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Term vs. Cash-Value Insurance

When it comes to life 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

Simplicity
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.

Competitive pricing
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.

Flexibility
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, IRAs, and college savings accounts. Moreover, the IRS has relaxed penalties on early withdrawals for things like first-time home purchases, educational expenses, and catastrophic medical bills.

Investment options
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.

Reasons to consider cash value life insurance

Tax-efficient estate planning
This is not a big deal to most people. But 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?

Forced savings
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.

For more, visit the Fool's hilarious (not really) and informative (really) Insurance Center, or ask questions on our Insurance discussion board.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 23, 2009, at 7:53 AM, RaiddinnRZ wrote:

    Article neglected to examine the difference between insurers. Often the ones with lower cost insurance are the ones with lower likelihood to actually pay out or the ones that will make you go to court to sue for payouts (which costs money a lot won't have).

    Article also neglects to mention that whole life pays out in case of disability and in a lot of other cases whereas term life and the "buy term and invest the difference within a policy" stuff doesn't (universal, etc).

    With term life, you are unlikely to see any payouts ever. You will pay more and more every year for less and less coverage until you become completely uninsurable at a time when you are reasonably likely to die.

    With whole life, you are guaranteed a death benefit payout in virtually every case except suicide which instead returns all your premiums paid inside a certain number of years and after that time usually you can get a death benefit payout in case of suicide.

    Whole life costs more because it is guaranteed payout.

    Life insurers make most of their money off term life insurance because they take money in and never pay it out.

    Whole life, on the other hand, usually results in payouts that are more than the insurance company has taken in. They make up the difference by investing your premiums (usually) but with markets like these their loss is your gain.

    Additionally, the number one reason for whole life is estate planning, because you want to pass money on to your kids when you die so they can be better off than you were. This point was completely avoided in the above analysis. It should have been more emphasized even if it wasn't covered.

  • Report this Comment On September 11, 2009, at 2:14 AM, thetruth01 wrote:

    The comments by RaiddinnRZ is full of misleading statements (twisting) and if they were employeed by a life insurance company they could lose their license to sell life insurance.

    There always bad apples in every industry, but if you purchase term from a highly rated insurance company payout are not a problem. Actually companies that sell cash value life insurance have had more class action lawsuits because of misleading statement like RaidinnRZ's.

    They payout on disability is a rider that you have to pay extra most life insurance policies have this option cash or term.

    Cash value policies are the most expensive type of life insurance and most people are under insured because of this. Tipically a person can buy more coverage for less and then invest the difference and they would money ahead. Look up Suzy Orman or Dave Ramsey if you don't believe me.

    Term policies you can buy 20, 30 or 35 year terms were the cost of the policy does not go up. If you look at the cost of insurance in a Universal policy they usually go up every year and eventually you are eating away at your cash value.

    There are four rules you should for in your cash value policies 1. Zero cash value the first 1-4 years 2. low rate of return on cash value 3. To get your money out of your cash value you have to borrow the money and the interest goes to the insurance company. 4. When you die you get one or the other so in other words you get either the cash value or the face amount not both.

    For example Bob has a whole life policy for $100,000. When he dies he has $75,000 in cash value. Bob's widow will get the $100,000 only and the insurance company gets the $75,000. In reality the cash value is not your money it is the insurance companies money.

    Another thing lets say Bob takes a loan out on his cash value for $70,000 to pay for retirement needs. Bob is being charge interest every month now to along with the premium payment. Since the month charge now is to much for Bob to afford he can't pay the full amount his policy will be cancelled so now he doesn't have life insurance. What is worse is Bob will have to pay taxes on the money he loaned out, because now it is considered ordinary income.

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