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How does life insurance work?
Life insurance plans are available in several variations, but they generally fall into two categories: term policies and permanent policies. each comes with its share of pros and cons, and the key to determining if one is a good investment is understanding how it works.
term life insurance
As the name suggests, this type of policy covers the policyholder for a set period of time. It pays a certain amount, called a death benefit, if the insured dies within a specified period, which means that he can only access the payment in the years in which the plan is active. once the term expires, the policyholder has three options: renew the policy for another term, convert it to permanent coverage, or cancel the plan.
permanent life insurance
Unlike term life insurance, a permanent policy does not expire. It comes in two main types: whole life and universal life plans, which combine the death benefit with a savings component.
Whole life insurance policies offer coverage for the life of the insured and savings can grow at a guaranteed rate. meanwhile, universal life insurance uses different premium structures, with earnings based on market performance.
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what are the benefits of permanent life insurance?
One of the main advantages of a permanent life insurance policy is that it can be used as an investment tool to build wealth. here are some other benefits of this type of coverage, according to the financial website investopedia.
1. tax-deferred growth
Permanent life insurance allows the policyholder to invest tax-deferred, meaning they are exempt from paying taxes on interest, dividends, or capital gains on the cash value of the plan, unless they withdraw the proceeds .
“This is similar to the tax benefits you get with certain retirement accounts, including IRAs, 401(k), and 403(b),” explained investopedia. “If you’re maxing out your contributions to these accounts year after year, it may make sense to invest in permanent life insurance for tax reasons.”
2. lifetime coverage
Permanent policies cover the insured for life, unlike term life insurance, which ends coverage after a set number of years.
“If you anticipate that people will be financially dependent on you beyond the duration of a typical term policy, for example a disabled child, this benefit may be attractive to you,” the financial website noted.
3. access to cash value
Policyholders can borrow against the cash value of a permanent life insurance policy if the need arises without incurring penalties, unlike tax-advantaged retirement plans such as 401(k).
4. accelerated profits
Policyholders can receive between 25% and 100% of their policy’s death benefit even if they are still alive if they develop a serious illness, such as invasive cancer, heart attack, kidney failure, or stroke, and use the money to pay medical bills.
investopedia noted, however, that these benefits are not unique to permanent life insurance, adding that people can often access them in other ways “without paying the high administration fees and agent commissions that come with permanent life insurance.”
what are the drawbacks of a permanent life insurance policy?
Cost is one of the biggest drawbacks of permanent life insurance plans. requires policyholders to pay higher premiums compared to term life coverage. permanent policies can also have tax implications if beneficiaries choose to waive coverage or if the insured dies with outstanding loans. Also, borrowing from cash value or accessing accelerated benefits can reduce the payment amount.
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How can policyholders build wealth through life insurance?
Permanent life insurance plans allow policyholders to build cash value in addition to the death benefit. They can use these funds to pay their premiums, get a loan at a lower rate than banks offer, and supplement their retirement income. In addition, according to Investopedia, policyholders can use the cash value accumulated in their policies to “create an investment portfolio that maintains and accumulates wealth.”
But how exactly do permanent living plans build cash value? According to the financial website, cash value accumulates as the premiums paid by policyholders are divided into three parts. part of the payment goes to the death benefit, part covers operating costs and insurer profits, and the rest is allocated to the cash value of the plan.
“The life insurance company generally invests this money in a conservative return investment,” noted investopedia. “As you continue to pay policy premiums and earn more interest, the cash value grows over the years.”
buildup, however, slows down over time.
“In the early years of your policy, a larger portion of your premium is invested and allocated to the cash value account,” the financial website explained. “Typically, this cash value can grow rapidly in the early years of the policy. then in later years, the accumulation of cash value slows as you age and more of the premium is applied to the cost of insurance.”
investopedia added that cash value accumulation varies by policy type. whole life plans, for example, offer guaranteed cash value accounts that “grow according to a formula determined by the insurance company,” while universal life policies accumulate cash value based on interest rates current.
The following chart illustrates how cash value builds on a $100,000 whole life insurance policy with out-of-pocket premiums starting at age 35 for a male non-smoker.
The financial website also advised permanent life insurance policyholders to use the cash value built up in their plans instead of simply ignoring it.
“don’t let the cash value that has built up in your policy go to waste; the cash value of your policy at the time of your death reverts to the insurance company, not your heirs,” the firm noted.