Updated Dec. 18, 2019:"Life insurance is a financial safety net for families."
You've probably come across this definition while tackling your money checklist. "Financial safety net" is definitely the most concise way to convey why life insurance is important.
To help you understand how life insurance works, here are three things life insurance covers — and one big thing it won't.
1. Income loss due to the death of the policyholder
When someone with life insurance dies, their beneficiary can file a claim for the policy's death benefit. The death benefit is a lump sum of money the beneficiary can use to cover all the expenses the policyholder was taking care of, like the mortgage, auto loan or utility bills. Depending on how large the death benefit is (i.e. how much coverage you buy), life insurance can also be used to cover future expenses, like the cost of your child's college education.
So, fundamentally, life insurance allows you to provide for the people who depend on you, if you were to die while they're still under your care. (We can help you figure out how much life insurance you need and compare quotes on policies here.)
2. A tax-free inheritance
In most cases, a life insurance policy's death benefit is not subject to taxation. The money is simply disbursed tax-free to the beneficiary. The few exceptions are tied to certain investment gains, as opposed to the death benefit itself, or policies paid out to a beneficiary inheriting an uber-large estate, which you can learn more about here.
3. Funeral expenses
The unexpected death of a loved one creates an immediate financial burden many young families aren't actively saving for: the cost of a funeral and burial, which can run anywhere from $7,000 to $10,000. Many policyholders work end-of-life expenses into their coverage, so, again, depending on how much life insurance you purchase, your beneficiary can use its payout for your funeral.
The big caveat: application fraud
Here's something else most people don't realize about life insurance policies: They come with what's known as a contestability period. That's a period of time after your policy goes into effect (usually two years) when the insurer can review your application for fraud.
If you die within your contestability period and the insurer discovers you misrepresented your risk of death by withholding or denying medical conditions, risky habits or other pertinent information during the underwriting process, your beneficiary's claim can get denied. The company could alternately reduce the death benefit by the amount of money you should have been paying in premiums.
If the insurer discovers misrepresentations on your application during your contestability period and you haven't died, it can cancel your policy or up your premiums. You can learn more about the contestability period here, but the big takeaway is: Tell your prospective insurer everything. You don't want any holes in your family's financial safety net.
Image: Aleksander Nakic