If you are single, or one half of a two-income, no-dependents household, you probably won't need much life insurance, if any. With a little planning, you can establish a low-risk savings fund to cover funeral costs, then invest the money you would have paid in insurance premiums.

On the other end of the spectrum, if you are the sole breadwinner for a large family with little savings, you are likely to need substantial life insurance. After basic food and housing is covered, life insurance premiums are likely to be next in line in terms of priority, perhaps even ahead of auto loan and credit card payments.

As you shop around, you'll be offered an array of insurance options. For the most part, they fall under two categories: "term" insurance and "cash value" insurance.

Term insurance basics
Term life insurance is just that -- life insurance, and nothing more. Your premium payments are applied 100% to the cost of the insurance.

As retirement approaches, your need for life insurance is likely to decline, as children become able to support themselves (even if your own little "rebel without a clue" may not yet be willing) and retirement savings begin to approximate a lump-sum life insurance payment. At this point, term insurance is easily dropped, without penalty.

Cash value basics
The second class of life insurance encompasses a wide variety of financial products that are often lumped together under the label "cash value insurance." Examples include whole life, universal life, and variable life. These products combine term life insurance with a long-term, tax-sheltered savings plan.

The most important thing to understand about cash value policies is that they are designed to be held for life. There are usually significant up-front charges associated with setting up the savings plan, investing the money, and paying the agent's commission. Even with these charges, tax-sheltered savings can still catch up to taxed investments and begin delivering a real advantage. That said, it can take 10 to 20 years for the needle to begin moving your way. For this reason, please do not enter into a cash value insurance plan without doing a lot of homework.

In a nutshell, here's how cash value works. A portion of your regular premium payment -- roughly the amount of an equivalent term life premium -- pays for your life insurance. The balance, minus management charges, is applied to your cash value savings account. To build savings, premiums are higher than term life premiums, by roughly the amount of your savings contribution.

The cash value savings goal -- at least as these policies were originally conceived -- is to provide income to cover life insurance payments in your golden years, when premiums become prohibitively expensive. When you buy the farm (not literally, of course), any savings balance remaining is passed on to your beneficiary either as a portion of the insurance death benefit or in addition to it, depending on the policy type.

Be aware, though, that it can be tough to spend your cash value savings if you want to use them for something other than insurance payments. Pulling money out of the plan will likely result in income taxes that negate the fundamental tax-shelter benefit. Many policies allow you to borrow against your savings at low interest rates, but you are still paying for the use of your own money, and the rules can be complicated, especially if you have no interest in paying back the loans (returning money to the plan).

The cash value sales pitch
Insurance companies profit handsomely from folks who unwittingly buy into cash value plans and then drop them early. Agents make more in commissions when they sell these plans than they do from term life sales. These are not necessarily indictments of the industry, as cash value plans provide a valuable consumer service under certain scenarios. But they are reasons to be a very careful shopper when it comes to cash value insurance.

One common sales tactic is to stress that cash value policies are "permanent" and that a payoff is "guaranteed," as opposed to those "temporary" policies in which your money simply "disappears." Term life can be as "permanent" as you choose to make it, via guaranteed renewable policies. And equivalent amounts of money "disappear" to pay for actual insurance costs, whether the policy is term or cash value. There can be benefits to a cash value plan, but these are not among them.

A final note: Less scrupulous agents may push cash value insurance with confusing presentations and emotional arguments that don't hold up to careful examination. Getting these folks to separate the two basic pieces -- insurance payments versus a savings plan -- can be like getting a politician to talk about the real issues. Insist that agents explain these policies on your terms, with the benefits broken down into these two pieces.

Now what?
We are squarely in the "buy term life and invest the difference" camp. To be more clear, when we say "the difference," we're referring to the savings plan component of cash value premiums. We think that most people should invest this difference themselves!

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.")

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