Do you still need life insurance?

(MoneyWatch) "Do I still need this whole life insurance policy?" asked a 65-year-old, who was trying to prepare for retirement. The answer is annoying: It depends.

Life insurance is a necessary component of a family's financial security. That said, I often take issue with the insurance industry, which seems to recommend insurance as the solution to every financial problem. Not every person needs life insurance at every point in life.

Life insurance is critical when your death would cause a financial hardship for your survivor(s). It is also an excellent tool for estate planning. But many retirees continue to pay for coverage that they may not need, simply due to force of habit. Let's start by defining the basic types of coverage.

Term life insurance is appropriate for people who have a specific insurance need for a defined period of time. An example would be a young couple with kids who have not yet saved a sufficient nest egg to support their survivors in the event of premature death.

During the stated term of a term-life policy, if the insured dies, the insurance company pays the face amount of the policy to the named beneficiary. The amount of coverage can include living expenses for survivors; the lump sum amount necessary to fund future educational expenses; and/or money to provide for the future retirement needs of the surviving spouse. Premiums for term policies are often reasonable for those in good health up to about age 50. After 50, premiums start to get progressively more expensive.

For people who need life insurance in place until they die, permanent life insurance is preferable to term. Permanent insurance combines a term policy with an investment component and comes in three flavors: Traditional whole life, universal and variable universal. Whole life policy owners rely on insurance company dividends as the source of accumulation inside the policy. Universal and variable universal life holders invest by using sub-accounts, which are akin to mutual funds, inside the policy.

Permanent life insurance earnings grow on a tax-deferred basis, but you don't have to die to get your money -- these policies allow you to borrow against your cash value. The downside is the hefty price tag. High fees and commissions can lop off as much as three percentage points from the annual return. There are also up-front commissions that are typically 100 percent of the first year's premium. Also, some buy permanent coverage only to find that they can't afford the premiums a few years into the contract. Those who bail out within the first few years will likely lose everything they have put in, due to surrender fees that can apply during the first 7-10 years of the policy.

So, should you keep a permanent policy that is in force? If you need insurance to provide liquidity upon your death (maybe you own a private company or real estate that you don't want your survivor to be forced to sell), then permanent insurance is for you. If your death would trigger significant estate taxes and you want to provide the money to pay the taxes, then keep the insurance, preferably inside of an irrevocable life insurance trust. Finally, if you have a pension that is based only on your life, and you want to provide your spouse with additional retirement funds, the policy can make sense.

But for many, paying for a permanent policy may not be worth it, even if well beyond the surrender period. Contact your insurance agent to determine whether the policy could stay in force without your paying any further premiums, based on the accumulated cash value. Otherwise, you might want to extract the money in the policy through loans, which reduces cash value and/or death benefits. If you want to cancel and grab the cash, beware that you may trigger a tax event, so be sure to ask the agent about the total tax hit you could incur.

See, I told you -- it depends!

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