Permanent Life Insurance
The process of buying life insurance begins with determining how much coverage you want. Only then do you determine if you're going to buy a term or cash value (also known as whole life) insurance policy. For years, the term/cash value debate has been raging, but developments in recent years have made term an even more attractive prospect. One of these developments is the advent of low-cost term policies with rates that stay level for decades (up to 30 years). Another important development is the tax advantages that became available with the Roth IRA. But this debate shouldn't be so confusing. Remember that life insurance is a financial product that can be broken into its four components: expenses, cost of insurance, rate of return on cash value, and how the policy is taxed. Permanent life insurance is designed to provide insurance protection over your entire life. It provides for the payment of the policy's death benefit to your beneficiaries, regardless of when death occurs, as long as you make the scheduled premium payments for your policy. In addition, permanent life insurance offers you the opportunity for tax-deferred cash value buildup inside the policy. Your premium payments provide both death benefit coverage and cash value. One form of permanent life insurance, variable life, lets you — not the insurer — choose how the cash value in the policy is invested among a range of investment options offered by the insurer. The cash value within the policy is not guaranteed but rather increases or decreases according to the investment experience of the investment options you select. In either case, as long as you pay the necessary premiums, you have the death benefit protection you need while you gain an opportunity for tax-deferred growth of the cash value inside your policy. If you decide you no longer need the protection or want the policy's cash value for some other financial need, you have the option of cashing in (surrendering) the policy — with possible tax consequences on any value over and above your cost basis (the amount of premium dollars you have paid into the policy) and any surrender charges applicable — or taking a loan against the cash value. Your policy's death benefit and cash value would be reduced by the amount of the loan. Obviously, any money you borrow from the policy does not participate in the investment experience of the policy investment options you've selected. You can choose from policies having different premium payment amounts and patterns. Some policies are payable for life while others are guaranteed to be paid-up after several years. Some feature guaranteed level premiums while others have premiums that increase once or more in the future. Many offer the opportunity, within limits, for you to tailor the premium amount and frequency based on your own needs and preferences.
About Permanent Life Insurance.
Many people have recommended buying cheaper term life insurance and investing the premium difference. But historically there hasn't been an investment that quite matched the tax advantages of cash value insurance. Now, there is one that's even better: the Roth IRA. You contribute after-tax dollars to either the Roth IRA or a cash value insurance policy. If you don't cash in your Roth IRA or cash value policy, the proceeds will go to your beneficiary tax-free when you die. This is in stark contrast to traditional IRAs, which have minimum distributions beginning at age 70 1/2 and are ultimately taxed when they're left to survivors. But suppose you have a cash value policy and decide to cash it in because you no longer need insurance -- say, your spouse has predeceased you. Doing this with an old cash value policy creates an ordinary taxable gain. But withdrawals from a Roth IRA are tax free as long as it's held for more than five years and you're over 59 1/2. This is a significant advantage to the policyholder. What about the other three components of cash value life insurance?
Permanent Life Insurance Offers Cash Value Buildup
Consider the following:
1. Expenses The commission load of a cash value policy is the highest of any common financial product. But you can fund a Roth IRA with a no-load mutual fund that has no commissions at all. In addition to the commission load of cash value policies, there's a tax on all life insurance premiums that varies by state. But a Roth IRA isn't insurance, so it's not subject to this tax. These high expenses alone make the option of buying term and investing the difference -- or using the difference to pay down debt -- a much faster means of building your net worth than cash value insurance.
2. Cost of insurance This also is known as the mortality cost or pure insurance cost. It falls on top of sales commissions and premium taxes, and it's similar to what an equal amount of term insurance costs. But the similarity is in theory only, because cash value policies charge significantly more for this mortality component than do today's term policies. Also, with term policies, these lower term rates are guaranteed not to increase, whereas the company can raise the mortality charges within a cash value policy.
3. Rate of return on cash value With a cash value policy, more of your premium goes for investment than for insurance. Your premiums are placed into investments that accumulate to a predetermined amount (your death benefit) over your life expectancy. Within the cash value package there also is a term policy that pays in case you die early. Since cash value policies are long-term investments, it's important to consider how the insurance company invests these values. About 80 percent of cash values typically go into bonds, mortgages, policy loans, and cash. These debt-based returns have historically yielded about 7 percent, as you become an indirect lender through your insurance company. You plan to keep your cash value policy for life, so are these the best investments for your money? Or does it make sense to invest in stocks or stock-based mutual funds, which have historically yielded more than 10 percent? Policyholders in their 40s with a 40-year life expectancy will triple their ultimate funds by averaging 10 percent per year instead of 7 percent!
With all this in mind, are there cases in which cash value life insurance is appropriate? Yes, if you're not going to follow through and invest the money you save as a result of buying term. Many people end up buying term and spending the difference. That's why I would strongly suggest that you commit to a monthly deduction for your Roth IRA. Also, remember that term insurance is only to be used for a set period of time and will not continue indefinitely. If your and your spouse's Adjusted Gross Income is less than $150,000, you're probably eligible to each fund a Roth for a total of $4,000 per year -- more than most people put in whole life anyway.
If you're still healthy and own cash value insurance, carefully consider this strategy. It involves the following decisions:
Do you still need life insurance? If so, how much?
Can you qualify for that insurance?
Where do you get a good value term policy?
What level period should you use?
Is there a taxable gain at the surrender of your old policy? If so, how can you avoid it?
Where should you get a Roth IRA and how should it be invested?
Remember that a cash value life insurance policy can be reduced to four basic parts. By carefully combining level term insurance with Roth IRAs, you excel in all four areas. You obtain much lower insurance costs while avoiding significant sales commissions and expenses. You also earn a higher long-term return on the investment element while having it taxed more favorably.
These four efficiencies make this the best way for most people to buy life insurance.
