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The Five Most Common Life Insurance Mistakes

Michael Reynolds | February 16, 2023

[Prefer to listen? You can find a podcast version of this article here: E172: The Five Most Common Life Insurance Mistakes]

Life insurance is not a topic that most people love to talk about. First, it involves thinking about death. Next, it involves spending money on premiums that offer no tangible perceived benefit.

It’s no wonder that so many Americans are underinsured.

Even for those Americans who are insured, it’s very common to fall into some of the most common mistakes made with life insurance.

So what are the five most common life insurance mistakes?

Thinking You Don’t Need Life Insurance Because You’re Young and Single

Many people think life insurance is just for those who have a spouse or partners and/or children. This is mainly because life insurance is designed to replace your income if you were to pass away. This provides financial protection and continuity for those who rely on your income.

But if no one relies on your income, then you don’t need life insurance, right?

Not so fast. Even if you’re young and single now, that may not be the case forever. You may eventually be in a situation where someone is relying on your income. You may get married or live with a life partner. You may have children. You may become a caretaker for an aging relative.

So you may be thinking “I’ll just get life insurance if/when that happens.” This may seem logical, but the problem is, life insurance gets more expensive as you get older. It also gets more expensive if you develop health issues. In some cases, you could even be ineligible for life insurance.

As a result, many people end up ineligible for life insurance right when they need it the most.

To avoid this situation, you can “lock in” a life insurance policy when you are younger and healthier, therefore paying low premiums. If your situation changes later in life and you find yourself with financial dependents, then you can update your beneficiaries accordingly.

For some perspective, a one-million-dollar 30-year term life insurance policy on a 28-year-old woman in the top health class is less than $40/month at the time of this article’s publication. For a man, the same policy is less than $50/month (these figures are subject to changes and are only used as examples based on current rates).

Not Having Enough Coverage

Many people think of life insurance as simply a way to provide a small lump sum to loved ones to help with funeral expenses and a few other things upon their death. This results in a significant number of people being underinsured.

The ideal use case for life insurance is an income replacement in the event of the death of the person insured.

For example, let’s say a family of four includes Partner 1 who earns $100,000/year, and Partner 2 who earns $50,000/year along with two children ages 4 and 7.

If Partner 1 passes away, that leaves a dramatic income gap. The elimination of the majority of the household income would likely result in Partner 2 having to significantly downgrade their lifestyle and make some dramatic life changes in order to support the family. It would be incredibly stressful and difficult for Partner 2 and could have tragic financial consequences. All this would be on top of the emotional trauma of Partner 1’s passing.

A small lump sum of even a few hundred thousand dollars will not go very far in this situation.

This is why many professionals recommend a death benefit of 10-15 times the income of the insured person.

Why 10-15 times? It depends on the situation but generally, the amount of the death benefit is designed to allow the surviving partner to pay off all debts and create an income from the money. Since life insurance proceeds are tax free, this would give Partner 2 some options for generating investment income that may not be a 100% replacement but could be enough to provide financial continuity.

Relying on Life Insurance Through Your Job

Many employers offer life insurance as part of a benefits package (generally called “group” life insurance). Normally you can get $50,000 included at no charge with the option to buy more at a very low rate.

The maximum amount of life insurance that you can get through work can vary depending on your employer and the specific policy they offer. But in general, most employers have a limit on the amount of life insurance you can buy through the group policy.

This means you will likely not be able to get the right amount of coverage through your job.

More importantly, if you rely on your employer to provide you with life insurance, then your life insurance is tied to your job.

When you leave your job, you may not be able to convert your policy into a private policy. And even if you can, the rates are likely to increase significantly or you may not even qualify. And if you take a new job with an employer that doesn’t offer life insurance or you transition to self-employment, you may end up without life insurance and will have to start over and apply at an older age which may make it more expensive.

So what’s the better route? Buying a private life insurance policy that is not tied to your employer can be a much better way to secure the right amount of coverage while locking in a policy that stays with you regardless of any job changes.

Buying Cash Value Life Insurance

You’ve probably noticed that term life has been mentioned so far with no mention of cash value life insurance. That’s because cash value life insurance is generally not appropriate for most situations.

Cash value life insurance can come in many forms, including Whole Life, Variable Life, Universal Life, IUL, and other types of policies.

Most financial products have a place and are appropriate for certain situations. Cash value life insurance can have value in certain specific situations.

However, for the vast majority of people term life insurance is the most suitable type of life insurance.

Cash value life insurance is significantly more expensive than term life and as a result, most people end up dramatically underinsured because they can’t afford to buy the proper amount.

One of the selling points often promoted by those selling cash value life insurance is the fact that it is “permanent” because it (technically) does not expire, thus lasting your “whole life.”

But most people don’t need life insurance for a lifetime. Life insurance is very important in earlier stages of life. But most people no longer need it later in life when they are mostly or completely debt-free, have adult children who are self-sufficient, and have built up enough assets to be able to survive at least partially on investments.

Term life insurance is ideal because it’s there when you need it and it expires when you don’t.

Finally, cash value life insurance is often sold as an investment. However, the returns generated from these policies are often subpar when compared to investing more directly in the market through tools like mutual funds and ETFs inside of retirement accounts.

With a few rare exceptions, term life insurance is the ideal product for most people.

Failing to Define Contingent Beneficiaries

The whole point of life insurance is to provide a financial benefit to loved ones in the event of your passing. This is why you name a beneficiary on your life insurance policy. But what if your beneficiary does not survive you?

This is why it’s very important to also name contingent beneficiaries. A contingent beneficiary is a person who receives the death benefit in the event that the primary beneficiary does not survive you.

In many cases, this is another relative or it can be children. It can also be a trust, which can be especially useful if you have minor children who are not old enough to handle large sums of money yet.

Be sure to consult a professional who can discuss estate planning with you if you have questions about the best way to name beneficiaries and contingent beneficiaries in your life insurance policy.

Conclusion and Statistics

Let’s recap with some statistics about life insurance from Policygenius:

  • Only 52% of American adults have life insurance.
  • 27% of American adults with life insurance only have group coverage — which usually isn’t enough (and rarely stays with you if you leave your job)
  • 10 to 15 times is the multiple of your annual income that most financial advisors recommend you need when buying life insurance for income replacement
  • 40% of life insurance holders wish they had purchased their policies at a younger age
  • 5 to 15 times – How much more permanent life insurance (like whole life insurance) costs vs. term life insurance
  • 4.5% to 9% – Average percent increase in your insurance costs as you age, assuming your health stays the same
  • 2 to 3 times – How much rates for smokers cost vs. rates for non-smokers (but a year after you quit smoking, most companies will offer you non-smoker rates
  • 24% – Difference between premiums for men and women (with women paying nearly 1/4 less than men, on average)

Life insurance is not always fun to think about or pay for, but having the proper coverage in place can be a life-changing decision if it’s ever needed. It can also bring peace of mind when you know that you’ve implemented a plan for your loved ones in the event of your passing.