed since the individual purchased the insurance policy. Even though 40 years have gone by, any beneficiary listed on this insurance policy would be entitled to an insurance payout.

Whole life insurance can be very expensive depending on the amount of coverage you purchase.

Term Life Insurance Better Than Whole Life?

Does Everyone Need Life Insurance?

People should only buy life insurance under the following circumstances:

  • People depend on them financially and their death would substantially impact the quality of life for those left behind
  • They are not “self insured,” meaning they do not have a large enough nest egg to pay off outstanding debts that may be transferred to heirs

Single People

If you are single and people do not depend on you financially, there may be no reason for you to purchase life insurance. If you have a pension or nest egg that would be able to financially take care of any heirs or spouses upon your death, you may not need life insurance.

Children

Children do not need life insurance policies unless the parents would need the money for funeral arrangements.

Stay At Home Moms

In our household, I am the primary income earner. My wife stays home and does not provide any income. However, we have a substantial life insurance policy on my wife.

Why?

If my wife were to pass away, I would have to pay for daycare and other expenses that my wife does “for free.” By staying at home with the kids, my wife saves us a ton of money and she is worth her weight in gold.

Just because someone doesn’t earn an income, doesn’t mean they don’t contribute financially to the household.

How Life Insurance Works If You Outlive Your Policy

Outlive term life policy

This is an excellent question and goes back to the previous statement regarding term life insurance policies. Typically with a term life insurance policy, if you outlive the term of the insurance policy, you forfeit all of your premium payments.

Adding Riders To Term Insurance Policies

Since insurance policies are a way for individuals to plan for the future, some people believe term life insurance is unwise. To alleviate forfeiting term life premiums, there are options to attach specific “riders” to term insurance policies. This can protect the contract holder in the event they outlive their policy.

Return Of Premium Rider

One rider that can be added to a term life insurance policy is a return of premium rider. This protects the insured in the event they outlive the term of the policy.

For example, imagine a 46-year-old individual purchased a 20-year term life insurance policy at the age of 20. This person would have outlived their 20-year term policy by six years if they did not purchase another policy.

Some people believe this creates an unfavorable scenario when that individual lives beyond the 20-year term and forfeits all of the premiums they paid over 20-years. Using this example, let’s calculate the math.

If you have an individual that has purchased a 20-year term policy that equates to 240 payments. If that person paid $50 per month for the term life insurance policy, they would have paid a total of $12,000 for that 20-year time frame. Any consumer who has paid $12,000 only to see it “go down the drain” may not be happy with this scenario.

Implementing a return of premium rider would make provisions to return the $12,000 to the insured at the end of the 20-year term. Keep in mind that a return of premium rider is optional. Most consumers purchase term life insurance policies because they are cheaper and more cost-effective than a whole life policy.

To incur an additional cost while protecting yourself after your term has expired is an option – but it may not be the best one.

Accelerated Death Benefit Rider

There are other features of a term life insurance policy that can protect an insured while they are living. Having a living benefit rider protects individuals in the event they become ill with a chronic illness. These riders are more commonly referred to as accelerated death benefits.

This type of rider covers individuals if they become chronically, critically, or terminally ill. In some instances, insurers can advance up to 90% of the face value of the insurance policy to help cover the cost of medical care, treatment during an illness, or any cost related to long term care.

Before you purchase an accelerated death benefit rider, look into your basic term life policy. Some of these contracts include accelerated death benefits.

Can You Outlive Whole Life Insurance?

If you have a whole life policy, this point becomes mute because this type of policy covers you for your entire life. If you have a term insurance policy, outliving the term of the plan may not benefit you. If you have a straightforward term life insurance policy and you outlive it, essentially, you will forfeit all of the premiums that were paid during that term.

With riders such as the return of premium or accelerated death benefits, you get the most protection in the event you outlive your life insurance – but it will cost you.

Life Insurance Pay Outs

money coins pay off debt early, life insurance payout

Ultimately, the purpose of purchasing life insurance is to protect your family and loved ones in the event of your death. Insurance policies help to provide for your loved ones financially when you die.

