When I met with our financial advisor, one of the first things she suggested was to get term life insurance… not whole life insurance.
She also suggested I get them from different insurance companies.
What's funny is that it was the same advice I once received from our business accountant. It was one of our first meetings; and, as I explained what I did (what? personal finance blogging? what's that?), we jumped around on a few topics casually until we hit on life insurance. My business accountant told me that he only ever purchased term life insurance because he liked to keep his investing and his insurance separate.
While there are benefits to mixing the two (most notably the tax benefits); I always enjoyed the clean separation.
What is Term Life Insurance?
Term life insurance is the simplest form of life insurance. You get insurance for a set period (term) for a fixed premium. The term can be anywhere from a year to thirty or more. If the insured person dies within the term, the beneficiary is paid the amount of the policy.
If someone buys a 30-year $500,000 policy, makes premium payments, and dies within 30 years… the beneficiary gets $500,000 tax-free.
It's pretty simple.
Insurance policies can have a low benefit, as low as $1,000, and sometimes even a low term of just a few years. Bestow offers plans as short as 2 years with benefits as low as $50,000.
The disadvantage of term life insurance is that there is no cash value. It's like other insurance policies (like auto) – you pay for coverage and when you stop paying, you have nothing to show for it. This also makes them cheaper than the alternatives.
What is Permanent Insurance?
Permanent insurance is a broader category of insurance that includes whole life insurance.
- Traditional whole life,
- Universal life,
- Variable life, and
- Variable-universal life.
Traditional Whole Life Insurance adds an investing component and removes the term. It's called “whole life” because it covers your whole life. The policy builds a cash value based on an underlying investment strategy. This cash value is something you can use. You can borrow against it and you can cash it out.
Universal Life Insurance has a flexible premium with a minimum payment to keep the policy active. Any amount you pay above that premium is then invested in the policy. Every month, the “cost of insurance” amount is deducted from the policy. The rest is considered the savings component. If the savings component is indexed to the market, such as the S&P 500, then it's known as Indexed Universal Life Insurance.
Variable Life Insurance is like the others except you have several separate accounts for the savings component. You get to choose those investments so you can pick stocks, bonds, mutual funds, etc. With variable life insurance, the premiums are typically not fixed. (Premiums can be adjusted within limits)
Variable-Universal Life Insurance is a variable life insurance policy with a flexible premium.
When you stop paying the premiums (“surrender the policy”), you get the cash value minus any outstanding loans. I won't go into the nitty-gritty details of each type of permanent insurance, but they are all set up in similar ways. The big differences are in how much you pay and what the underlying investment strategies may be.
Why is Permanent Insurance Better?
The argument is similar to renting vs. buying a home.
With term life insurance, you pay premiums, but build up no cash value in the policy. If the term expires, your policy ends and you have nothing to show for it. If you die, your family gets the death benefit payout. Death benefit payouts are not taxed. You don't even have to report them.
With whole life insurance, you pay premiums, but you also build up a cash value. There is no term, so it never expires (hence permanent/whole life); but if you stop paying, or let the policy lapse, you can get back the cash value of the policy.
Why is Term Life Better?
First, it's simpler. You pay for coverage, your beneficiaries get paid if you die, that's it. No extra bells and whistles. No fees to worry about.
Every other insurance policy works like this. When you get renter's insurance, you pay for protection, and you don't build up a cash value in the policy. If you have a claim, you get paid. If you never get a claim, you never get anything.
It's also easy to understand how it fits into your financial picture. If you have financial obligations, such as a home mortgage, it might make sense to get a term life policy for the value of the mortgage. If you die, the policy can be used to pay off the mortgage and leave your family in a better financial situation.
Socrates, a long-time reader that I frequently email, was a real estate broker in California for 15 years. He offered this advice about term life insurance:
Term is good for accomplishing some milestones, paying off the mortgage, getting kids through college, etc. Once those goals have been achieved then the only necessary thing is a policy to cover final expenses (usually $10-25K) unless there's enough of emergency funds to cover that!
The only time I recommended permanent life is when someone had a hard time-saving money in an IRA or 401K. Then, this will work cuz the reason it's more expensive is cuz after the cost of insurance is taken out the rest is invested (nowadays in just about anything). It's a forced savings plan & if young enough the cost is low & most of the money is invested & can grow nicely. (Not as much as low-cost mutual fund / ETF but again the insurance is the primary the investment is a secondary factor!
Again, for people who aren't good at saving on their own or they are constantly tapping into their savings, this can be a solution because you're less inclined to tap into this because of the tied insurance element.
