How Does Life Insurance Work?


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Life insurance policies are designed to provide a financial payout, often equal to the coverage amount, to the beneficiaries specified by the policyholder upon their death. If the policy is active when you pass away, your beneficiaries can submit a claim to receive the death benefit.

Life insurance is a contract between you and an insurance company where regular life insurance payments secure a lump-sum payment, known as a death benefit, for your beneficiaries upon your passing. Beyond providing immediate relief for funeral costs and debts, the life insurance payout 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 and how it works is also essential for making decisions that will best secure the financial future of your loved ones.

Key Takeaways

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Life insurance is a type of insurance that pays money to the beneficiary upon the death of the insured person.

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There are two kinds of life insurance policies: term and permanent. Both offer death benefits, but one may suit you better based on your circumstances.

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Life insurance isn't just for those who have children or spouses. If you're single or childless, you can name your siblings, parents or a trusted friend as your beneficiary.

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A beneficiary doesn't need to be a person — it could be a trust. If you don't name a beneficiary, your death benefit goes to your estate.

Life Insurance Basics

The primary purpose of life insurance is to offer protection for your loved ones in the event of your death. You keep the policy active by making regular life insurance payments. In return, life insurance guarantees your loved ones get a certain amount of money when you pass away. This death benefit is tax-free.

There are various forms of life insurance policies, primarily term and permanent, each with its own set of rules and benefits. Knowing the life insurance policy details can help you choose the right one for your needs.

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 policy coverage.

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

What Is Life Insurance?

Life insurance is a contract between you and your insurance company. The purpose of life insurance for most people is to ensure that 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 life insurance policy coverage. In exchange, insurers release a tax-free life insurance payout to your chosen beneficiaries upon your passing. When a beneficiary receives payments, they have the freedom to use the life insurance money 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 your attributes and life insurance policy details like coverage length and limits.

Types of Life Insurance

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. Life insurance payments remain the same throughout.

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

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

Term Life Insurance and How It Works

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. Its affordability compared with a permanent policy is one of the key benefits of a life insurance policy of this nature. 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. For young and healthy individuals, a term life policy could be the cheapest choice, highlighting its role in fulfilling the main purpose of life insurance.

Once your policy expires, you can choose to let it go if you feel you no longer need the coverage, renew it or convert the term plan to a permanent policy. This flexibility is vital to understanding life insurance and strategically planning for your financial future.

Permanent Life Insurance and How It Works

Permanent life insurance provides coverage for your entire lifetime, offering a guarantee that your beneficiaries will receive life insurance compensation no matter when you pass away. Because of this, it costs significantly more than term life insurance.

A distinctive aspect of permanent life insurance is its investment component, allowing the policy to serve as a safety net and a financial growth tool. This feature contributes to the benefits of a life insurance policy, as it accumulates 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 because these plans are more expensive. Your policy may lapse if you miss life insurance policy payments.

Common Life Insurance Benefits

The primary benefit of life insurance is the financial support your family receives if you unexpectedly pass away while the policy is in effect. This life insurance compensation is referred to as a 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:

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    Accelerated Death Benefits

    This enables you to receive a portion of your life insurance payout if diagnosed with a terminal illness.

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    Return of Premium

    Your insurer returns all premiums you paid while your policy was in effect if you outlive it.

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    Cash Value Withdrawal

    When you access a portion of the cash value of your permanent life insurance policy.

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    Long-Term Care Benefits

    Access the death benefit to cover long-term care expenses your health insurance policy doesn't cover.

Being informed about these benefits of a life insurance policy enhances your ability to make educated decisions about your policy.

Life Insurance Coverage Amounts

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 coverage amount provides more life insurance compensation, but it also means you pay higher premiums. We've provided the following guides for the four common life insurance policy values:

Life Insurance Claims Process

Life insurance policies will normally pay for losses arising from the insured's death. However, insurers don’t automatically release a life insurance payout. Beneficiaries must trigger the process of claiming life insurance after death. This involves completing forms and providing 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 life insurance companies issue life insurance compensation within 14–60 days from beneficiaries filing a claim. Insurers may pay out the life insurance money either as a lump sum or through an annuity, offering monthly or annual payments, depending on the chosen life insurance payout options. Several situations cause delayed life insurance payouts, such as the insured passing away during the first two years a life insurance policy is in force or the cause of death being homicide. Other reasons include omitting known health issues or engaging in risky activities.

