By Chris Arnold
After recently attending an event held at NerdWallet headquarters, it dawned on me that I am one of only a few advisors in their network who focus on life insurance as a tool to help protect and grow client assets. My experience in general has been that there is not much public knowledge or understanding of life insurance.
So I thought write about the topic that everyone was waiting for: life insurance! I’m sure that statement is accurate only with a small population of readers, but clearly life insurance is a financial topic that warrants a thorough discussion.
There are several issues related to life insurance that I’d like to cover in future articles. For now, I’ll touch on the discussion surrounding the philosophy of ‘buy term and invest the rest.’
Does that adage sound familiar to you? Have you spoken to your insurance broker requesting term coverage and gotten a discussion of the virtues of permanent insurance (also known as cash-value insurance)? So what’s ‘better’: buying term and investing the difference or buying a permanent insurance policy that builds cash value?
The short answer is: it depends. Allow me to discuss some issues surrounding ‘buying term and investing the difference’ versus buying a permanent insurance policy.
‘Buying term and investing the difference’ refers to using the amount that it would cost to buy a permanent life insurance policy and comparing it to the cost of a term policy for the same face amount (death benefit) just for the period of time (or term) it’s needed. For this example, although there are different kinds, let’s use a whole life policy for the permanent life insurance policy. Term insurance is far less expensive than whole life insurance at the beginning so with the difference in costs for the different policies, take that amount you would have spent on the whole life policy and invest it instead.
Let’s run some numbers to see how that turns out.
The cost for a $250,000 whole life policy for a 40 year old non-smoking male at the preferred rate class can vary from product to product and company to company, but one quote from a reputable company I represent is about $347 per month. In 20 years, the cash value is guaranteed to be $70,018 but under current values would be $105,721 with a death benefit that has grown to $326,352.
The cost for a $250,000, 20 year term policy using the same parameters would be as low as about $23 per month.
Taking the difference, or $324 per month, and investing it over 20 years at an 8% annual return would result in an amount of about $190,843.
So clearly the ‘buy term and invest the difference’ strategy is superior, right?
This is where ‘it depends.’
One of the first questions is: ‘What is your objective with the dollars you are considering either putting into a life insurance policy or into a different investment?’ What a whole life policy has that the investment option does not is guarantees that are backed by the financial standing of the issuing insurance company. In your investment account, you could be cruising at 8% for 19 years only to have a market downswing reduce your portfolio by 20% or more in year 20. That won’t happen with a whole life policy — if you pay the stated premiums on time, you will have the amount of cash value that is reflected in the policy. So whole life insurance takes the market risk out of the equation.
Another question is, will you really ‘invest the difference?’ Many folks whiff on this. They get the cheap term insurance then never set up their recurring monthly investment account. So they are protected in the event of an untimely death, but are not putting funds into something that is geared to grow over time. A whole life policy forces the issue: you have to put the amount into the policy to keep it going. Of course an issue there is the risk that your future cash flow varies and that could impede your ability to make those premium payments. If that’s a risk that concerns you in your situation, a whole life policy may not be the best for you but there are other flexible-premium permanent policies available that may suit you better. Once cash values build up over many years, it is possible to stop paying your premium out of pocket entirely and instead use surrenders of paid up additions or other methods to keep your policy afloat. Sorry for the insurance-speak just then – I toss that out there just to let you know there can be some flexibility down the road whether a whole life or other kind of permanent life insurance policy is used.
And what about getting your money out of the policy or the investment, depending on which you choose? If you are ‘investing the difference’ in a non-qualified account, you can be eligible to be taxed on the growth at the applicable long-term capital gains rate. Dividends will be taxed as income in the year they are paid. If you are utilizing a qualified account like a traditional IRA or 401(k), you won’t be taxed until you withdraw your funds and then your growth will be taxed as current income.
Usually the most advantageous ways to get the cash value from an insurance policy is 1) by way of withdrawing premiums, then using loans, or 2) by just using loans. Withdrawing cash value in excess of the premiums paid will result in that amount being taxed as current income so it’s important that withdrawals and/or loans are set up correctly. But a big benefit of getting money out of insurance policy is that if it’s done correctly, both what was put in and the growth can be taken out in a tax free manner. There are very, very few places to put money, have it grow, and take it out without having to pay tax and life insurance is on that short list. So if you are in a high income tax bracket, this can result in a benefit that mitigates the lower growth projections associated with permanent life insurance relative to ‘investing the difference’. If you just don’t like taxes or what they might become in the future, a permanent life insurance policy could appeal to you. With the USA having over $16 Trillion in national debt currently, do you think that future tax rates will be higher or lower than they are today?
Oh, and by the way. After 20 years, you won’t have any more insurance under the ‘buy term’ scenario. True, you may not need it if the mortgage is paid and kids are done with college. But there is a segment of the senior population who are looking to have some life insurance in place for when the inevitable comes for a variety of reasons not limited to final expenses and leaving a legacy to family or charity. With the whole life scenario, that 40-year-old can stop paying premiums after 20 years and have a reduced paid up amount of coverage guaranteed to be $156,000+ but projected using current assumptions to be $235,701 and grows over time to more than $400,000 at age 86 with cash value growth ongoing that whole time as well!
In the end, getting a whole life or other permanent life insurance policy is not right for everyone. Whole life rates of return may be just too low for you (in which case one of the other kinds of permanent coverage may suit you better). The fees, costs, and loads built into the policy may turn you off (but to invest you must pay fees in your 401(k) and to your advisor). You may not qualify for a life insurance policy because you have medical issues (but can get a policy on your healthy spouse or kid as an alternative). So, I caution you strongly against simply accepting the mantra of ‘buying term and invest the difference’ as 100% accurate all the time. The reality is that for many it is worth considering a permanent life insurance policy that is properly structured to meet your specific needs.
Let me leave you with this compromise: How about getting term life insurance for one amount as a baseline amount of coverage, then get a small face amount permanent policy that you can pay into to get the benefits associated with permanent life insurance? Make sure to leave some left over in your budget so you still have funds available to invest in your 401(k), IRA, or otherwise. In that instance, you have covered your life insurance protection needs while having cash value growth potential in a tax-friendly environment through your policy as well as put funds to work with the potential for greater rates of return over time in your investment accounts. I call that a win-win-win which is rare, but always nice if you can get it.