With that being said, there are instances when insurance policies do not pay out. It is essential to understand what is in your contractual agreement with your life insurance company. Such instances include:

Suicide

Some insurance policies include a suicide clause. This means, if you commit suicide within a specific time frame of your insurance policy, your loved ones do not receive any death benefits. At most, your loved ones would receive the premiums that were paid towards the plan.

Usually, there is one to two years for a suicide clause.

Smoking And Other Health-Related Issues

During the application process for your insurance policy, there are several questions that are asked of you before the issuance of the policy. Most of these questions pertain to your daily habits such as smoking, your occupation, or any hobbies that would put you at risk.

If you are a smoker and failed to disclose this information on your insurance application, the insurance company has the right to cancel your policy and deny any death claims.

Dangerous Activities

If you are a higher risk applicant or someone who participates in high-risk hobbies such as skydiving or bungee jumping and failed to disclose this in your policy application, this could cause your insurance policy to deny any claims.

You are still able to obtain coverage, but you would need to list the hobbies on your application and possibly pay a higher premium to be protected.

Illegal Activities

If you die while committing a crime, you can forget it. Something as simple as trespassing may make your beneficiaries ineligible to receive a payout if you succumb to a life-ending injury during a crime spree.

Act Of War

This clause is intended for individuals who are in war zones regularly or individuals who travel to regions of the world that have armed conflict. In such cases, your claim could be denied.

Living Outside Of The United States

There may be a clause in your life insurance policy that does not pay benefits if you decide to move outside of the United States. Before signing your insurance policy, you must read the details to make sure you are covered whether you live in or outside of the United States.

Fraud

Presenting false information on your insurance application could be considered fraud.

Anytime there is an insurance claim that is filed for life insurance benefits, the insurance company is sure to investigate the cause of your death. If the insurance company finds certain health conditions or activities more prevalent for an extended amount of time, your death claim could be denied.

Life Insurance Payouts And Taxes

social security tax How Does Life Insurance Work? [Complete Guide]

In short, beneficiaries are not taxed on life insurance payouts. According to the Internal Revenue Service, life insurance payouts are not required to be declared as gross income. Typically, any death benefits are distributed tax-free to beneficiaries.

There is a caveat to this question. If there is interest earned on the death benefits, the interest is subject to taxation. For example, if the policyholder elected to hold a payout for a certain amount of time as opposed to having the benefits paid out immediately, the interest that accumulates is taxable.

If the beneficiary of a life insurance policy dies before the policyholder, the payout goes to the policyholder’s estate. The person who inherits the policyholder’s estate may have to pay estate planning taxes or inheritance taxes at a later time.

In general, a life insurance payout is not taxable. However, there are instances where taxes do need to be considered. In such cases, it is wise to seek the advice of a tax professional.

Life Insurance Payouts – Lump Sum?

Not surprisingly, many beneficiaries prefer to have a lump sum settlement. While this is the preference of many, it is not a requirement. There are other options for settlement of life insurance payouts.

Interest Option Payout

With this option, the insurance company holds the proceeds and pays the beneficiary interest payments that are earned at regular intervals.

Fixed Period Option

With this option, the insurance company pays the beneficiary a set amount for a fixed period that includes the interest payments and the proceeds of the policy.

Fixed Amount Option

The insurance company pays the beneficiary a set amount over a fixed amount of time that includes the proceeds and the interest. With this option, the proceeds are paid out until the funds are completely depleted.

Annuity Option

With this option, the insurance company pays the regular beneficiary payments over the beneficiary’s entire life.

All of these options can be combined based on the beneficiary’s choice. For example, if the recipient is close to retirement, they could choose to receive a fixed period option for the initial payout. After they retire, they can elect to receive the payment in the form of an annuity where the money is paid to them for the remainder of their life.

How Does Life Insurance Make Money?

With the vast amount that an insurance company pays out for premiums, one would think insurance companies could go broke by paying out a few premiums per year. The fact of the matter is people die every day. So how do insurance companies make enough money to pay these policies for beneficiaries?