Understanding the life insurance process and the details of the life insurance policy can help beneficiaries navigate these challenges more effectively and ensure they receive the life insurance money they are entitled to without unnecessary delays.

Compare Life Insurance Rates

Ensure you’re getting the best rate for your life insurance. Compare quotes from top providers to find the most affordable life insurance coverage for your needs.

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What Life Insurance Covers

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.

Specific life insurance policy information and the scope of your coverage will vary depending on the policy and provider.

What Life Insurance Does Not Cover

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. This exclusion, which is a part of the suicide clause, specifically prevents beneficiaries from claiming life insurance benefits under these circumstances.
  • 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.

Learning about these rules helps clarify what life insurance means in a tax context and ensures you can understand life insurance fully before making a decision. Remember to thoroughly check life insurance details and terms to familiarize yourself with its exclusions.

Tax Implications of Life Insurance

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 insurance or universal life insurance 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.

Understanding life insurance and its tax implications allows you to better align your policy with your financial goals. Make sure to review the life insurance rules and consider consulting a tax professional to avoid unexpected tax liabilities while maximizing the benefits of your policy.

Who Needs Life Insurance?

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.

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    Young Adults

    Life insurance can serve as an early investment, 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.

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    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.

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    Singles 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.

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The best time to purchase life insurance is when you’re young since premiums are cheaper. As you age, you may develop health problems that cause rates to increase or, worse, disqualify you from purchasing a policy.

How Much Life Insurance Do You Need?

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 life insurance 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.

How Much Life Insurance Do You Need?

Answer three simple questions to get your recommended coverage amount.

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Determinants of Life Insurance Costs

Insurers use a variety of factors to determine the cost of life insurance. It results in premiums that vary because of an individual’s unique details, such as age or general health conditions. Learning more information about the different elements affecting your life insurance premium can help you make an educated purchase.

  1. 1
    Term Length

    Term length refers to the amount of time a life insurance policy stays in effect. The longer the term length, the higher the likelihood your insurer will have to pay out your death benefit, making your premium more expensive.

  2. 2
    Coverage Amount

    The coverage amount is how much your insurer pays out as a death benefit. The higher your coverage, the more your insurer will have to pay, leading them to charge a higher premium.

  3. 3
    Age

    How old you are when you purchase your life insurance policy can significantly affect your premium. Younger individuals typically benefit from lower rates, emphasizing the benefit of life insurance acquired early in life.

    For example, the average cost of a $500,000 life insurance policy with a 10-year term for a 30-year-old woman in excellent health who has never smoked is $17 monthly. A similar policy may cost a 50-year-old woman with the same profile $53 per month.

  4. 4
    Gender

    Generally, women have longer life expectancies, so insurers often offer them more affordable life insurance. On average, a 40-year-old woman in excellent health who has never smoked pays around $35 per month for a 20-year term life insurance with $500,000 coverage. A 40-year-old man with a similar profile purchasing a policy with the same length and coverage pays an average of $44 monthly.

  5. 5
    Overall Health

    You’ll need to complete a medical exam before most insurers agree to sell you a life insurance policy. If you are in good health, you’re less likely to die within your coverage period, which leads insurers to approve you for a lower premium. Health issues or pre-existing conditions such as a high BMI or a heart condition may result in more expensive rates.

  6. 6
    Smoking Status

    Insurers find smokers more of an insurance risk than non-smokers. They are more likely to develop health issues and have a shorter life expectancy.

    The average monthly premium for a 20-year term policy with $500,000 coverage for a 40-year-old non-smoker is $44. The same policy will cost an average of $102 per month for a 40-year-old smoker. That's a 131.8% increase.

Gaining information about these life insurance factors provides a comprehensive view of life insurance basics and the purpose of life insurance, ensuring you select a policy that aligns with your budget and long-term needs.

Compare Life Insurance Rates

Ensure you’re getting the best rate for your life insurance. Compare quotes from top providers to find the most affordable life insurance coverage for your needs.

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How to Choose the Best Life Insurance Policy

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.

By understanding these distinctions and considering your personal and financial situation, you can make an informed choice that aligns with the benefits of a life insurance policy, ensuring you select a plan that meets your life insurance purpose and offers the right level of life insurance compensation to your loved ones.

Comparing Term and Permanent Life Insurance

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.

