Depending on the kind of policy you select, life insurance can have several purposes.
Protection of Beneficiaries
The most obvious reason for life insurance is to provide financial support (the face amount of the policy) for the beneficiaries named in the policy. People name beneficiaries for many reasons, including the following:
The most common reason people buy life insurance is to protect their immediate family from the financial consequences of the death of the breadwinners) and to give the survivors time to adjust to the loss without having to reduce their standard of living.
Payment of debts.
Some people take out life insurance to make sure that certain debts they have accrued will be paid if they die. Mortgage insurance, which pays off the balance due on a mortgage or deed of trust, is typical of life insurance taken out for this purpose.
To resolve potential business disputes.
People who go into business together usually want to avoid the legal hassles that can result when one of the principals dies. For this reason, they enter into “buy/sell” agreements. These important business contracts fix the price ahead of time that will be paid to the deceased owner’s family for the deceased’s share of the business. This arrangement allows everyone involved to avoid expensive and time-consuming endeavors such as determining the value of the deceased person’s share of the business or deciding whether the family of the deceased should be given an ownership stake in the business. Such buy/sell agreements are often funded by life insurance policies taken out by the business on the lives of the principals.
As an Investment
Some forms of insurance accrue cash values and are thus deemed investments. Over a period of time, portions of the premiums paid to the life insurance company are invested by the company to earn money, some of which accrues over the years to the life insurance policy itself. This accumulating worth is known as the cash value of the policy. Some forms of life insurance, called annuities, are used to guarantee a specific level of income in later years.
As a Tax Shelter
Unlike some investments, the income earned during the existence of a cash value life insurance policy is tax deferred. That is, while dividends payments and interest earned in a bank savings account will be taxed in the year the income accrues, earnings that accumulate as cash value in life insurance policies are not taxed until withdrawn. This can be a significant advantage, especially since the money can be used as collateral for a loan (which is also nontaxable) from the insurance company.
In addition, life insurance proceeds paid upon the death of the insured are not income taxable. Thus, if you protect your family by buying life insurance equal to five years of your earnings, the actual protection given is much higher since the income taxes you would have paid had you earned that amount of income will not be paid when that same amount of money comes to your survivors from life insurance.
As a Tool of Estate Planning
Some wealthier persons use life insurance to avoid estate taxes or to pay probate expenses. However, the federal estate tax doesn’t tax the first $600,000 of an estate, and some states don’t even have inheritance taxes. Thus, for the average family, life insurance as a form of estate planning is not a major issue. It will not be discussed here in detail. If you have any questions, contact a lawyer who specializes in probate law or is a qualified estate planner.