Life insurance may not have crossed your mind before there was a newborn relying on you. But having a baby changes everything.
How life insurance works
Life insurance pays money to a beneficiary — a spouse, for example — when the person insured under the policy dies. The payout is called a death benefit. You list the beneficiary on the policy when you buy coverage.
Here’s an example of how it could work: You buy a $1 million policy insuring your own life and name your spouse as a beneficiary. If you die while the insurance is in effect, your spouse receives the $1 million payout. The money would support the family in your absence, such as paying the mortgage and funding your child’s college education.
Types of life insurance
There are two main types of life insurance: term life and permanent life.
Term life is temporary. Term life is the most affordable kind of life insurance. You can buy a lot of coverage for a low price. You buy a policy to cover a time period, such as 10, 20 or 30 years. If you die during the term, the policy pays the beneficiary. The coverage stops at the end of the term, and the policy pays nothing if you’re still alive.
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Permanent life insurance lasts your entire life. It pays out whether you die next year or in 50 years. Whole life, universal life, variable universal life and indexed universal life are types of permanent life insurance. These policies are more complex than term life because they include an investment component known as cash value. The cash value account grows slowly, tax-deferred.
Once the cash value is substantial — after, say, 15 to 20 years — you can borrow against it, use it to pay premiums or buy additional coverage. You can even surrender the policy for the cash value, minus a surrender fee. Surrendering the policy ends the coverage, and the beneficiary would receive no payout upon your death. Any outstanding loans against the cash value at the time of death will decrease the payout to the beneficiary.
Which type of policy to buy
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Term life insurance is sufficient for most families. It’s cheap, so most people who need coverage can buy enough to create a strong safety net. Buy a term long enough to cover the years when you’re building savings, paying off debts and have the costs of raising a child. Ideally, at the end of the term, you won’t need life insurance anymore because he kids are grown and financially independent, your mortgage and other debts are paid off, and you’ve accumulated enough savings for your spouse to live comfortably in retirement.
Permanent life insurance is useful if you have a lifelong financial dependent, such as a child with special needs. If you’re wealthy, you can also use permanent life insurance as an estate planning tool. Your heirs could use the life insurance payout to pay the federal or state estate taxes. State taxes vary, but in 2017 federal estate taxes are applied only to estates worth more than $10.98 million for a couple or $5.49 million for a single person. (A spouse does not have to pay estate taxes on money inherited from the deceased spouse.)
Think you might need permanent life insurance, but can’t afford it? Most term life policies are convertible to permanent life insurance. You can buy a term life policy and convert portions of it to permanent coverage over time.
Why both parents need life insurance
It’s not just the breadwinner who needs life insurance. Stay-at-home parents should have coverage too, even if they don’t earn income. A stay-at-home parent provides valuable services, such as child care, that the surviving parent would have to pay to replace. A life insurance payout could also enable the surviving breadwinner to take a few years off work while the family regains footing.
How much life insurance to buy
To figure out how much life insurance to buy, think about your family’s financial needs if you weren’t there to support them. Here are four steps:
- Decide how many years of income you’d like a life insurance policy to replace, and multiply your income by that number.
- Add other financial obligations, such as debts and college costs for your children.
- Include the cost of services you provide that would have to be replaced
- Subtract savings and any other life insurance coverage you already have.
NerdWallet’s life insurance calculator takes you through the process and can help you estimate an amount to buy.
When you buy a policy, you name a beneficiary, such as your spouse, to receive the life insurance money. Don’t name your young children, though, even if you want the money to benefit them. If the beneficiary is a minor when you die, the life insurance company can’t pay the benefit until the court appoints a guardian.
Instead, one option is to set up a life insurance trust to hold money and property for your children and name the trust as the beneficiary. You appoint a trustee, such as your spouse or another adult, to manage the trust according to your instructions. An attorney can help you set up a trust, and the life insurance company can tell you how to word the beneficiary designation.
How life insurance is priced
The annual price depends on the type of policy, the amount of coverage and, if it’s a term life policy, the length of the term. Other factors include:
- Age: The younger you are the less you pay.
- Sex: Women generally pay less than men.
- Health: The healthier you are the less you pay.
- Smoking habits: Smokers pay more than nonsmokers.
- Hobbies: People with risky hobbies, such as scuba divers, pay more for coverage.
Life insurance prices vary among companies. You can get term life insurance quotes online, but you’ll want to work with a financial advisor if you’re choosing a permanent life insurance policy.
With life insurance, you’ll know your family will be on solid financial ground if you can’t be there. That might even help you sleep better at night — at least when the baby’s not up.