How Does Life Insurance Work?

Life insurance is a financial instrument designed to provide a safety net for your loved ones when you're no longer around to support them. It's a contract between you and an insurance company, where you agree to pay premiums in exchange for a lump-sum payment, known as a death benefit, to your beneficiaries upon your passing. Beyond providing immediate relief for funeral costs and debts, it can replace lost income, fund your child's education and even contribute to estate planning.

Selecting the right coverage involves weighing multiple factors. Understanding the ins and outs of life insurance is also essential for making decisions that will best secure the financial future of your loved ones.

Life insurance offers financial protection for your loved ones in the event of death. You pay regular premiums to keep the policy active, and in return, the insurance company promises a tax-free death benefit to your chosen beneficiaries. There are various forms of life insurance policies, primarily term and permanent, each with its own set of rules and benefits.

According to the Life Insurance Marketing and Research Association (LIMRA), around 52% of adults in the United States have life insurance. Despite this, 41% of American adults believe they don't have enough life insurance coverage.

Finding the best policy and the right coverage requires careful consideration of your circumstances. Knowing what life insurance is, the different policies available and factors affecting life insurance premiums can also help you determine whether buying life insurance suits your needs.

Life insurance is a contract between you and your insurance company. Most people purchase life insurance because it assures them their families will have something to fall back on after they have passed.

As with all insurance policies, you need to pay premiums to maintain coverage. In exchange, insurers pay a tax-free lump sum to your chosen beneficiaries upon your passing, who then have the freedom to use the amount in several ways. Death benefits can help pay for funeral expenses and burial costs, as well as household bills or mortgage payments. Some policies offer living benefits, which means you can access a portion of your death benefit while you’re still alive.

Your premium depends on several factors, such as coverage limits, policy length and your unique attributes.

Life insurance policies come in two main types: term and permanent. Regardless of which you choose, your beneficiaries will receive death benefits if you die while the policy is active. Another similarity is the premium — it remains the same throughout.

What sets these two apart are cost and length. Term life insurance covers you for a specific amount of time for affordable rates. If you outlive your policy, your beneficiaries don’t receive a cash payout.

Permanent life insurance offers coverage that lasts your entire life. It also allows for a cash-value account, wherein a portion of your premium is set aside and grows over time. Once you accumulate enough cash value, you can begin borrowing against it, allowing you to benefit from the policy while you’re still alive. These characteristics make permanent life insurance more expensive.

Term life insurance provides temporary coverage. You determine the length of the policy upon purchase. Temporary does not necessarily mean short. Term life insurance typically covers 10-, 20- or even 30-year periods. Compared to a permanent policy, term life insurance is more affordable. Its lower premiums are a result of providing temporary coverage.

If you’re only looking for coverage for short-term needs, such as educational costs or your mortgage, term life insurance may be a logical choice. It is also a good option if you want affordable coverage. If you’re young and healthy, term life insurance may be your cheapest option.

Once your policy expires, you can choose to let it go if you feel you no longer need the coverage, renew it or convert it to a permanent policy.

Permanent life insurance provides coverage for your entire lifetime. It guarantees your beneficiaries will receive death benefits regardless of when you die. Because of this, it costs significantly more than term life insurance.

However, it includes an investment component. It means you don’t only get coverage, but you also get additional financial support through that component. This type of policy builds cash value over time. Once the cash value reaches a sizable amount, you can borrow against the account.

You may find permanent life insurance a better option if you want your policy to double as an investment vehicle. It’s also a better choice if you have a lifelong dependent, like a child with disabilities. Make sure you’ll be able to afford the premium for the long term since these are more expensive plans. Your policy may lapse if you miss payments.

The primary benefit of life insurance is the financial support your family receives if you unexpectedly pass away while the policy is in effect. It's referred to as death benefit. Insurers will pay a tax-free lump sum to your beneficiaries.

