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Avoid common mistakes with life insurance

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Life insurance is a fundamental component of most financial plans. Yet consumers frequently make mistakes either when buying life insurance or while keeping it in force. Here are some of the more common mistakes to avoid.

1. Letting premiums define your decision. People often start from the premise that they can afford to pay only a certain amount on insurance premiums, and that determines the amount of life insurance they buy. Instead, you should first determine how much insurance coverage you need.

This usually is based on such factors as current income, future income needs, return from the invested death benefits, etc. Once you've determined the proper amount of coverage, you then can decide which type of insurance to buy. For example, you may only be able to afford term insurance for that amount of coverage, or a cash-value policy such as universal life may be appropriate.

2. Thinking of life insurance as an investment. Certain types of life insurance do build up money over time, which can be used to pay for the premiums or borrowed against to supplement retirement or college. But above all else, insurance should be bought first for its death benefits, not its potential investment return.

3. Automatically buying term. Term life insurance, in which you pay only for the death benefit, is an appropriate type of insurance for many people. However, other types of policies such as universal life, variable life or second-to-die icies may be a better choice in certain situations.

It's important to choose the insurance that's right for you, not pick something just because you've heard it's what everyone should buy.

4. Confusing illustrations with facts. Life insurance illustrations typically are charts or tables designed to show the policyholder how much a cash-value policy will be worth over time. For example, the illustration might show the consumer making 10 annual premium payments, at which point the policy's dividends would be sufficient to pay future premiums.

However, illustrations are only projections of what may happen in the future. They are not guarantees. The company's interest rates may decline, and earnings may not be sufficient to cover the premium in the future, necessitating additional out-of-pocket payments.

5. Failure to monitor your insurance. At least every year or two, reexamine your policies to be sure they are still doing the needed job. For example, your circumstances may have changed (marriage, divorce or birth, for example) and the amount of insurance may no longer be adequate, or it is no longer the correct type of insurance policy.

Be sure the carrier is still highly rated. Ask your insurance company for a current in-force illustration to compare with the original illustration. Are interest rates or investment returns from selected stock mutual funds still producing the intended return?

6. Forgetting to change beneficiaries. Divorce, death, birth or other life circumstances may dictate a need to change beneficiaries. Yet it's easy to overlook. Imagine seeing the death benefits from a policy on your recently deceased spouse go to that person's former spouse instead of you. Worse, imagine if you had to pay the estate taxes on those benefits. It happens.

7. Needlessly replacing a policy. Sometimes it is appropriate to drop a cash-value life insurance policy and replace it with another policy, especially if your life circumstances have changed. But be careful about dropping a policy just to get a "better-performing" policy. The first-year premium on the new policy typically goes to fees and commissions, with little or none of it going into your cash-value accounts.

8. Having the wrong ownership. Insurance benefits are free of income tax to beneficiaries, but they can still face estate taxes if the insured owns the policy a very common situation. When the insured dies, the policy benefits become part of the insured's estate and thus subject to estate taxes. To avoid this, have someone else own the policy or put it into an irrevocable life insurance trust.

(The preceding article was produced by the Institute of Certified Financial Planners and provided by William O. Woody, CLU, ChFC, CFP, of Stovall Woody Associates.)

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