Life Insurance FAQ
Confused about life insurance? Many people are. But it's pretty important to understand as you plan to protect the people you love. Find answers to common questions.
How does life insurance work?
A life insurance policy provides tax-free money to your loved ones when you die. It can help cover final arrangements, or pay off a mortgage or other expenses. Some policies also build cash value, which you can use during your lifetime.
There are 2 main types of life insurance policies:
- Term life insurance. This type of policy lasts until a certain age or for a certain period of time. When the term is up, you can renew your policy or let it end. It tends to be less expensive than permanent insurance.
- Permanent life insurance. This type of policy offers coverage you can’t outlive, as long as you pay your premiums. There are different types of policies, but most build cash value. You control when and how you take payments from your policy (there are no required distributions or early withdrawal penalties).
Should I buy term life insurance or permanent life insurance?
Start by asking yourself these 3 questions:
- How long do I need the policy? Term insurance may be a great fit if you need coverage for a limited length of time, like 10 to 20 years. If you want lifelong coverage, permanent insurance may be a better choice.
- How much can I afford? While term policies typically cost less than permanent policies, the cost for any type of coverage is based on age. The earlier you buy a policy, the less it will cost.
- How much risk am I comfortable with? This applies to policies that offer cash value (permanent policies). You can choose how you want your cash to grow, from policies that offer a fixed interest rate to more aggressive investment strategies.
If you want permanent insurance but it doesn’t fit in your budget right now, consider buying a term policy that can be converted to a permanent policy at a future date (typically within a specified time limit).
Buying a convertible term policy during your healthy, younger years helps avoid the question of insurability later on (you don’t have to go through the underwriting process again). This is a more a budget-friendly option.
Still not sure? Take this quiz to help you figure out what kind of life insurance you may need.
How is the cost of life insurance calculated?
Permanent policies generally have a higher initial premium than term policies, because a portion of the premiums goes toward building cash value. But both term and permanent policy costs are generally based on 3 factors:
- Mortality. This is the calculated likelihood of death, largely based on age, gender, health, occupation, and hobbies.
- Expenses. These include the costs of operating the issuing company and administering the policy.
- Riders. These are benefits added to the base policy, which are often optional, that may require additional premiums.
How does a permanent life insurance policy build cash value?
It depends on the type of policy you have. There are 4 main types of permanent life insurance policies, which build cash value by investing a portion of your premiums in different ways (with different levels of risk): 1
- Whole life.2 The policy offers guaranteed cash value which grows over time, based on an investment strategy determined by the insurance company.
- Universal life. Cash value accumulates based on current interest rates (meaning rates can vary), with a minimum rate guarantee.
- Indexed universal life. Interest rates are based on the up or down movement of a specific stock market index or indexes over a specific period of time. There is more risk, but also the potential for more cash value growth.
- Variable universal life. Cash value grows based on the performance of investment subaccounts.3 This type of policy provides the highest risk/reward potential.
Can I use my cash value?
You can access the cash value that accumulates inside a permanent life insurance policy in 3 ways: 4
- Loans. These are typically free from current income tax, even if they exceed total premiums paid (called the policy’s “cost basis”). Interest is charged on the loan, and may either be paid or accrued to the loan. Outstanding loans are deducted from the death benefit when you die. Or, if the policy is later surrendered (you end the policy), the unpaid loan amount is deducted from the cash value.
- Partial surrenders from universal life policies. These reduce the death benefit, dollar for dollar. They’re usually income-tax free, unless they exceed the total premiums paid (cost basis). This is one of the potential benefits of life insurance that many people aren’t aware of.
- Full surrenders from universal life policies. This means taking the entire remaining cash value from a policy and ending the policy. You’ll pay income tax for any portion of the cash value that exceeds premiums you paid. Unpaid balances of any loans are forgiven at the time of surrender, but will be added to the surrender value when calculating tax on the proceeds.
How is the death benefit paid?
Insurance companies pay death benefits to your beneficiary after you die. (Some policies allow you to access a portion of the death benefit if you become chronically or terminally ill.) Payout options typically include:
- Lump sum. The death benefit is distributed to the beneficiary in one payment.
- Income options. The insurance company keeps the death benefit and an income is paid to the beneficiary for life (or for some other stated period of time).
- A continued interest account. The death benefit is held by the insurance company in an interest-bearing account, which can be accessed by the beneficiary on demand.
How does underwriting work?
Underwriting lets insurance companies charge rates proportionate with the risk of insuring specific individuals. As part of this process, the insurance company may ask you certain questions or require you to undergo medical tests or exams.
Underwriting can take a few days to a few weeks. It depends on the complexity of your case, and the time it takes to get information from third parties, such as your doctor.
1 All guarantees and benefits of the insurance policy are backed by the claims-paying ability of the issuing insurance company. Policy guarantees and benefits are not backed by the broker/dealer and/or insurance agency selling the policy, nor by any of their affiliates, and none of them makes any representations or guarantees regarding the claims-paying ability of the issuing insurance company.
2 Principal does not offer a whole life insurance product.
3 Investing in variable universal life insurance involves risk, including possible loss of principal.
4 Withdrawals and policy loans may decrease the amount of death benefit and cash value. Surrender charges and other policy charges may apply to distributions taken from the policy. If the life insurance policy is a Modified Endowment Contract (MEC), distributions may be subject to income taxes.
The subject matter in this communication is provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Insurance products issued by Principal National Life Insurance Co (except in NY) and Principal Life Insurance Co. Plan administrative services offered by Principal Life. Principal National and Principal Life are members of the Principal Financial Group®, Des Moines, IA 50392.