Some policies allow you to take advantage of your coverage while you're still alive. These are called living benefits. They often have secondary benefits, some of which are:

• Accelerated Death Benefits: Your insurer pays out a portion of your policy if you are diagnosed with a terminal illness.
• Return of Premium: Your insurer returns all premiums you paid while your policy was in effect if you outlive it.
• Cash Value Withdrawal: When you access a portion of the cash value of your permanent life insurance policy.
• Long-Term Care Benefits: Access the death benefit to cover long-term care expenses your health insurance policy doesn't cover.

It's worthwhile to be aware of the different benefits your life insurance policy can provide depending on your life circumstances.

Your policy’s coverage amount translates to how much your insurer pays out as a death benefit. There’s no standard coverage amount for life insurance, but the more common policy face values are $100,000, $250,000 and $500,000.

Your appropriate coverage amount depends on your financial situation. You can use the DIME method to estimate how much coverage you should purchase. It covers the following:

• Debt: How much debt would you be leaving for other people to pay? Include loans you’ve taken out.
• Income: Multiply your current income by the number of years you want to provide income replacement for your loved ones.
• Mortgage: How much is your current mortgage balance?
• Education: Consider how much college tuition, room and lodging costs.

Overall, a higher amount means your loved ones receive more financial support, but it also means you pay higher premiums.

Insurers don’t automatically pay out death benefits. Beneficiaries must trigger the process by filing a claim. They will need to complete forms and provide evidence about the cause of death.

Insurance companies typically require a copy of the policy and a filled-out claims form. Beneficiaries must also provide a copy of the death certificate, which must be certified through the county, municipality or hospital where the policyholder died.

Most insurers will pay out death benefits within 14–60 days from beneficiaries filing a claim. The company will make payments through a lump sum or an annuity, which pays monthly or annually.

Several situations cause delayed payouts, such as the insured dying within two years of the policy’s issuance or the cause of death being homicide. Other reasons include omitting known health issues or engaging in risky activities.

Life insurance generally covers death due to illness, accidents and natural causes. Here's a detailed look at what a typical life insurance policy might cover:

• Death by Illness or Accident: The policy pays out if you die due to an illness or accident.
• End-of-life Expenses: Funeral and burial costs can be covered, easing the financial burden on your family.
• Estate Planning Costs: If you have a large estate, life insurance can cover taxes and legal fees.
• Monthly Bills and Mortgage Payments: The death benefit can help your family maintain their standard of living by covering ongoing expenses.
• Income Replacement: The death benefit can serve as income replacement, ensuring your family can maintain their current lifestyle even in your absence.
• Educational Expenses: You can allocate the death benefit to cover tuition fees and other educational expenses, ensuring that your children's future remains secure.
• Debt Repayment: You can use the death benefit to settle debts, such as mortgage, car loan or credit card debt, preventing the financial burden from passing onto your family.

The scope of your coverage will vary depending on the policy.

While life insurance offers broad coverage, it's not a catch-all safety net. Here are some common exclusions:

• Pre-existing Conditions: Some policies may not cover deaths related to pre-existing medical conditions if the policyholder did not disclose them during the application process.
• War and Terrorism: Most life insurance policies do not cover deaths that occur due to acts of war or terrorism.
• Hazardous Occupations: Insurance companies consider some occupations hazardous, and deaths related to these occupations may either increase the premium or lead to certain exclusions. Examples include miners, loggers, fishermen, firefighters, police officers and construction workers.
• Death by Suicide within the First Two Years: Most policies won't pay out if the policyholder dies by suicide within the first two years.
• Insurance Fraud: Providing false information on your application can lead to a denial of the death benefit.
• Specific Exclusions: Some policies exclude deaths due to risky activities like skydiving or car racing.

Remember to thoroughly check your policy's terms to familiarize yourself with its exclusions.

Before purchasing a life insurance policy, learning about its tax implications would allow you to make sure it aligns with your overall financial plan.

Death Benefit

Suppose you are a beneficiary receiving a death benefit from a life insurance policy due to the insured person's death. In that case, the amount you receive is not considered taxable income. You don't have to include it in your gross income, nor do you have to report it on your tax return.

