Most Americans are confused about life insurance. They admit this and aren’t doing anything about it. That is unfortunate, because changes in the life insurance industry are very favorable to insurance buyers.
Let’s take a look at the traditional debate of term insurance vs. whole life insurance.
Term insurance is a “life insurance only” policy, and the policy expires after a period of time. There is no cash value, investment account, or other benefit. If the insured passes away, the beneficiary receives the insurance amount. If not, once the policy expires the insured receives nothing back. A term insurance policy also can lapse during its term if the insured chooses not to pay the premiums or cancels the policy.
There are two general situations when term insurance is the best choice. Since term insurance is less expensive than the alternatives, it is appropriate when the insured cannot afford anything else.
Term insurance also should be used for a temporary insurance need. For example, suppose insurance is purchased so that a mortgage will be paid or the children have money for college expenses. These insurance needs will end when the mortgage is paid or the children have graduated from college. They also might end when the insured has saved enough to provide for these needs.
Permanent insurance, or cash value insurance, is the alternative. This category includes several types of insurance, such as whole life, variable life, universal life, and others.
As the name implies, this type of insurance is best for a permanent insurance need. The two most common uses of permanent insurance are to pay estate taxes and to increase the inheritance of loved ones.
Permanent insurance can be a good way to leaves assets for heirs. Usually the benefits to the beneficiary far exceed the cost of the premiums to the insured. Using insurance allows the insured to leverage assets. In addition, the insurance benefits are income tax free to the beneficiary. The benefits will be free of estate taxes if the policy is held in a properly constructed irrevocable life insurance trust.
Some advisors recommend using permanent insurance as another form of retirement or investment savings. In addition to offering death benefits, the policies have a cash value account which earns interest or other investment income. The returns often are not high, and the costs can be steep. But the cash value usually can be tapped tax free through loans. All other forms of saving should be considered first.
One disadvantage of permanent insurance is that it is expensive. A part of the higher expenses is for higher commissions, and part is for the cash value account. As an example, a 45-year-old male might pay about $1,000 in annual premiums for a $500,000 term policy but $8,500 annually for a whole life policy with guaranteed premium, death benefit, and cash value.
Another disadvantage of permanent insurance is keeping the policy in force. Most people suffer some kind of financial downturn during their lives. At that time, many let their permanent policies lapse because the premiums are needed for other expenses. The cash value the insured can receive after letting the policy lapse is a small fraction of the extra premiums that were paid.
The best solution for many people is a combination of term insurance and permanent insurance.
Buy term insurance to cover needs that are expected to end at some point, such as the mortgage and college expenses. Then, buy permanent insurance to cover the permanent needs, such as an inheritance or estate taxes. This approach allows full insurance coverage at a much lower cost.
Newer policies also are making the decision easier for many people.
These policies generally are called return of premium term insurance. Like traditional term insurance, the policies expire after a fixed period of years. But the twist is that the owner of the ROP policy gets all of the premiums returned at the end of the policy without interest.
The premiums for an ROP policy are higher than for straight term. A traditional term that costs about $1,000 annually would cost about $1,700 annually as an ROP. The extra premium is in effect a savings account, and the effective return on that account usually works out to about 5% to 6% annually. In addition, the return of the premiums likely is tax free, though there is no clear rule on that from the IRS.
The policy does not carry a separate account. So, choose an insurer that is financial stabile. If the insurer fails, no premiums will be returned.
Insurers can make money on these policies because a percentage of policy owners let them lapse each year. When the policy lapses, the insured has some premiums returned, but not all.