Insurance companies, just like any other company, are for-profit businesses. Insurance companies take a portion of the premiums that are paid monthly by policyholders and invest them in the stock market, bonds, or even bond yields. This type of investment ensures they can make money on your money.

Theoretically speaking, if you have an individual who has paid a $1,000 annual premium over 20 years, this equals $20,000 in total premiums. If the policyholder dies during that 20-year term, the insurance company is contractually obligated to pay the face amount of that insurance policy to the beneficiary.

If the policy holder outlives the 20 year contract, the company not only keeps the $20,000 but they also made interest on the money over the 20 year time span.

For example, let’s take the 46-year-old individual who has a 20-year term policy. Over the 20 years, they paid $1,000 per year in premiums. This would total $20,000. If the face value of the insurance policy is $100,000, the insurance company is contractually obligated to pay the $100,000 to the beneficiary even though they’ve only received $20,000 in premiums.

Since insurance companies are a for-profit business, they find ways to invest those premiums over time, so they can afford to pay death benefits to beneficiaries.

Is Life Insurance Worth Getting?

pros and cons of life insurance

The thought of leaving your spouse and children with a substantial financial burden upon your death is one that is unbearable for many consumers. Life insurance is an excellent idea to protect your loved ones from the financial burden that’s left behind when you die.

For example, if a husband and wife make a combined annual income of $150,000 per year and one of the spouses passes away unexpectedly, the household income may be cut in half. Life insurance helps to protect against the financial devastation caused by the death of a loved one and helps to make up for the loss of income that’s incurred when someone passes away.

Life insurance can also be used to plan for the future.

Even though term life insurance is more affordable than whole life, some whole life policies come with investment features that allow you to plan for your financial future. Whole Life policies such as an index universal life insurance policy have an insurance feature but also has an investment feature that allows you to pay towards your retirement or other unexpected costs that could arise in the future.

The main goal of obtaining insurance is to protect your loved ones when you pass away. When deciding to purchase a life insurance policy, there needs to be questions that are answered to ensure you’re making the best decision for your family long after you’re gone.

The main mistake most consumers make is not getting enough insurance to protect their families. When obtaining an insurance policy, it is vital to determine monthly expenses and other financial obligations that still occur after you passed away. It is always best to consult with an insurance professional to determine how much insurance is needed but a general rule of thumb is to have 10x your annual salary in life insurance.

What Age Should You Get Life Insurance?

Keep in mind, life insurance premiums are calculated on many factors. One of the main factors is age. The older you get, the more likely you are to have higher premiums every month.

The average age of an individual to purchase life insurance is 35. While this is the average age, some parents buy life insurance for minors by purchasing a permanent or whole life insurance policy for a lump sum. The more popular choice for life insurance is for adults to buy a policy for themselves to protect their families.

As we grow older and circumstances in life change, it is crucial that we change our plans as we change. If you are at the average age of 35 and single, a lot could change by the time you turn 38.

At the age of 38, you can have a wife, 2.5 kids, a dog, and a mortgage. The need for a life insurance policy would be different for a 35-year-old single individual; then it would be for a 38-year-old person married with more financial obligations.

The Average Life Insurance Premium

The average amount of a life insurance policy is contingent upon the age when the person purchased the policy. The younger the age, the lower the premiums. When individuals decide to buy a life insurance policy, they often look at the monthly rate and then work backward.

For example, if a 25-year-old female has a choice of a $50,000 insurance policy versus a $100,000 insurance policy, they would typically look at the monthly premiums and how much it would cost to maintain that policy over the term of the contract.

For a 25-year-old individual, a $250,000 term life insurance policy on average would be $16.02 per month. For a $500,000 policy, the monthly payments would be $24.63 per month. These are average quotes for these life insurance amounts.

Life Insurance Claims Can Be Denied

denied life insurance

There is always a chance that a claim can be denied by an insurance company. It is an unfortunate event, but it does happen. It is important to understand the reasons why life insurance claims can be denied and how you can avoid this occurring.

