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Insurance. Even saying this word makes some people cringe. For the most part, you are familiar, and perhaps used to, the insurance you have on your car, house, and hopefully to pay your medical bills. It’s a part of your normal budgeting that you take for granted, and in the case of car and house, hope you never need to use.
Life insurance is part of most responsible people’s financial planning. Whether it is to make up for lost income, send a child to college, or provide for other loved ones, you should understand your options and choose accordingly.
Term Life Insurance
There are two main categories of life insurance, Term and Whole Life. Term is the simplest to describe and that where we’ll start. Term is just that, a policy that has a fixed cost for a certain period of time, most often 10,20, or 30 years. For a 40-year-old male non-smoker, a $500,000 policy would cost about $250 per year for 10 years, $425 for 20 years, and $700 for 30 years. One might choose a certain term to match up with an expense that may go away. The birth of a child is often the time that one first considers the need for insurance, and a 20 year term policy fits nicely with the timing of raising the son or daughter and sending them off to college. The 30-year term, if bought at this age, will bridge the gap till retirement so a spouse (working or not) is not left with the sudden drop of income. The amount you choose to purchase is another discussion, too little and your family may have serious consequences upon your passing, too much and your throwing money away that you should be investing or otherwise using to enjoy life. For complete replacement of income, a good rule of thumb is to insure yourself for twenty times your income. As time passes and this number is impacted by inflation, your retirement savings should be growing so the total real value continues to increase. For others, a term that coincides with other life events, such as planned mortgage payoff, makes sense. Note: Many term policies come with a guaranteed renewal feature; you can buy a new term policy with no exam, but at the rate in effect for your age at the time of renewal.
Whole Life Insurance
Quite a bit more complicated are Whole Life and its variants, namely, Traditional whole life, Universal life, and Variable life.
Compared to the above, a Traditional whole life policy with a $500,000 death benefit may cost closer to $4000 per year. Quite a jump, but in return you get dividends which can be used to increase cash value or eventually grow large enough to reduce or fully pay the premiums or be borrowed from the account. The investment vehicle is hidden from the customer, and the insurance company announces the return each year, with a minimum usually set.
Universal life differs slightly in how the premiums payments are capped and how returns are calculated. Typically, the policy earns interest each year, again with a guaranteed minimum. One variation of universal is a Single Premium policy, in theory, the accumulation within the account will always provide enough funds to cover the mortality premium. It’s possible, however, that the account value is depleted and years later, premium payment become due.
Variable Life Insurance
Last, and likely least understood, is Variable life. This insurance offers the most choices of end products to use as investments within the account, typically the same variety of funds as most mutual fund families will offer. There are no guaranteed cash values and as the account is subject to both death benefit premiums each year along with internal expenses and fund expenses, this is a very expensive way to invest for the long term.
The Whole life policies do offer features that term cannot provide such as the ability to borrow money back at a low interest rate. But, of course, this is your own money you are borrowing. Given the ‘forced saving’ nature of this flavor of insurance, they appear best suited to someone who may not be disciplined enough to do this on their own and would otherwise find themselves with no real savings to speak of. For someone comfortable making their own investment decisions, the advice to buy term and invest the difference continues to remain the superior choice.
Do you have life insurance? If so, which type did you buy? Which do you think is the best for most people? Tell us your thoughts in the comments.
Evolution Of Wealth says
Your final recommendation is that if someone is disciplined, to buy term and invest the difference. Is that what you do? How has it worked? How do you think people have done with this mentality over the last 10 years? 20 years?
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EOW – I tried to keep objective on this choice, stating the facts as I understand them.
Ok, disclosure time – I am 46 and have approx 8X our gross income in retirement savings, net of the house, i.e. if you cancel out the mortgage we have House + 8X income, and no debt.
We are extreme savers, saving 20% of income in bad years, more during good years. Our number at the end of 99 was just over 5X for what it’s worth.
I think that it doesn’t take a genius to average (S&P – .08%) over time. Yet, I’ve read that the majority seems to buy high, sell low enough to lag by a huge margin.
Again, I feel I was objective enough only to suggest that long term it would take discipline to invest well. The majority would do better to stay in T-bills or TIPs compared to how they actually invest.
Jason @ Redeeming Riches says
Good post and explanation.
To me, one of the most important aspects of this insurance is missing however – tax free withdrawals.
You have to start with what you want your insurance to do for you. If it is straight death benefit for when you die and you want it cheap, then term is a great choice.
If you make too much to fund a Roth IRA, then a Variable Universal Life (VUL) policy can make a ton of sense. You can sock away a TON of money and use it down the road TAX FREE.
This strategy isn’t for everyone, but it can work very well for many.
By the way, you don’t have to always borrow, you can take out straight tax-free withdrawals too – just be sure you realize it reduces your death benefit.
As with anything, you have to do the research, understand what your purpose for the money is and understand what you’re buying.
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We have VUL in smaller policies for my husband and I. We got them right after we married. However, we don’t really expect that much from them. They were small, we didn’t really know much about anything, and our friend was selling them. The reasons we do things…However, I now have a nice, cheap (and substantial) term life policy on me, and when my husband is done with school and making money, we’ll get one on him.
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I took the Dave Ramsey approach to my insurance.
At age 22 with a stay at home wife and baby girl I needed insurance to protect them in case something happens to me. I did a bit of research and term life insurance was the best option for me.
Life insurance should be just that, insurance, not an investment. I can get much better returns with much less cost by investing the difference between the premiums of whole vs. term life insurance in a Roth IRA.
Besides, a $1,000,000 20 year policy only costs me $38 a month, a bargain for the peace of mind it buys me.
The best kind of life insurance is the kind that is in force when you die! By the way, there are a number of substantive factual errors in the article. Universal Life is not a “variant of whole life”. This fundamental error leads to other errors in understanding, which in turn leads to errors in making good decisions about obtaining life insurance.
I’ve become a big fan of permanent life insurance because of the tax benefits. Without a doubt, our income tax rate is going to go through the roof over the coming years to compensate for our country’s massive debt. Perhaps when I’m ready to retire (in 30+ years) the tax rates will be manageable again, but I can’t count on that. Thus, I’m putting money into both my 401k and a permanent policy that I can use in retirement. It may not work for everyone, but that’s what works best for me. My 401k may be taxed heavily when I withdraw funds at 65+ depending on tax rates, but the perm policy will allow me to take tax-free withdrawls.
Life insurance should be CONSIDERED as more than something bought for the death benefit; it can be an investment depending upon your personal financial situation.
As with any investment or financial plan, there really can’t be a blanket rule that works for everyone. I like that this article points out the differences between the types of policies, but wish it would refrain from making a generic statement about which is “better”. The better investment, as any credentialed financial planner will tell you, is unique to your situation. (Great blog post though! I enjoyed the topic!)