Right before I retired the industry came up with hybrids. A policy that is a part term (the bulk of your coverage) & a small portion in whole life (to cover the basics like the final expenses) that stays with you.
If you invested the cash portion well, at some point the cash value can even cover future payments, usually, 10-15 years down the road & it feeds itself as long as the market holds up.
There are many variables & each situation is unique! The expression of ‘buy term & invest the difference' only works if you stick to invest the difference diligently.
Term life is also cheaper. There's no cash value to the policy and no investment component, you're just getting coverage. If there were an investment component, managing those investments would come with fees. Whole life gets a bad reputation because sometimes it's hard to know exactly how much you're paying because the fees can be obfuscated in the returns.
The downside is that there is a term. As you age, getting a new policy will get more and more expensive. As more things happen in your life, such as new medical conditions, you may find yourself uninsurable. The advantage of whole life is that you keep the policy as long as you keep paying.
Why Do People Get Permanent Life?
Nothing in life is one size fits all. Permanent life insurance makes sense for some people and today I want to share with you the experience of Bill K., a Wallet Hacks reader, who emailed this after reading this article:
I was born in 1957. My parents wisely bought a New York Life whole life policy for $20k that allowed me to pick up an additional $10k policies at various points as I aged (i.e., 21, 25, etc.). Those options correlated with my growing family, mortgage, etc. However, at 20 I was diagnosed with Type I diabetes, and at that point began insulin therapy. Also at that point, ALL traditional life insurance doors, both term, whole and universal, slammed shut in my face. All I had were these small $10k policies (8 in all) so for most of the past 25 years I have maxed out my insurance at $100k. Not much for a guy with my earnings (MBA); but it was something.
Now at 62, semi-retired and living in Palm Springs, I no longer need insurance. Kids are grown and in good jobs, the mortgage on our small house in the SoCal desert is paid off, spouse of 35 works part-time also, we are doing okay and enjoying life.
However, all of these small policies that have been maintained over the years now have a cash value of close to $100k. Several annual premiums are paid through dividends. The “gift” my parents gave me as a toddler has an unexpected benefit. I can borrow against the value at a ridiculous 1960's interest rate of 4%. This cash is being used for us to defer drawing SS until age 70, the best annuity around. And we continue to let the bulk of our assets grown in tax-sheltered IRAs. If I eventually pay back the loans, great. If I should die without doing so, the benefits to my heirs are reduced, but that is not a huge concern for me, especially since our two kids graduated with zero college debt.
So I happily pay the small annual interest charge on these cash value whole life insurance loans. Preserve the nest egg residing in our IRAs, delay social security, and have some additional cash NOT in an IRA to enjoy the first 8 years of our semi-retirement when we are both healthy and active.
It won't work for many, but it worked for us, due to my medical condition (which I've managed for 40 years with no complications with insulin, diet, and exercise) and due to my parents' foresight.
You Can Have Both
Nothing prevents you from having, both, a whole life policy and a term life policy. It could be that you have a whole life policy and you want to add a term life policy to cover a need for a set period. For example, maybe you have 10 years left on your student loans, so you may decide you want to protect the next years with a term policy.
As my business accountant explained to me, you can always get a term life insurance policy and then open a brokerage account for your investing. It's unlikely the policy issuer is going to invest you into funds that are cheaper than Vanguard or Fidelity (this is not even counting their fees!). It's unlikely they will be as simple as a three-fund portfolio, and it's unlikely you will have a strong understanding of how it will fit in your portfolio.
If you don't want to do it yourself, the worst case is that you can stick it with a robo-advisor and pay their extra fees (only around 0.25%).
What About Taxes?
As for the tax benefits, the death benefit on any life insurance policy is tax-free. That's true for all policies, term or permanent.
That leaves the investment portion. Is it better to invest through a whole life policy or do it yourself?
All things being equal, long term capital gains rates on your investments are just 20% (or less). Is 20% at the back end better or worse than a little siphoning off along the way? That's hard to know… but I do want to throw in a curveball that may make it a moot point.
There are special tax rules when it comes to inheritance. If you are passing assets to heirs, there is a step-up in basis. If you have significant gains in your investments, your heirs will get a higher basis and thus lower their taxes because the gains will have “disappeared.” (estate taxes may apply though)
Lastly, since you'll be saving on fees by investing the funds yourself, and your money will grow faster without the drag of fees; it could even overcome the tax benefits of the death benefit from a whole life policy.
Going with term keeps everything cleaner and easier to understand… and I like that. It also fits nicely with how I think about insurance.