Within a life insurance policy, there is a contestability period. This is a provision in the insurance policy that gives the insurer enough time to investigate information that was gathered during the application process. Typically, this period is between 2 to 3 years and is mandated by state law.

During this period, if the insurance company finds any misrepresentation of information in the application process or omission of serious information, this gives the insurer the ability to void the insurance policy. If during that time, a policyholder dies, the insurance company can deny an insurance claim.

Failure to disclose relevant information is grounds for a claim to be denied. If certain pieces of information are discovered to be missing from the application during the contestability period, the insurance company can use that as grounds to deny a claim. For example, if you fail to disclose a visit to your doctor for a severe medical condition, the insurance company could use this to deny the claim.

Failure to pay your policy premiums will cause your claim to be denied. It is an unfortunate situation when a beneficiary believes they are going to receive financial relief through a payout of an insurance policy only to find you did not maintain your part of the contract by making the premium payments.

How Long Should Life Insurance Should Last

Term life policies come in a variety of lengths. Generally, term life policies come in 10, 20, or 30-year timespans. The goal of life insurance is to cover your beneficiaries financially. If you will be able to get out of debt, pay off your mortgage, and retire within 30 years, this may be an appropriate amount of time.

If you can self insure in less than 30 years, you can opt to purchase a smaller time frame. The goal is to attempt to predict when your loved ones will be protected by the nest egg you have accumulated and the lack of debt.

Whole Life policies are different as they cover the insured for their entire life. Therefore, you do not need to predict how long you will need insurance.

Can You Cash Out Life Insurance?

A whole life insurance policy, that has a cash value, that can be utilized for a cash benefit. You can withdraw a limited amount of cash against these types of life insurance policies. Keep in mind, there may be a 10% early withdrawal penalty depending on your age. The cash withdrawal is usually tax-free as long as you withdraw less than the total amount of the premiums paid into the policy.

Cash withdrawals from your life insurance policy should not be taken lightly. If you’re financially strapped for cash, being able to cash out on a life insurance policy can come in handy. Keep in mind that any amount you withdraw from your cash policy will reduce the benefits when you die.

The sole purpose of purchasing a policy should be to protect your loved ones you leave behind when you die. You want to make sure you’re leaving your spouse, children, and any other beneficiaries enough money to be financially stable for a certain amount of time.

Getting Your Money Back If You Cancel Your Policy

get cash back

If you have a term life policy, the chances of getting money back if you cancel your insurance policy are slim to none.

Term Life Free Look Period

The free look period of an insurance policy is a stipulation within the insurance contract that allows an insured to cancel the policy if they change their mind. In essence, it is for consumers who have buyer’s remorse. If you cancel your policy within the free look period, any premiums you paid into the insurance policy will be fully refunded.

The free-look period can range from 10 to 30 days. It is important to check the terms of your insurance policy to determine how long your free-look period is.

Whole Life Cancellation

With a whole life policy, the forfeiture terms are much different than for a term life insurance policy. The amount of money you could receive back depends on how long you had the policy and the stipulations outlined within the insurance contract. Since whole life insurance policies have a cash value, it is likely you would receive some of your money back if you decide to cancel your insurance policy.

Canceling a whole life insurance policy is a decision that you should not take lightly. Cancellation of the policy can be subjected to future higher fees from the insurance company, so it is wise to think long and hard before you make the final decision to do so.

Does Life Insurance Check Medical Records?

Most insurance companies will accept the information that is provided on an insurance application by an applicant without requiring medical records. Often, insurance companies want to know basic information about you that includes:

  • Height
  • Weight
  • Date of birth
  • Lifestyle habits
  • Annual income
  • Other financial information

When answering the questions on a life insurance application, it is important to be as honest and as truthful as possible. If an insurance company finds out later that you’ve lied about a piece of information that is pertinent to their risk assessment of you, they can cancel your policy or deny a claim when your beneficiaries file a death claim.

When Medical Examinations Are Needed

There are some instances when insurance companies may require an in-person physical examination. Some insurance companies require you to schedule a medical exam if you’re trying to purchase a policy over a certain amount.

