Life insurance is often a good choice, when purchased early and before you're facing health and other challenges. Which kind to choose however, can be confusing. It is an investment that can become highly valued or a waste, depending on how you approach it.
Most people are familiar with term life insurance, which is when you pay premiums for a fixed death benefit over a finite amount of time. Then there are whole and universal life insurance policies, both of which are often referred to as "permanent" or "cash value" policies.
Most universal policies are cheaper than whole life and can be guaranteed for as many years as needed. But whole life policies grow through dividends and "paid-up additions" with reputable carriers. Whole life insurance has a cash savings component with consistent premium payments. Part of the premiums go toward the cost of insurance while the rest contributes to the cash value. The cash value earns interest over the life of the policy.
Premiums for both unfortunately are usually much higher than for term life insurance. You can however borrow against these policies to leverage other expenses. Most people will not need permanent insurance, at least not until they are older, and looking to cover basic, end-of-life expenses. While whole and universal life insurance policies have a cash and investment component with estate planning and tax benefits, they may also have high expenses and commissions, says Paul Jacobs, a certified financial planner and chief investment officer of Palisades Hudson Financial Group in Atlanta. To decide whether a permanent life insurance policy makes sense for you, answer the following questions:
Do you know what you're buying?
Life insurance products are "not investments per se," says Chris Acker of CB Acker Associates Insurance Services in Palo Alto, California. "Traditional whole life policies are bundled life insurance policies with no transparency of insurance costs, administrative costs, or interest rate assumptions." Insurance costs also rise over time, which means the cash value of a policy changes. "Wealthy families who need to pay estate taxes and want to pay with the cheapest dollars available, business owners who want to pass a business interest to a new generation as cheaply as possible at death, and individuals who purchase term life insurance who later develop a chronic health condition – these people should convert their term policies to a permanent policy if they wish to keep a life insurance benefit longer than their current term policy allows," Acker says. On the other hand, if you are not maximizing other long-term investment strategies and benefits, it's best to put a permanent life insurance policy on the back burner, says Drew Gurley, partner and co-founder of Redbird Advisors. "Assuming you're already maxing out your contribution to get your full company match, permanent life insurance is a great next step," he says "Advisors and consumers should be careful as to not overuse permanent insurance as a strategy. However, if used properly it can create a more tax efficient asset allocation with lower volatility," says Keith Friedman, an independent insurance and estate planning advisor in Stamford, Connecticut. "It should not be an either-or decision but rather a combination of using insurance products and the markets."
What is your stage of life?
Universal and whole life insurance policies are best for someone in their 30s and 40s who is "extremely disciplined and will never let their policy lapse," says Marc Lichtenfeld, chief income strategist for The Oxford Club in Delray Beach, Florida.
Term life insurance is often cheaper and more beneficial while investing your remaining funds in a diversified portfolio, Lichtenfield says. "Even if you pay your premium every month for years and obtain the full benefits of the permanent policies, the total returns will be roughly equal to that of a diversified stock portfolio. So you really don't come out ahead," Lichtenfield says.
Are you comfortable with risk?
"Sometimes we buy insurance for the insurance and sometimes we buy it for the potential growth of the cash value," says Charles Donaldson, a financial advisor with College Bound Coaching and an adjunct professor of finance and economics at Wilmington University in New Castle, Delaware. "If buying for the cash value, you should always fund the policy with the maximum amount in order for the policy to provide gains efficiently."
Whole and universal life policies may provide a tax advantage. Insurance can be issued as a modified endowment contract or as a non-MEC. Non-MECs are treated just like a Roth IRA in terms of taxes, Donaldson says. As long as the policy is in place, no tax is due on the gains if managed properly. Gains are taxed at withdrawal. If you're young, you can fund a non-MEC universal policy over time and withdraw small amounts strategically, while non-MEC whole life insurance is best suited as a savings vehicle for those who want to use their funds more quickly, Donaldson says.
Donaldson will often use a MEC life insurance policy to fund college, for example, with a one-time deposit of up to $500,000. "The money comes back out fast enough that there is no gain to be penalized on, the money does not have to be reported as an asset for financial aid," Donaldson says, "and as long as the correct company and policy type are used the family will get back 100 percent of the money they put in."
Most universal policies are cheaper than whole life and can be guaranteed for as many years as needed, Fisher says. But whole life policies grow through dividends and "paid up additions" with reputable carriers. Most universal life insurance policies stay level unless tied to a growth asset, Fisher says. "It all comes down to meeting the need first, not just choosing a product which sounds right," Fisher says.
As always it is best to speak with your insurance advisor or financial planner before making any of these decisions by yourself, if you don't have an advisor or are looking for a quote to get started on protecting the your financial future see our quote tool here.