It’s such a simple thing, really, usually just a box on a form where you write a name after the HR department bothers you about it. It may be one more of the things on your to do list, or you may have done it already.
I’m talking about the epically unromantic act that is designating a beneficiary for your life insurance. At least, it appears that way on the outside — what life insurance can do to take care of the people who depend on you can mean the world.
In my work as an attorney, I find that more than 80% of my clients have life insurance but few understand how it actually works.
So here are the Life Insurance basics…
Life insurance is a contract
You pay your premium to the insurance company, they agree to pay out a certain amount of money to the person you have designated (your “beneficiary”) when you die. Premium costs are based mostly on how much of a risk the insurance company is taking that they will have to pay the full amount soon or at all.
Life insurance comes in two general flavors, whole life and term:
- A term policy will pay out if you die within a certain time frame, which may be as definite as “20 years” or as loose as “as long as I work for X Company.” Under 30 and don’t smoke? The monthly premium on a 20 year term policy probably costs less than a weekly latte habit. Over 60? You may have difficulty getting life insurance at all and the premiums are going to be higher.
- Whole life is certain to pay out when you die, no matter how old you were when you got it or how long it takes for you to pass. The premiums for this type of insurance are higher because there’s no risk for the insured person. Why would life insurance companies take a bet they’re certain to lose? Because the higher premium gives them immediate access to funds to invest before the final pay out.
There are two reasons to get life insurance:
To replace your financial contribution in a partnership when you’re working, or to pass money tax-free when you’re retired.
Financial contribution to partnership
Sounds like it can’t be anything but a business relationship, right? Yes, life insurance is an incredibly valuable tool to help a small business continue or wind down gracefully if a key person passes away. For most people, the financial partnerships they have aren’t business matters at all, but family matters.
My fiancé recently realized that if he died, the student loans his parents co-signed would not be forgiven and they would suddenly be responsible for the payments instead. A life insurance policy to cover the amount he needs to pay to satisfy the loans over the period of time he’s repaying them could prevent that from happening.
One of the biggest financial partnerships many people have is a shared mortgage. Would your family be able to pay it without your salary? What about the regular non-contract costs of raising kids or caring for elderly relatives? These are all financial partnerships you have that might not be able to continue if you can’t contribute money from your wages as planned in the future.
For people who are no longer working
Life insurance can be an excellent way for wealth they already have to go directly to the people they want to have it without having to go through the courts, other family members or — in the United States — being taxed.
The two biggest problems I see with life insurance in my job:
- People don’t have enough life insurance.
- They don’t have a good plan for where it’s going to go.
Many of my clients who are working have an amount of life insurance (usually through their employer) that will cover two, maybe three times their annual salary. When you look at it on paper, that’s a lot of tax free money! When you think of how long your family could get by paying current bills with absolutely no financial contribution from you, though, it disappears fast. Ask an insurance agent about more coverage. Seriously.
Making a plan for where your money will go
The part that insurance agents don’t normally deal with is in making a plan for where your insurance money will go — and that’s where you want to talk to an attorney. Almost all of my clients who have a partner and children have their partner listed as the primary beneficiary and their children listed as secondary or contingent beneficiaries. This means the children will receive the payment if the partner passes away before or at the same time as the insured person. It’s a plan that makes sense that can also backfire with terrible results.
Real-life scenario, not uncommon: Your partner is driving, you are the passenger, you have a $100,000 life insurance policy with your partner as the beneficiary. Partner runs a stop sign and you are killed in a collision with another car. Your insurance company dutifully pays out $100,000 to your partner… just in time for the money to be taken by the other injured driver in the resulting lawsuit. The insurance money never gets a chance to take care of your family the way you had planned.
Change up the situation. You and your partner are both killed in a car crash, neither of you is at fault, your children are the contingent beneficiaries of your $100,000 policy. Now, no insurance company is going to write a $100,000 check to a six-year-old. The money will be available for a legal representative of a child to use on his or her behalf until the child is an adult, typically 18 years old in the U.S.
There is such a thing as a life-ruining amount of money
At 18, I had it together as far as a plan to go to college and law school, no credit card debt, responsible spending habits, reasonable car. Do you know what I would have done with a check for $100,000? I don’t know what I would have done with all of it, but there would have been at least two motorcycles with my name airbrushed on them. Age isn’t any guarantee of maturity, but it’s hard to see the mundane things you might need money like that for in the future when you haven’t lived without other people taking care of at least some of those details.
A good estate plan, put together with the help of an attorney who understands the benefits and potential pitfalls of your life insurance, can protect your family and make the most out of this useful tool.