Life insurance is an insurance contract that states, for the premiums paid, a person’s beneficiaries will receive a death benefit upon the person’s death paid by the insurance carrier. There are different nuances to different types of insurance with there being three major life insurance types you can buy: term, whole, and universal life insurance.
Who Are the Parties to an Insurance Contract?
There are three parties to the life insurance contract: the insurance carrier, the policyholder, and the insured. The insurance carrier makes the promise to pay death benefits in exchange for premiums. The death benefit is based on the life of the insured while the administrative control of the policy is handled by the policyholder or owner.
The owner can make the decision to cancel the contract, take a loan out, or cash out cash value. Owners are often the same person as the insured but can be a spouse or another party such as a business that has a demonstrable interest in the life of the insured.
What Types of Life Insurance Is There?
Not all life insurance policies are created the same. You have both temporary and permanent insurance with variations of both that can make finding the right policy confusing.
Temporary life insurance has the policyholder pay a premium for a certain period of time known as a term. When the term is up, premium payments are no longer needed because there is no longer the coverage of a death benefit. There are two primary types of term insurance:
- Level premium term: Pay the same premium for the duration of the term to get the designated death benefit.
- Return of premium: Has a set term with regular payments. At the end of the term, if the insured has not died, the policyholder gets a full refund of premiums.
Permanent life insurance is noted by having premiums pay partly for the cost of insurance and partly feed an internal savings mechanism in the account to grow cash value. Cash value becomes an amount policyholders can access as a loan or take out before the insured has died and use it as a living benefit. The most common types of permanent insurance include:
- Whole life: Pay a set premium for the remainder of your life and build cash value with a fixed interest rate.
- Universal life: Pay a variable premium for the remainder of your life with a cash value that can be fixed or variable depending on the type of universal life policy.
- Variable universal life: Universal life that invests the cash value in designated stock market mutual funds.
- Index universal life: Universal life that limits stock market gains to prevent major losses to cash value.
How Does Cash Value Work?
The cash value of a policy grows over time. In the cash of whole life and basic universal life insurance, the cash value grows based on an interest rate renewed annually based on current rates with a minimum guaranteed rate. When cash value is based on the variable mutual funds, returns are subject to the performance of the funds that may go up or down.
You have the option to leave the cash value in the policy, use it to buy more death benefit, take it out, or take a loan against it. The cash value is the amount you can receive if you cancel your insurance policy. You can take part of the cash value out, usually up to 50%, as a loan. This loan doesn’t need a credit check and you pay yourself back with interest.
Are Death Benefits Taxable?
As a rule of thumb, death benefits paid to your beneficiaries are not taxable. This is true when the money is going to a real person. However, if the policyholder names a trust as the beneficiary, the death benefits go into the estate and are taxed based on the estate tax rate.
Additionally, if the beneficiary elects to take the death benefits over time, they may be taxed on any interest earned in the policy, though the actual lump sum amount remains untaxable.