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On the surface, life insurance seems like a simple concept — you pay an insurance company a premium and, when you die, the company pays your beneficiaries. Permanent life insurance policies such as whole life insurance also contain an investment component, where things can get complex.
Part of your whole life policy premium goes into a tax-deferred account that accumulates “cash value” over time. With any cash value life insurance policy, as the account grows, you can borrow against it or potentially withdraw money. Insurance companies tout these policies not only as a way to leave a financial legacy to your heirs, but also as a good investment tool.
Critics of this strategy point out that returns on these investments tend to be lower and fees higher than with other investment vehicles. They say term life insurance — a cheaper life insurance option that does not contain an investment component — is a better fit for most people.
The benefits of whole life insurance
When you pay premiums to a term life policy, the payment has two basic parts — the first covers the cost of insurance and the second pays administrative costs. Once those chunks have been paid, there’s nothing left over.
In a whole life insurance policy, you’ll pay more than the costs of insurance and administration, and that excess will accumulate in a cash value account. The account grows at a fixed rate, sort of like a savings account. The benefit of whole life insurance and the reason you might prefer it to a savings account lies in the cash account’s tax treatment and flexibility.
Whole life cash accounts grow tax-deferred. That means that the interest you’re paid isn’t taxed, as long as the money stays in the account. You'd have to pay tax only if you withdraw more cash than you paid in.
Because of this, money can grow more quickly than it might outside of your account. All of your interest stays in the account, earning even more interest in future years.
You can then use that cash value in retirement to supplement your income. Permanent life insurance policies let you borrow against the value in your cash account without withdrawing it or needing to pay taxes.
» MORE: Compare life insurance quotes
We asked certified financial planners Steven Elwell, Damon Gonzalez and Brian McCann for their opinions on whether whole life insurance is a good investment.
Should everyone consider whole life insurance as part of a retirement strategy?
Steven Elwell, Level Financial Advisors, Amherst, New York: While everyone can consider a whole life insurance policy as a part of their retirement savings strategy, for the vast majority of people there will be other, more attractive options to use first. For most, their employer’s 401(k) will be the first choice, especially if there is an employer match, which is essentially free money. After that, IRA and Roth IRA accounts should be the next consideration.
Brian McCann, Bootstrap Capital, San Jose, California: There are some very important reasons to have a whole life policy, such as estate tax issues, care for a disabled child or dependent, and liquidity for closely held businesses. If you need a whole life policy for such a reason, you may also be able to benefit from the cash value that builds up in the policy for retirement. But I generally do not encourage people to save for retirement using life insurance policies. They can be an expensive way to save.
Damon Gonzalez, Domestique Capital, Plano, Texas: I don’t recommend these policies for everyone. Most Americans cannot afford to buy the appropriate amount of life insurance coverage through whole life insurance alone. The median income in the U.S. is about $62,000 per household [in 2018, the latest figure available from the U.S. Census Bureau's American Community Survey], and I think only the top 20% of income earners should consider whole life. Term insurance is cheaper and is almost always the best type of insurance for 80% of the nation.
When would whole life insurance be a good investment?
Steven Elwell: For very-high-income people who have maxed out their 401(k) plans, IRA and Roth IRA options, a whole life insurance savings strategy can make sense, especially if they have a need for life insurance. Another viable option for high-income individuals could be the use of a tax-deferred, nonqualified annuity if they don’t have a need for life insurance.
Damon Gonzalez: I typically recommend this strategy to people who are already maxing out their 401(k) plans, Roth IRAs (if they are eligible) and 529 plans (if they have children). The cash value is protected from creditors in many states. It also makes sense for someone who has built a good nest egg and wants to diversify part of his or her portfolio into permanent insurance. If you are in a high tax bracket, are risk-averse and will be happy with bondlike returns, you should look at whole life.
What are the main disadvantages of whole life as a retirement savings strategy?
Steven Elwell: Whole life insurance can come with high premiums and high investment costs when dealing with variable universal life insurance. Many times, an investor can find substantially less expensive investment options outside of life insurance. The longer the investment time frame, the more important these investment costs become.
Damon Gonzalez: The insurance company is expecting the premium you commit to each year, and they aren’t very flexible. Your policy could lapse if you lose your job and can’t make premium payments anymore. It is important to keep in mind that you are paying for life insurance, and the cost of insurance will be a drag on your overall performance.
Anything else consumers should keep in mind?
Damon Gonzalez: If you are going to purchase a whole life policy, there is a plethora of riders and acronyms involved, and you should hire an honest advisor who has experience designing policies to maximize cash value. The advisor will need to access different insurers’ illustration software to design the best policy for you based on your health, age and how much you want to save. You can receive drastically different illustrations from agents that represent the same company, so don’t be afraid to shop around.
Optimizing a policy for a client often means blending in term insurance into the whole life policy. This pays the agent less commissions and puts more money in your policy. Unfortunately some agents aren't willing to present these policy designs.
Steven Elwell: Consumers should keep in mind that many people calling themselves financial advisors have a financial incentive to sell whole life insurance as a retirement strategy when other avenues have yet to be utilized. I would caution investors that “buyer beware” should apply when an advisor appears to be pushing a product without reviewing other, less-costly options.
Brian McCann: If you don’t need permanent insurance, term insurance is a very affordable option. You can invest the money you save on premiums to build a retirement nest egg. If you haven’t maximized your tax-favored accounts, such as an IRA or 401(k), then you can also get tax benefits on your contributions.