Personal Finance Essentials

Life Insurance Basics

Life Insurance > Life Insurance Basics

Life insurance is a contract between you and an insurance company.

Life insurance is a contract between you and an insurance company. You pay regular premiums, and in return, the company promises to pay a death benefit to your designated beneficiaries when you pass away. Despite all the marketing language surrounding it, the core concept is that simple.

Consider Steve, a non-smoking 35-year-old in good health. He buys a $250,000 policy to ensure his young son can afford college even if Steve dies before he has a chance to save enough money. That example captures the essential purpose of life insurance: replacing income and fulfilling financial obligations that would otherwise go unmet.

The key components of a life insurance policy include:

Policy Owner

The person responsible for paying premiums. The owner also names the beneficiaries and controls the policy.

Insured

The individual whose life is covered. This may or may not be the policy owner.

Beneficiary

The person or entity that receives the death benefit. The policy owner can name multiple beneficiaries and can distinguish between Primary and Secondary beneficiaries. Secondary beneficiaries receive the benefit only if the primary beneficiaries die before the insured. Commonly, the primary beneficiary is the spouse and the children are the secondary beneficiaries.

Death Benefit

Also called the face amount – the sum paid to beneficiaries upon the insured’s death.

Premium

The regular payment made by the policy owner to keep the coverage in force.

Tax-Free Proceeds

Life insurance death benefits are almost always received income tax-free by the beneficiaries. There may be tax implications in certain business or trust contexts, but for most families, the full benefit is received without reduction for taxes.

Naming Beneficiaries for Minor Children

One important estate planning issue concerns naming minor children as direct beneficiaries of a life insurance policy. It seems logical – you bought the policy to protect your kids – but it creates a serious problem. If children under 18 are named as beneficiaries, they cannot legally receive the money directly. The funds will go into the custody of a court, which will appoint a financial guardian to manage them. There’s no assurance the court will appoint the same person you named as the children’s guardian in your will.

After potentially years of legal proceedings and substantial fees, the money may eventually land in a custodial account – only to be released to the child at age 18. At that point, the child receives full control of the funds and may choose a sports car over college, regardless of your intentions. A better approach is to establish a children’s trust in your will and name it as the secondary beneficiary, or to designate a custodian under a UTMA or UGMA account. Either approach gives you control over when and how the money is distributed.

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