What is life insurance?
Buying life insurance means you pay a specific amount, called the premium, every month, 3 months, 6 months or year. Once you pass away your insurance company pays a death benefit, a lump sum to your beneficiaries (family, friends or loved ones). This death benefit can be used to pay for your end of life expenses like unpaid credit card or hospital bills, or for funeral and burial expenses.
Now assuming you need life insurance, here are the 4 general categories you can choose from:
Term Life Insurance
Term life insurance involves paying small premiums for protection that lasts from 5 to 30 years. Your beneficiaries get the payout on your death. All your premiums go toward securing a death benefit so there is no investment component here.
Guaranteed universal life insurance
Guaranteed life insurance requires no health questions, no medical exams, offers instant acceptance, but there’s a catch:
- More cost per month. Since these companies are taking a greater risk, they charge more.
- Low amount of death benefit.
It is usually avoided but it may be the right insurance for you if you have certain medical conditions.
Final expense insurance
Funeral insurance, or final expense insurance or burial insurance is designed specifically to pay for your end of life expenses, like funeral and burial costs. Burial insurance is inexpensive, requires no medical exams and may offer as much as $20,000 in death benefit.
Whole and universal life insurance
Whole life insurance as the name suggests has no expiration and lasts your entire life. It allows you to accumulate a cash value. What is cash value? Cash value allows you to make additional contributions that builds a reserve that can server as a savings account you can withdraw from during your life. You can also invest this cash value.
Why is whole life insurance a good investment?
Though generally considered a bad investment, it may be a good consideration if you are young, have a high income and want your family to inherit your money.
Tax deferred growth
Until you withdraw the proceeds from your life insurance policy, you are not required to pay taxes on any dividends, interest or capital gains. This benefit also applies if you put money in any retirement account.
You can borrow against cash value
The money you put in a savings account can be used to buy a house or pay college tuition, tax free.
In case you develop a certain medical condition, you may receive between 25% and 100% of the death benefit during your life. This accelerated benefit can be used to pay your hospital bills. But it has the disadvantage that your beneficiaries will not receive the original amount of death benefit when you pass away.
Why is whole life insurance a bad investment?
If you look at whole life insurance from an insurance point of view, it isn’t that good of an option. The whole point of life insurance in most cases is getting your children to the point where they can take care of themselves and become independent. So not everyone requires coverage their entire lives.
It is often said, “But term and invest the difference.” The idea behind is that term offers low cost premiums that leave you with money you can invest in other things. Often the benefits you get from whole life insurance aren’t unique to it and you can get them from other life insurance policies without the downside of whole life insurance.
Though the actual cost varies depending on your age, health, risk you pose, etc, whole life insurance is extremely expensive compared to term life insurance, about 10 to 12 times. It has high agent commission and expensive management fees.
Diversification involves investing in different types of investments and companies. It decreases your investment risk without decreasing returns. With whole life insurance what you’re doing is investing large amounts of money in a single company relying completely on their goodwill. Should the company have a bad year, go bankrupt or change its policy on paying out policy holders, you will definitely suffer.
There is no whole life insurance policy that clearly tells you the details of what you are paying for. There are always hidden costs which makes it harder to understand what you’re paying for.
There are many terms of the policy that are complicated and sometimes even sales people have a hard time understanding them.
Whole life insurance uses tax free retirement income to attract people. What this mean is that you can take out loans against your policy without being taxed. Though attractive there are a couple of things to look out for.
You need to remember that interest is accrued every time you borrow from the insurance policy until you pay it back. Borrowing too much may even cause it to lapse. You may be left with having to pay more money or facing tax consequences. And if you die before repaying, your beneficiaries will receive a smaller death benefit.
With whole life insurance you have to pay premiums your entire life. Since the cost of these premiums is high, committing to pay them every year may become difficult. There may be situations in the future where having more options would be better.
If you choose to stop paying premiums, the policy lapses forcing you to withdraw the cash value, subjecting you to taxes. If the policy isn’t that old, you may get negative returns.
Positive Returns take many years
Whole life insurance policies take a very long time for the returns to reach a good level. There will be many years in the beginning where the returns will be negative. By the time you decide you want to do something else you will have spent a lot of time and money on something that generated poor returns. In the best case, you might get a return of about 4% in over 40 years of paying premiums.
Liquidity is the degree to which an asset can be bought or sold in the market without affecting its price. Liquid assets can be quickly bought or sold. With life you never know what may happen, so having access to your money is very helpful and gives you options. Whole life insurance is illiquid for many reasons.
For the first couple of years, you get negative returns, so you won’t be getting back any of the money you put in. If at some point in time you decide to not go with the insurance policy, you will have to pay surrender charges for cancelling the policy and there will be tax consequences.
If there weren’t other investment options, whole life insurance may have been a good investment. A lot of people have 401(k) or other retirement plans with their employers. All these plans give you control over your costs, provide more diverse options and avid the downside of whole life insurance.
Despite the fact that a lot of people don’t recommend whole life insurance doesn’t mean that there are no exceptions. Like every other financial choice, yours depends on your needs, situation and budget.