How does life insurance work?
Life insurance is a contract between a person (the policyholder) and an insurance company (the insurer). The contract says the policyholder will pay a monthly premium in exchange for a guaranteed death benefit. And if the policyholder passes away during the policy's term, that death benefit will be paid to the beneficiaries.
Two common life insurance plans are term life and whole life:
- Term life insurance is the most straightforward type of life insurance policy. A policyholder purchases a policy for a term, often between 10 and 30 years. If they pass during that time, the insurer agrees to pay a death benefit to the assigned beneficiaries. Term policies are often used when people have circumstances where they only need coverage for a set period. For example, parents with young children may sign on for a 20-year term policy knowing that when the policy is terminated, children will be grown and may no longer need the financial security it offers.
- Whole life insurance is a type of permanent life insurance, which means the policy is for the policyholder's entire lifetime, assuming they continue to pay premiums. A whole life policy agrees to provide a death benefit when the insured passes, but it also allows the policy to accrue cash value. That means some people view it as a dual life insurance policy and investment account.
Why is life insurance important?
Regardless of which type of life insurance policy someone has, there are several reasons why life insurance is important.
Replace lost income
For someone who is the primary breadwinner of the home, loss of life could result in devastating financial impacts for the remaining family. But a life insurance policy can provide support. Since the general recommendation for a life insurance policy death benefit is seven to 10 times the policyholder's salary, the right plan could provide loved ones with almost a year's worth of income. And that means less stress having to figure out how to move forward right away.
Help with debt repayment
Whether debt belongs to family members or was left behind by the deceased, life insurance can be used to take care of a lingering debt, like a business loan or mortgage. But the policyholder must buy a large enough policy to cover the outstanding debt to provide the best outcome for their family.
Provide a non-taxable legacy
Much of what people leave behind as part of their estate will be taxed by the government. But the payout from a life insurance policy is tax-free. That means beneficiaries will receive more money dollar for dollar than they may from other taxable accounts.
The bottom line
Life insurance is designed to provide financial protection for loved ones if the policyholder should pass while the policy is in effect. And finding the right plan can provide great peace of mind that their loved ones can replace lost income, repay debt, or receive a tax-free legacy. Knowing loved ones are cared for by the right insurance policy is an important step that can free up the policyholder to pursue other financial goals.
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Source: Fidelity Life