For example, if you’re trying to purchase a policy over $150,000, it is not uncommon for insurance companies to require this type of examination. The examination is arranged by the life insurance agent and is performed by a licensed healthcare professional that is appointed by the insurance company.

These examinations are flexible because the health care professional can meet you at a location that is convenient for you. During the physical examination, the healthcare professional will get relevant information on your medical history, such as medications, surgeries, or any existing medical conditions.

You will be asked about any family health history issues and take your blood pressure. Also, they will listen to your heartbeat, check your weight and height, draw blood, and get a urine sample. During their discussion, they will ask you about any lifestyle habits that could affect your health. Again, no matter how the application is taken, it is important to be as honest and as truthful as possible.

The Type Of Life Insurance I Purchased

life insurance for my family

Right now, I am 36 years old, married with three kids. I am the sole income earner for our family, and my wife is a stay at home, mom, and wife. If I were to die today without life insurance, my wife would struggle to maintain our family’s current quality of life.

My house is not entirely paid off, and my nest egg is about 1/3 of where I want it to be when I retire. Due to this, I needed to purchase term life insurance for my family.

I purchased the maximum amount of term life insurance I could through my employer. I was able to buy a $250,000 term life plan that is in place while I remain employed. This $250,000 is exceptionally cheap and costs about $9 a month for me.

Even though my wife doesn’t provide monetary income, if she were to pass away, it would be challenging to pay for daycare and all of the other services she offers for “free” on a daily basis. Because of this, we also got a $200,000 term policy on her through my work for a similar amount.

I also recognized that $250,000 might not last very long with a mortgage and monthly expenses, so I purchased an additional $750,000 20 year term plan outside of my work. The extra $750,000 is about $30 a month.

You read that right, I have a 1 million dollar policy on my life – and my wife hasn’t killed me yet!

I recommend having 10x your annual salary in term life insurance for proper coverage

What We Would Do With Our Life Insurance Payout

If my wife passed away, I would use a portion of the $200,000 to pay off my home completely. The rest I would use to fund daycare and other child-related expenses.

If I suddenly died, my wife will pay off the home and invest much of the 1 million dollars so she can live life off the interest. Also, it will give her some breathing room so she can find a job if she wants.

How long will 1 million last? If you were to invest 1 million dollars in the stock market, you would receive an average annual return of $80,000. With a paid-off house, she could easily manage off this amount.

Why I Chose A 20 Year Term Life Policy

The reason I chose a 20-year term policy was due to my current financial position and a bit of forecasting. When my 20-year term policy expires, I will be 55 years old. I should have everything paid off and a substantial nest egg as well as my pension at that time.

With a paid-off house, large nest egg, and pension, there would be no reason for me to have life insurance. At this time, I will be self-insured, and my wife will easily be able to survive with the same quality of life we currently maintain.

Need Life Insurance? Follow These Steps

First and foremost, check with your employer. Many employers have life insurance as part of their benefits package they offer at reduced costs. This is usually the best way to get the first part of your life insurance.

Online searches are one of the best ways to find life insurance policies that are right for you if you need additional insurance. With an online search, you’re able to shop multiple insurance providers simultaneously without having to make numerous phone calls or drive to various locations. This can be a more convenient option for individuals who don’t want the headache and hassle of talking to multiple insurance agents.

For instance, a company that has sponsored Arrest Your Debt is PKA Insurance. On their website, you can get instant term life insurance quotes from over 30 companies.

life insurance company

Wrapping It Up

If you have a family and people who rely on you or your income, what would happen to them if you died today? Not only would they be left to pick up the pieces but they would also need to figure out how to pay the bills in an emotionally difficult time.

In the worst-case scenario, make sure you protect your family if you are suddenly taken from this world. Term life insurance is very cheap and should be included in your budget as a need if your family heavily relies upon you financially.

Evaluate your current financial situation and decide whether life insurance is right for you. If it is, check with your employer and other companies to get the proper coverage and best rates possible.

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