Insurance companies and insurance agents often market life insurance policies as an alternative to traditional investments (full disclosure, I am a licensed insurance agent). There is no doubt that some policies have investment-like characteristics, but are they good investments?
Basic life insurance concepts
Before we can evaluate life insurance as an investment alternative, we need a basic knowledge of how an insurance policy works. One important caveat, life insurance can be very complex. This article is not designed to unpack all of the intricate parts of an insurance policy, but only enough to help evaluate if life insurance should be used as an investment or just as a death benefit.
All life insurance policies have two essential components: the death benefit (what you receive) and the premium (what you pay). Insurance companies do not offer polices for free. This might seem obvious, but after hearing many life insurance sales pitches over the years, I could see how someone may be led to believe that the policy is essentially free. It never is.
Term life insurance
Basic life insurance, or term insurance, does not have a cash value component. You pay a premium to the insurance company each year and if you die during the term of the policy, the company writes a check to your beneficiaries. The death benefit payable is generally free of federal income taxation. Term policies purchased many years ago had a premium that increased every year. This increasing premium compensated the insurance company for the fact that each year you age, you are one year closer to death and, therefore, more expensive to insure. Today, most term insurance policies offer a level premium for 10, 15, 20, or even 30 years. Generally, the longer the level premium period, the higher the premium that will be charged.
Permanent life insurance
Permanent (cash value) life insurance policies come in many varieties, including whole life, universal life, adjustable life, variable life, indexed life, or some combination of those terms – each with its own risks and expenses. Regardless of the type, the concept of using a permanent policy for an investment is the same. You pay a premium higher than what you would pay if you simply purchased a term insurance policy and the difference is essentially deposited into some sort of underlying investment. Each year, the cost to insure your life plus other policy charges are deducted from the cash accumulation and the balance grows inside of the policy on a tax-deferred basis.
Under current law, withdrawals from the cash value of the insurance policy are generally first considered a tax-free return of the premiums you paid into the plan and then taxable earnings (an exception is if the policy has been deemed a Modified Endowment Contract or “MEC” which is beyond the scope of this article. All single premium life policies are MECs, most policies are not). Once the contributions are fully withdrawn, the policyholder can borrow the earnings from the policy and pay no tax since loans are not taxable. The idea is to stop paying premiums into the policy at some point and have the cash value pay the insurance charges while you take tax-free distributions from the plan. Upon death, the death benefit is used to pay off the outstanding loan and any balance will be paid income tax-free to the beneficiaries.
This favorable taxation treatment is the primary advantage of using a cash value life policy as an investment. You can invest after tax dollars into the policy and withdraw a significant amount of the cash value tax-free through a combination of withdrawals and loans. It is important to understand that 100% of the cash value will never be available for withdrawal since the internal insurance charges must still be paid and the remaining cash value is typically the source of those payments. The primary disadvantage to insurance as an investment is you must pay the internal insurance charges for the life insurance benefit. These charges increase with age and are deducted from your cash value each month and lower your effective rate of return on the investment component.
Rules to follow
Now that you have a basic understanding of life insurance, we can outline some rules of thumb to determine if you should consider permanent life insurance as an investment.
The first rule is if you don’t need insurance, then don’t buy insurance. There is simply no reason to pay for the cost of the insurance if you don’t need the insurance. And the older you are, the more emphatic the “don’t” becomes. Remember, the older you are, the more it costs to insure you. Maximize your tax-deferred retirement plans and contribute to a 529 college savings plan if college funding is needed. If you like the taxation of the life insurance policy, then invest your retirement dollars in a Roth 401(k) or Roth IRA, if you qualify. The contributions are made with after-tax dollars and qualified withdrawals are generally income tax-free – just like the life insurance policy, but without the associated life insurance costs.
Once you have capped your retirement plans, you may want to consider a tax-deferred annuity. While there are charges in these plans that do not exist in a stock, bond or mutual fund, those charges are typically not as high as the insurance costs inside of a permanent life insurance policy.
If you do need insurance, a cash value policy may be advantageous since you will be paying for the cost of insurance whether you purchase a term policy or a permanent policy. But before you allocate funds to a cash value policy, maximize the contributions to your 401(k) and/or IRA plans. And if you are planning for your children’s education, nothing is better than a 529 college savings plan. If, after contributing the maximum amounts to these plans, you still have excess cash to invest, then, certainly consider a cash value life policy. You can even mix and match a term policy with a cash value policy. Purchase the minimum permanent policy you can in order to maximize the cash you want to allocate to it. Then fill in the balance of the insurance need with a term policy.
One important caveat — if you need insurance coverage beyond the 20 or 30 years you can obtain through term insurance, then a permanent policy is the only choice. This, however, has nothing to do with the investment qualities of the policy, but the structure of the policy itself. If you want or need to provide coverage for a dependent regardless of when you die, then no term insurance policy in the world can provide that coverage. For example, you may want to provide a death benefit for a special-needs child whether you die at age 50 or at age 90. That need can only be filled by a permanent life insurance policy.
If you need life insurance and have plenty of cash to invest, obtaining a cash value life policy may make sense for you as part of your investment strategy. However, be cautious. Permanent life insurance and income taxation is complex. You should always seek the advice of qualified insurance and tax professionals to help you make an informed decision.
Clark D. Randall, CFP, is a financial planner and owner of Financial Enlightenment, a wealth management firm.
Article Source : https://www.marketwatch.com