Term insurance is one of the most popular types of life insurance, in large part because it tends to be the least complex and most affordable. Most people buy it as an income replacement mechanism in case the primary breadwinner in the family suffers an unexpected death.
If that occurs, the term life insurance policy pays a one-time lump-sum amount, called the death benefit. The beneficiary in the surviving family then uses the money to cover daily living expenses, such as food, housing, transportation and other basic needs. Depending on the size of the death benefit, it can also be used to pay off debts, set up a college education fund or provide for a rainy-day fund in case for future emergencies
How Does Term Life Insurance Work?
Buying term life insurance is a fairly straightforward financial transaction. You purchase life insurance coverage for a specific period of time – anywhere from one to 30 years – and agree to pay a monthly premium to keep the policy active. In return, the insurance carrier promises to pay the amount of the death benefit to your named beneficiary(ies) if you die while the policy is in effect.
The key phrase here is “while the policy is in effect.” Most insurance companies will give you the option of paying monthly, quarterly, semi-annually or annually. But if you fall behind in your payments or stop making them altogether, the company has the right to terminate the policy. In that situation, you would no longer be eligible to receive the death benefit even though the term stated in the policy has not been completed.
What happens at the end of a term life insurance policy?
Once the term expires, so does the policy. You stop paying the premiums and the insurance carrier is no longer obligated to pay the death benefit if you die after the term has expired. This is why term life generally has lower premiums than whole life or universal life. It’s also why many people buy another term policy after the first one expires, especially if the term was for a short period of time.
Keep in mind that life insurance rates are calculated using life expectancy charts. The older you get, the greater your statistical chances of dying, and the more a policy will cost. So if you outlive the term of your policy or lose it due to non-payment, it will likely cost more to buy a new policy. The best course of action is to buy life insurance while you’re young and healthy, establish a long term for your policy, such as 20 or 30 years, and always keep current on the premium payments.
Advantages of Term Life Insurance
In addition to low premiums, term life offers a number of attractive benefits.
- Except in rare situations, the IRS does not tax the death benefit payout. Your beneficiaries receive the full benefit amount stated in the policy.
- Term life payouts are exempt from probate, which can be a time-consuming and costly process.
- If you decide you want life-long coverage instead of insurance for a specific term, most term life policies will allow you to convert the policy without having to be reevaluated.
- Most term policies come with an “accelerated death benefit rider” that allows you to receive some of the death payout before you die if you contract a terminal illness.
There are some downsides to term life. If you decide you want a larger death benefit, the policy does not allow that to be changed. You have to purchase a separate term life policy to obtain the extra coverage you need. Term life doesn’t build up a cash value, like universal or whole life. Once the term is complete, the policy expires, and you are no longer covered. Despite these conditions, term remains a cost-effective and affordable means of providing financial protection for your family.
What Does Term Life Insurance Cover?
Most people who buy term life use it as an income replacement tool, so the surviving family won’t have to struggle to make ends meet. However, there are no restrictions on what the money can be used for. If the death benefit exceeds the amount needed to replace your income, the money can be used in many different ways, such as paying off the home mortgage, establishing a college fund for the children or paying for the funeral expenses.
Since you won’t be around to help manage the money, it’s a good idea to choose your beneficiaries wisely. In particular, avoid naming minor children as beneficiaries, as this can cause serious complications in many states. To ensure your family uses the money wisely, you can place it in a trust or specify in your will how it should be spent.
Choosing the Right Term Life Policy
There are several different types of term life insurance, including:
- Guaranteed level term
- Annual renewable term
- Return of premium term
- Decreasing term
- Modified term
The term life policy type you choose will affect everything from how much you pay for the policy to whether you receive cash back if you outlive the term of the policy. For example, many people wonder, “Can you cash in on a term life insurance policy?” In most cases, the answer is “No!” because term life does not accrue a cash value like whole or universal life insurance.
Others wonder, “Can you surrender a term life insurance policy?” Again, the answer is almost always “No.” To surrender a policy means to discontinue it before the term is up and collect the cash value. You can always cancel a policy at any time. But as a term life policy has no cash value, you won’t receive any money if you do.
To identify the right term life policy for your needs:
- Determine how long you want to have life insurance coverage. If you’re fairly close to retirement, you many only need it for five or 10 years. If you have young children, you may want 20 to 30 years to make sure they are protected until adulthood.
- Carefully review your financial situation, including how much you earn and how much you spend each year on living expenses, and identify the amount of death benefit required to cover those expenses.
- Get policy quotes from several different insurance carriers. This will enable you to review pricing and features and find the policy that best fits your needs.
- Select your beneficiary carefully. In most cases, this will be your spouse or some other adult you know and trust. If you want to name your minor children as the beneficiary, appoint a trustee to manage the money or place it in a trust until your children become legal adults.
- Carefully read the entire policy before you sign. If you have any questions, don’t hesitate to ask the insurance agent. A life insurance policy is a legal document, and once you sign, there is no going back.
Term life insurance can be a life saver for your loved ones if you were to die unexpectedly. Take the time to understand the different types, identify which one best fits your budget and financial goals, and see that the death benefit will be properly managed after you’re gone. Life insurance could be the greatest gift you could ever give your family.