Interest Earned

Any interest you earn on the death benefit is a different story. If the life insurance proceeds are paid to you in installments that include interest, that interest is considered taxable. You should report it as interest received on your tax return.

Policy Transfers

If someone transfers a life insurance policy to you for cash or other valuable consideration, the tax exclusion for the death benefit is limited. Specifically, you can only exclude an amount equal to the sum of the consideration you paid, any additional premiums you paid and certain other amounts. This is subject to some exceptions, and you should report the taxable amount based on the type of income document you receive, such as Form 1099-INT or Form 1099-R.

Cash Value Withdrawals

If you have a policy like whole life or universal life that builds cash value, withdrawing more than your basis (the total amount of premiums you've paid) will result in the excess amount being taxable.

Loans

Loans taken against the cash value of your life insurance policy are generally not taxable as long as the policy stays in effect. If the policy lapses or is surrendered while a loan is outstanding, the loan amount up to the gain in the policy could be taxable.

Many people can benefit from having a life insurance policy — it allows your loved ones to have financial support in the event of an unexpected passing. You can use death benefits to cover a wide array of expenses, including tuition fees, mortgages and regular costs associated with the household.

For instance, it can serve as an early investment for young adults, locking in lower premiums for future financial security. Parents may find value in guaranteeing their children's educational needs, even if they're not around to contribute.

For business owners, life insurance can be a strategic asset. It can facilitate business continuity by providing funds to buy out a deceased partner's share or to recruit and train a replacement for a key employee. In essence, it's a financial cushion that can prevent a company from crumbling due to the sudden loss of essential personnel.

Even if you're single with no dependents, having a life insurance policy can cover your debts and funeral expenses, sparing your family from taking on these burdens. Moreover, some policies come with living benefits, allowing you to tap into the policy's cash value for emergencies or retirement.

You have the freedom to choose how much coverage your life insurance policy provides — it can range from $100,000 to $1 million or more. Remember, though, that the bigger the payout, the higher your premium. You’ll need to weigh this against ensuring your death benefit is enough to support your loved ones should you pass away unexpectedly.

To ensure you have enough life insurance, you can examine your current financial responsibilities and see if your policy can cover the total amount. These should include your mortgage balance, future expenses (such as college tuition) and any existing debt.

Another way to determine how much life insurance you need is to multiply your annual salary by 10 and use this as a baseline.

You must consider several factors when deciding which type of life insurance you’ll purchase. Both term and permanent life insurance policies have their own set of advantages and disadvantages. Permanent life insurance may cost you more, but you have coverage for your entire life. Term life insurance is an affordable way to get coverage. However, once it expires, your premium may increase if you want it renewed.

If you have a short-term loan or have young children, a term life policy may be enough. These involve expenses that may diminish over time — for instance, as your children grow older, they’ll be less dependent on your income. If you have a lifelong dependent, such as a child or sibling with disabilities, or if you require long-term care, you may be better off with a permanent life insurance policy.

Life insurance can benefit most people, but knowing what term and permanent life insurance offers can help you decide which type best suits you. The table below details the benefits and drawbacks of each. One may fit better than the other, depending on your situation.

When you’re choosing a beneficiary for your life insurance policy, spouses and children are obvious choices. After all, financial support for the family is the most common reason why people purchase life insurance in the first place. If you’re not married, you can name your siblings or your parents. Even a trusted friend can be a recipient of your death benefit.

There are two types of beneficiaries. A primary beneficiary is a person or entity you want to receive the payout first. If the insurer cannot find your primary beneficiary, the death benefit goes to the secondary or contingent beneficiary. Remember, a beneficiary doesn’t have to be a person — you can set up your policy so that a trust gets the payout.

If you don’t name any beneficiaries on your policy, your death benefit goes to your estate, which could result in a delayed payout or diminished amount.

Learning the answers to some of the most frequently asked questions can provide more information about how life insurance works.