Should I buy term life or cash value insurance?
Fools are squarely in the "buy term life and invest the difference" camp. To be more clear, when we say "the difference," we are referring to the savings plan component of cash value premiums. We think that most people should invest this difference themselves!
To be fair, though, the topic is more complicated than this, and we should present both sides. Let's start with our arguments for buying term life. We'll follow this with some scenarios where a cash value policy might make sense.
Why term life is better for most people
Planning financial goals around a cash value insurance plan can get really complicated. There are non-trivial rules governing things like the size of your cash value savings versus the policy death benefit, and the repayment of policy loans. Term life, on the other hand, is the essence of simplicity -- pay the premium, get covered for the term.
Because they are so simple, term life policies can be easily compared on the basis of price. This has led to a very competitive market in which term life policies are rapidly becoming a commodity.
Many term life policies are both "renewable" and "convertible." The former insures that you can re-up for another term policy without a medical exam. The latter allows you to convert your term life policy into an equivalent cash value policy from the same carrier, should this make sense during the term of the policy.
Not all term life policies offer these features, however, so be sure to ask for them specifically if you want them. (In particular, be sure you know what they mean by "renewable.")
On the other hand, cash value policies only work out well when they are held for life. Once you're in, it's tough to get out without a little financial pain.
Tax-advantaged savings available elsewhere
The fundamental savings advantage of cash value insurance savings is tax-sheltered earnings. Most Americans, however, now have access to a wide variety of tax-sheltered savings plans, including employer-sponsored retirement plans, individual IRAs, education IRAs, and state-sponsored tuition savings plans. Moreover, the IRS has recently relaxed penalties on early withdrawals for things like first-time home purchases, educational expenses, and catastrophic medical bills.
As is the case with some employer-sponsored retirement plans, cash value investment options are often limited. Variable life policies typically offer index funds, but not necessarily a broad-market index fund, and rarely the option to buy individual stocks.
Some reasons to consider cash value life insurance
Tax-efficient estate planning
This is not a big deal to most people. The federal exemption from estate taxes is closing in on $700,000 and, according to the current plan, will reach $1 million by 2005. Nonetheless, if you are planning to leave a multimillion-dollar cookie jar for your heirs (hello, my long-lost uncle!), and want Uncle Sam's hands kept out of it, you may want to sit down with an estate planning specialist.
A specialist might recommend a cash value life insurance plan as a means of bypassing the tax man -- we don't know. In general, this is a very complicated topic and well beyond the scope of what we can easily cover here.
Insufficient retirement savings
Most of the insurance-planning computations covered so far assume that you have a separate plan for retirement savings. If this is not the case, and you expect to continue working through your golden years, to make ends meet, you may want to consider a cash value policy. Term insurance in retirement years will be extremely expensive, and may not be available at all. In this case, cash value life insurance may be the only way to provide your spouse with sufficient replacement income, should you die first.
You're older and not in great health
Term life insurance gets more expensive as we age. It's cheap while we're young, prohibitively expensive when we get up to age 60 or so (for the same face value). As we age, though, face value could decline as our needs drop, so premiums could be held relatively constant in real terms. We cover this in more detail in What should I look for in a renewable term policy?
By moving some savings contributions into a bill that must be paid -- your premium payment -- cash value plans do promote savings discipline. However, automatic payroll deductions into a tax-sheltered retirement account can serve the same purpose. Also, funds can be automatically and regularly transferred from your bank to your brokerage account or dividend reinvestment plan (Drip). Compared to these options, a cash value policy can be a relatively expensive way to feed your piggy bank.