Type of Life Insurance
Pros
Cons
Who It’s Best For
Who It May Not Work For

Term

Offers multiple options for policy length

May cost more if you want to renew your policy after it expires

Those who want an affordable life insurance policy

Those who have life-long dependents, such as a child with disabilities

Permanent

Earns cash value and provides lifelong coverage

Higher premiums

Those who want to use their life insurance as an investment vehicle

Those who aren’t comfortable with an expensive premium

How to Choose the Right Beneficiary

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.

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Make sure to review your beneficiaries regularly. Life events such as getting married, divorced or having a child may require updating your policy.

How to Buy Life Insurance

Most people see the need for life insurance but don’t carry a policy, commonly because they aren’t aware of the steps involved in purchasing it. Understanding the process can clear up confusion and help you make an educated decision for your life insurance needs.

  1. 1
    Calculate how much life insurance you need.

    First, determine how much coverage you need. Consider all your financial obligations (present and future) and make sure your life insurance will cover the total amount. Your income is also a good benchmark — we recommend taking your current annual salary and multiplying it by 10.

  2. 2
    Research life insurance companies and what policies are available to you.

    Insurance companies offer a variety of life insurance policies. The company with the lowest rates isn’t always the best option. Make sure to check other aspects such as financial stability, user experience ratings and customer complaint ratios.

    These will help you determine which company will give you the best deal and increase the likelihood that your beneficiaries can easily file the claim for your death benefit.

  3. 3
    Determine the type of life insurance you want, as well as the coverage amount.

    Both of these factors affect the cost of life insurance. Consider your financial responsibilities and see whether a term or permanent life policy is more appropriate for your situation. Remember, either one has advantages and disadvantages.

    Your coverage amount should be enough to help your beneficiaries pay for expenses if something happens to you.

  4. 4
    Gather multiple life insurance quotes.

    Explore what different insurers have to offer. You can usually get quotes online, so you don’t have to visit various agents. You can also use an online comparison tool to make your search more efficient.

  5. 5
    Compare life insurance quotes and policy options.

    Although insurers use the same factors, they compute rates differently. It’s not unusual to find varying rates from different life insurance companies. Comparing life insurance quotes from three or four insurers gives you more options and lets you choose the best one.

  6. 6
    Decide on a policy and purchase it.

    When you find a policy that you’re happy with, you can fill out an application form. Most insurers allow you to do this online. You may also need to submit an Attending Physician’s Statement from your doctor.

    Insurers may have different life insurance processes, but typically, you’ll go through a phone interview and a medical exam. Insurance companies use the results from these activities to determine whether you’re eligible. If you are, you’ll receive the policy documents to sign.

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When selecting a policy, it's essential to understand the life insurance payout options available to your beneficiaries. The most common option is a lump sum, where beneficiaries receive the entire death benefit at once, providing immediate financial relief.

Some policies offer annuities, where the death benefit is distributed in regular payments over a set period. This option can help beneficiaries manage long-term financial needs, such as paying off a mortgage or funding education. Carefully consider which life insurance payout option best supports your loved ones' future financial stability.

Compare Life Insurance Rates

Ensure you’re getting the best rate for your life insurance. Compare quotes from top providers to find the most affordable life insurance coverage for your needs.

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Life Insurance FAQ

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

What is life insurance?

How does life insurance work?

What does life insurance cover?

What does life insurance not cover?

What are the benefits of life insurance?

How to purchase life insurance?

When does a life insurance contract become effective?

Can I have more than one life insurance policy?

How long do you have to have life insurance before it pays out?

How long do life insurance policies last?

How long do you have to claim life insurance?

Who gets the life insurance payout?

Does life insurance pay out the full amount?

How much do beneficiaries get from life insurance?

What types of expenses can your life insurance beneficiary pay for with the benefit?

How long do life insurance policies take to pay out?

How do life insurance companies handle cases?

Can you use life insurance before you die?

Do you get money back on life insurance?

When does the insured stop making payments?

What voids life insurance?

About Mark Fitzpatrick


Mark Fitzpatrick headshot

Mark Fitzpatrick is a Licensed Property and Casualty Insurance Producer and MoneyGeek's Head of Insurance. He has analyzed the insurance market for over five years, conducting original research and creating personalized content for every kind of buyer. He has been quoted in several insurance-related publications, including CNBC, NBC News and Mashable.

Fitzpatrick earned a master’s degree in economics and international relations from Johns Hopkins University and a bachelor’s degree from Boston College. He is passionate about using his knowledge of economics and insurance to bring transparency around financial topics and help others feel confident in their money moves.


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