Depending on what your overall financial goal is, permanent life insurance may make the best sense for you. However, for most people term life insurance provides the coverage they need while being a cheaper alternative to the more expensive permanent polices and frees up cash to invest in more appropriate investment and retirement vehicles for greater growth.
Overwhelming odds favor the possibility that you’ll be pitched the idea that a cash value life insurance plan is a great investment vehicle at some point in your life. With insurance companies offering guaranteed risk-free rates of return with some investment options and market-competitive returns in other options, using a whole life plan to save for retirement may seem like a no-brainer. Digging deeper may cause you to question whether there is such a thing as a guaranteed competitive rate of return and may ask you wondering how you can best prepare for retirement, final expenses, and the needs of your heirs.
Types of Insurance
Being overwhelmed by the options seems to be a rite of passage for those shopping for insurance. Before jumping to explain why a typical American would be served best by buying term life insurance and investing the rest, consider the life insurance options that are available. Life insurance policies are either term or permanent. Term policies protect your beneficiaries from financial loss in the event of your death, they build no cash value, and they lack an investment component to the policy. Sound familiar? It should! It’s exactly how automotive insurance works. Car insurance only pays out if you are in a crash while you have a policy in effect. If you go 20 years without a claim, you’ve only bought peace of mind.
Term policies cover the insured person for a number of years. Whether that’s 10, 20, or 30 years is up to the insured person. These plans are inexpensive to purchase and offer significant death benefits because of these plans only payout when the insured person dies. How inexpensive are term policies? A 30-year-old male in good health who does not smoke could purchase $200,000 of coverage on a 15-year guaranteed-level- term policy with a medical exam for less than $13.00 a month.
Permanent life insurance plans are also referred to as cash value policies. They pay out a death benefit to your beneficiaries in the event that you pass away while the plan is in effect and they feature an investment component inside of the policy. Whether you are considering variable life, universal life, or whole life policies, the one thing that ties them all together makes them similar is their investment feature.
A big part of the reason why permanent life insurance is so expensive is that a portion of your monthly premiums is directed into the investment account. The growth of the invested money is tax-advantaged and can be used to buy additional life insurance coverage, support long term care expenses, pay for child college costs, or fund any of life’s major expenses.
As straightforward as these policies seem, many public financial celebrities dislike the use of a life insurance policy as an investment vehicle. Their skepticism typically boils down to the commissions paid by insurance companies to salespeople and the expenses associated with the plans. The argument goes that a typical investor would do better to purchase a term life insurance policy and invest the premium difference in a low fee index fund or mutual fund. There is a good degree of truth to this criticism, but using cash value life insurance still makes an enormous amount of sense.
Permanent life insurance is more customizable than term products. The addition of policy riders allows insured parties to use life insurance products to fund long term care, provide coverage to children, and mitigate other risks. These features come at a price. The same 30-year-old male quoted above considering a $200,000 universal life insurance plan would spend about $115 a month to fund the policy.
In most cases, little to nothing.
Who Should Buy Life Insurance?
There are four categories of people who need life insurance. If you don’t find yourself fitting into at least one of these categories, life insurance is likely not necessary for you.
No one wants to leave a burden for their family to face when they pass. For people who struggled through life and expect to leave little behind, a small life insurance policy that covers final expenses and some lingering bills makes sense. Assuming you are not covered through your work with a small life insurance policy, you can get special coverage through an affordable final expense plan.
These policies are designed to be issued to older clients, so age is not as large a factor in approval as it would be with other policies. The policies also provide a much lower death benefit than a traditional term policy. To appreciate how final expense insurance is priced, consider that a 60-year-old man in regular health should expect to pay about $45 a month for $10,000 in coverage.
The second type of person who needs life insurance is someone who has another person depending on them for financial support. Whether this is a spouse, minor child, or adult child with special needs, if someone looks to you for financial assistance it is incumbent upon you to make sure they are cared for in your absence. Experts typically recommend buying 8 to 10 times your annual income in level term insurance.
The third group of people who need to consider a long duration term policy or a permanent life insurance plan is those who fear that their family medical history predisposes them to contracting a disqualifying ailment in the future. While a family history of many of these ailments needs to be disclosed at the time of application, it is often easier to get a life insurance policy in place before symptoms of disease present themselves. If you’ve got a family history of type 1 diabetes, cancer, or any number of genetic disorders, seriously consider securing coverage to benefit your future dependents now.
Finally, wealthy individuals who have estates that exceed the federal estate tax threshold or who live in states that subject their estates to additional taxes should consider permanent life insurance. Because permanent life insurance reduces your estate’s value and pays a tax-free death benefit to your heirs, it can be used to transfer wealth while sheltering inheritances from taxing agencies.
