Life insurance policies can be confusing, with complicated rules and arcane language that often make it hard for consumers to understand the costs and benefits. With a little research and expert guidance, though, you can make the right decision that saves you money and creates financial security for your family.
First, a quick summary. There are two main types of life insurance: term life insurance and permanent life insurance, such as whole life:
With a whole life insurance policy, policyholders pay the same premium for as long as they live. A payout is guaranteed at the time of death for the policy’s beneficiaries, and some of the money paid into the policy accumulates “cash value” in the form of a tax-sheltered investment account that the policyholder can borrow against.
With a term life policy, policyholders pay a premium for a defined length of time, such as five, 10 or 20 years, and the policy pays out a death benefit to the beneficiary only if the insured person dies during this term. There is no cash-value investment component. This option is typically much less expensive than whole life, and people often turn to this option to cover them during a certain phase of life, such as when their children are young or they are paying a mortgage.
Because of the long-range planning aspects of life insurance — and because of the investment component of whole life insurance — financial advisors often counsel clients about how insurance plays into their overall retirement planning. We asked financial advisors Rachel Podnos and Andy Tilp, who are members of NerdWallet’s Ask an Advisor network, for their opinions on which kind of life insurance is a good fit for consumers.
What should consumers keep in mind when deciding between these two options?
Rachel Podnos, financial advisor, Merritt Island, Florida: Consumers should keep in mind the issues they are trying to resolve by purchasing life insurance. In most cases, that purpose is to replace lost income for loved ones should you die prematurely.
For the majority of people, term insurance is the best way to accomplish this goal. The smart strategy is to use life insurance for 20 to 30 years when it is the least expensive, and at the same time accumulate enough wealth not to need the insurance anymore.
Whole life insurance can accomplish this main goal, too, but it lasts until your death and comes with a savings vehicle attached. It is also marketed as an investment. Generally, whole life policies do not make good investments and have incredibly high fees and expenses. Keep in mind that insurance salespeople are often paid very high commissions to sell whole life policies.
Andy Tilp, financial advisor, Oregon: The purpose of life insurance, by definition, is to ensure individuals who depend on your income can replace it and continue without you. Despite the sales pitches and marketing material, life insurance is not for wealth-building or college savings, nor is it an investment.
Compared with term insurance, the cost of whole life is significantly more for a fraction of the coverage. Thus, a permanent policy providing coverage of 10 times your income, plus college and debt, is likely cost-prohibitive. A better strategy is a low-cost term policy. Invest the difference and build your wealth.
In what situations does whole life insurance make sense?
Andy Tilp: If the value of an estate is greater than the federal estate-tax exemptions ($5.45 million for an individual, $10.9 million for a couple), and the tax bill would force the sale of a business, farm or other nonliquid asset to pay the taxes, then a permanent policy that covers the tax bill may make sense.
If one person has a pension that stops or is reduced at the pensioner’s death, and the survivor will be dependent on the income, a permanent policy could protect the value of the pension.
In almost all other cases, whole life insurance should be at the end of the chain. I’d want someone first to build taxable investment accounts so there is a balance among traditional IRA, Roth IRA and other taxable accounts. This gives greater flexibility in how assets are accessed in retirement. Next, I would suggest investment property as a good way to produce income. Once someone has several million dollars stashed in those previous assets, whole life insurance could start to make sense, in my opinion.
Rachel Podnos: If you own a large, illiquid business that you don’t plan to sell before your death, it’s wise to buy a whole life policy because your heirs can use the proceeds to pay the large estate-tax bill they will likely face when you die.
A whole life policy also might make sense if you are a person who won’t “buy term and invest the difference,” as the saying goes. If you are not a disciplined saver, the forced savings component of whole life insurance can be beneficial.
But that’s it. If you want asset protection and tax-deferred growth, open a retirement account.
What are some tips to help consumers decide which option is best for them?
Rachel Podnos: The biggest tip I have is to get advice from an expert you can trust. I highly recommend talking to a fiduciary advisor or getting multiple quotes from an independent insurance broker who is not employed by any insurance company. If you do these things, you are likely to get objective and competitively priced recommendations. You may even be told you don’t need life insurance at all.
Andy Tilp: For the vast majority of people, a fixed-rate, term policy is best. Life insurance is necessary only until you can “self-insure,” meaning you have sufficient assets to provide for your survivors. Compared with term insurance, permanent life insurance is expensive. Term gives the protection needed and lets you invest the difference.
Life insurance is an important piece of the financial puzzle. If you want professional help in selecting the type and amount of insurance needed, work with a fee-only professional planner who does not have the potential conflict of interest that is inherent with commission-based products.
Is there anything else consumers should know when making this decision?
Andy Tilp: Consider “laddered coverage.” As a hypothetical example, while children are young, and the asset base is small, a $500,000, 20-year policy and an additional 10-year, $250,000 policy may be necessary. Then, in 10 years, once the need diminishes and the wealth grows, the term is no longer required, and you can save the premium payment.
Another tip: Use a personal policy as your primary policy and an employer plan for extra coverage. The cost of employee-paid optional insurance often increases with age and is lost if you switch companies.
Rachel Podnos: Here is what consumers should know: Not everyone needs life insurance.
The purpose of life insurance is to take care of those who rely on your income should you die. If you do not have people who rely on your income, or if you have enough assets to take care of your dependents without life insurance, then you likely do not need life insurance. For these reasons, most people at retirement age and beyond do not need life insurance.