You'll often hear that if you have people in your life who depend on you financially, or who stand to suffer financially in the event of your untimely passing, then having a life insurance policy is a must. And that's solid advice. But not all life insurance is created equal, and if you're in the market for a policy, it pays to consider term life insurance rather than whole life. Though the latter can be a reasonable choice for some people, for most, signing up for whole life insurance is a move you're more likely to regret.
Term life versus whole life
Let's start by laying out the key differences between a term life and a whole life policy. Term life insurance, as the name implies, covers you for a specific period of time -- its term. Thirty years is a common duration. During that time, you pay your premiums (monthly, quarterly, or annually, depending on the policy you have), and in exchange, your heirs are guaranteed a predetermined death benefit should you pass away.
Whole life insurance, on the other hand, covers you indefinitely, provided you keep paying your premiums. In addition, a portion of each premium goes toward your policy's cash value, which accumulates over time.
It's that cash value that gives whole life insurance its appeal. You can borrow against it, withdraw funds from it, or surrender your policy and collect that cash value -- minus the policy surrender fee.
Keep in mind that your policy's cash value is not the same thing as its death benefit. The latter is the amount of money your beneficiaries will be entitled to upon your passing, and it's an entirely separate part of the equation.
What's so bad about whole life insurance?
If you're horrible at money management but can swing your premiums for the long haul, then a whole life policy could serve as a means of forced savings, since you'll eventually have the option to tap your policy's cash value. Or, to put it another way, if you don't trust yourself to consistently sock money away in a retirement plan, but you do trust yourself to set up automatic billing so your insurance premiums come out of your checking account month after month, then a whole life policy may be a reasonable option.
But aside from that one saving grace, whole life insurance is generally not your best bet if your financial goals are to secure affordable life insurance and to invest your money for growth.
First, understand that for any given death benefit, your monthly premium for a whole life policy will be much, much higher than for a term life policy. Given that whole life insurance offers perpetual coverage for as long as you pay, that makes some sense -- but that doesn't make it affordable. Policygenius reports that whole life insurance can cost six to 10 times more than a comparable term policy. That greatly increases the odds that you won't be able to afford your premiums at some point down the line. If that happens, you may have no choice but to drop your coverage, leaving your loved ones vulnerable.
Proponents of whole life insurance -- particularly, those who sell it -- will tell you it's a good purchase because it's not just insurance: It's an investment. The cash value of your policy is guaranteed a certain level of growth, and you'll benefit from the tax-deferred nature of that growth. But tax-deferred growth is by no means a novel feature. You can take advantage of it in a number of popular retirement savings vehicles like IRAs and 401(k)s. The difference -- and it's a big one -- is that these plans tend to offer much higher rates of return over time than whole life policies, provided you choose your investments wisely.
For example, say you're a 40-year-old man looking for coverage so as not to leave your wife and kids in the lurch in the event you pass away unexpectedly. Your choices are a 30-year term life policy with an annual premium of $500 versus a whole life policy with an annual premium of $3,000 for the same death benefit. Take the term life policy, and you're saving yourself $2,500 a year in premiums. If you turn around and invest that sum steadily in stocks, you should have little trouble generating an average annual 7% return -- that's actually a few percentage points below the stock market's average. Keep that up, and you'll have just over $236,000 in 30 years.
And to be clear, that 7% average annual return is considerably higher than the likely annual return on a whole life policy's cash value.
Even if you were to invest your $2,500 annual savings more conservatively, at a 3% average annual return, you'd be sitting on about $119,000. And as long as you'd invested that money in an IRA or 401(k), you'd get the same tax-deferred growth that a whole life policy promises. In some cases -- namely, a Roth IRA or 401(k), that growth will actually be tax-free.
Now you may be thinking: "But what happens if I opt for term life insurance and my coverage runs out?" Sure, that's a possibility. But if you sign up for a 30-year term policy in your mid-30s or later and you're still alive and kicking by the time your policy expires, at that point, you'll be eligible for Social Security and penalty-free IRA or 401(k) withdrawals. And if you pass away, leaving a spouse behind, he or she can collect Social Security survivors benefits which, spread out over time, might easily mimic the death benefit your life insurance would pay out.
But most important is this: Life insurance is at core intended to replace the financial support you provide to your loved ones in the event that you aren't there to do it yourself. When they're younger, your children are relying on your income, and your spouse likely is as well. By the time you're in your mid-60s or older, you're probably headed for retirement, or retired already. You don't need life insurance to replace income you're no longer bringing in -- and if you've invested properly, as discussed above, your financial situation should be stable regardless.
Is whole life insurance always a bad idea?
As mentioned above, whole life insurance can be a means of forcing yourself to accumulate some savings, and there's something to be said for having lifelong coverage. But whole life insurance is so prohibitively expensive that unless you're really doing well financially, you're at risk of being forced by circumstance to drop your coverage at some point when you can't afford it, thus negating any benefit that the policy would have offered you or your loved ones.
Generally speaking, you should expect it to take around 15 to 20 years before a whole life policy's cash value will be worth more than the premiums you've paid into it, because during that time, a large share of those premiums is going toward fees, commissions, and the many expenses associated with providing the policy. That means if you dump your policy at the 12-year-mark, you're out of luck.
The bottom line is this: If you have the means to pay hefty whole life premiums over time, you have the means to put those same funds into tax-advantaged retirement plans and invest them the way you want to. And while tapping retirement funds early to cover other financial needs generally isn't an ideal choice, you do have some flexibility when it comes to those accounts. You can withdraw IRA funds to buy a home, for example, and you can borrow from your 401(k) if you must. As such, there's little sense in locking your money away in a whole life policy when term life insurance offers you much more financial leeway.