When Permanent Life Insurance is a Solid Investment
Fees and commissions aside, permanent life insurance makes sense in a number of circumstances. It is advantageous for people from an insurance perspective whenever a person fears that they may not be able to renew term life insurance policies due to illnesses, disabilities or disorders that may present later in life. Permanent life insurance is just that – permanent. There is something to be said for buying the knowledge that you will always have coverage in place and that is one of the key benefits of a cash value policy.
The insurance product also makes sense when the purchaser wants the option to infuse predictability into their long term care expenses. When coupled with long term care riders, permanent life insurance can create a heavily tax-advantaged pool of money to provide for nursing home care. People expecting to rely on Medicaid subsidies to provide also benefit from whole life insurance plans when they are held in an irrevocable trust. Because assets in these trusts will not disqualify you from Medicaid eligibility, they can be used to transfer wealth to heirs, provide a steady stream of discretionary income, and can pay for final expenses.
Investors with a high net worth would also do well to consider using cash value insurance as a mechanism to avoid the estate tax. Couples with a net worth exceeding $10.98 million at the time of their passing are subject to the federal estate tax. It’s quite a hefty tax and for those who qualify, it will take 40% of every dollar over $10.98 million.
Don’t think that an estate tax is something that you would ever need to worry about? Think again! All of these states have independent estate taxes and some of them kick in at estate values as low as $1 million and that often includes your primary residence. Because state estate taxes are taken on top of federal taxes, it doesn’t strain the imagination to consider the case of someone who is close to a federal or state estate tax limit benefiting from the purchase of whole life insurance, annuities, and the use of irrevocable trusts to strategically exempt some of their assets from their taxable estate.
Consider a woman who lived in Oregon at the time of her passing. If she had an estate worth $1.5 million when she died, $500,000 of her estate would be exposed to a 10% state tax. That costs her heirs a whopping $50,000. Had she used a combination of irrevocable trusts and cash value insurance to shelter $500,001 of her estate’s value, her net worth would have remained the same, she could have accessed her investments through sheltered withdraws from her life insurance policies, and her estate would have been immune to the estate tax.
Knowing how much this saved in comparison to the fees and expenses associated with cash value insurance is challenging because the fee structure of every plan is different. What isn’t hard to say is that sheltering any money from a 40% federal tax and a state tax that exceeds 10% is a big move that demands serious consideration.
You’re Lending Money to Yourself?
Banking on yourself or loaning money to yourself is a central concept in investing with permanent life insurance plans. When you buy permanent life insurance, a portion of your premiums is directed to the cash value account and that portion grows with the collection of dividends and increases of fund values. While the accounts can go down in value, they typically increase along with the stock and bond markets.
Life insurance plans with sufficient cash value allow policyholders to take loans from the cash value. The loans do charge interest and the interest is repaid to the account. This is essentially the same way a 401(k) loan operates. If you die with an outstanding loan, your death benefit can be reduced and your beneficiaries will receive less than the amount you may have expected.
Borrowing from a plan’s cash value is the only way to get funds out of the account short of canceling the permanent life insurance plan. While cancellation is always an option, it does come with exposure to a significant number of early termination fees. These fees can be substantial for less mature permanent life insurance plans.
It’s Part of the Plan
So when does it make sense to use a cash value life insurance product to invest? First, it makes sense when you’re interested in using your life insurance product to fund other major expenses. This is particularly true for long term care and nursing home expenses. A well-funded cash value life insurance policy that has a long term care rider attached to it could easily grow to fund years of long term care.
Second, it’s a great idea whenever you are confronting a unique challenge. Whether this is an avoidable estate tax burden, a desire to fund an irrevocable life insurance trust to support a special needs child, a wish to create a readily accessible source of liquidity for a business that would support the buyout of a partner when they pass, permanent life insurance can support a number of special needs.
Third, it makes sense when you’re holding the policies inside of an irrevocable trust to support the lifestyle of a special needs dependent or maintain your own Medicaid eligibility.
Who isn’t it appropriate for? Typical Americans would do best to buy term policy coverage and invest the premium savings. If you find that you are not consistently maxing out all of your tax-advantaged savings, you need to focus on taking advantage of those lower fee options first. Because these plans have more investment options and because they typically are offered at far lower fees, they just make sense.
True Blue Recommendation
While permanent policies like whole life and universal life work well for some people, a solid term life insurance policy is ideal for the majority of people out there. Term life insurance also allows you to convert the policy to a permanent policy in the event you decide you wanted to switch your strategies. Focus on building up your retirement accounts first and when those are fully funded, begin looking at more advanced products like permanent life insurance.