The decision of whether to buy term versus whole life insurance can be more complicated than you think. Knowing all the angles will help you with this.
Finding the right type of life insurance coverage is one of the most foundational aspects of personal finance. But if you’re like many consumers, you may be having difficulty deciding whether term versus whole life insurance is right for you. Some advisors you may have spoken to showed you various alternatives for term coverage, while others tried to sell you a whole or other type of permanent policy. The debate between buying term life insurance versus permanent coverage is not a new one. For decades, the merits of buying term life insurance and investing the difference compared to what a consumer would pay for a whole life policy have been touted by groups such as Primerica Financial Services.
Meanwhile, many other life insurance companies continue to market permanent life insurance as a foundational financial planning tool. But which option is best? The answer ultimately depends on your needs and objectives. There are times when one option or the other is clearly the best choice, but in many cases you will find that either path has its own advantages and disadvantages.
How They Work
A term life policy is a relatively simple product. It offers pure death benefit protection for a certain period of time, such as 10, 20 or 30 years. It is much cheaper than any form of cash value life insurance, but can become very expensive once insureds reach their later years. There are several types of term coverage, such as guaranteed renewable, mortgage term, decreasing term and level premium term. Guaranteed renewable term guarantees that the insured may renew the policy at the end of the term with no additional underwriting.
Of course, this guarantee comes at an additional cost. Some term policies have rising premiums or shrinking death benefits, and accelerated benefit riders are now also available for an additional cost in many policies. These riders will pay out some or all of the death benefit while the insured is still living if he or she becomes disabled or is diagnosed with a critical illness such as cancer or heart disease. Some term policies also offer a return of premium rider for an additional cost that will refund some or all of the premiums paid into the policy when the term expires.
Cash value life insurance costs more to begin with, but will remain in force for the insured’s entire life as long as premiums are paid. This type of insurance has a built-in savings account that grows tax-deferred over the life of the policy, which can then be used as retirement savings. Although they are more expensive, far more cash value policies pay out their death benefits than term policies. And cash value policies can also eventually accumulate to the point where they become paid up, which means that you won’t have to make any more premium payments to keep the policy in force.
Cash value accumulation can eventually become a substantial asset for you after you have paid premiums into the policy for many years. And policy loans may not need to be repaid; they will simply reduce the amount of cash value and face value remaining in the policy. There are several types of cash value policies.
Whole Life Insurance
Whole life insurance is the simplest and oldest form of cash value policy, and its premiums and death benefit remain at a fixed dollar amount, regardless of how much it accumulates in cash value. Whole life insurance policies pay set dividends on a regular basis, which you can either take in cash, allow to grow inside the policy, use to buy additional coverage or decrease your premium.
Universal Life Insurance
Universal life insurance has flexible life insurance premiums and pays interest to the policy’s cash value, and its death benefit can fluctuate. The rate of interest that it pays will also fluctuate according to prevailing interest rates. Some UL policies pay interest that is calculated according to the performance of an underlying financial benchmark, such as the S&P 500 Index.
Variable Universal Life Insurance
Variable universal life insurance invests its cash value in a collection of mutual fund subaccounts that invest in stocks, bonds, cash and real estate. The cash value in this type of policy is not guaranteed and will rise and fall with the stock and bond markets. Regardless of what type of cash value insurance you have, you can access the cash value in your policy at any time, either via direct withdrawal or by taking out a loan against the policy, but the death benefit will be reduced by any outstanding loan amount when the policy pays it out.
Buy Term and Invest the Difference
Many financial professionals tell their clients that term insurance is always the best option because it is so much cheaper than any form of cash value coverage. But term insurance can become very expensive over time as the insured ages, and it may not be there at the time when it is needed if the insured becomes physically unable to be underwritten or can no longer afford the premiums. Nevertheless, buying term and investing the difference will most likely give the policyholder much greater coverage for the money than any type of permanent life insurance policy, at least while the term is in force. Advocates of this strategy also argue that “pure” investments such as stocks or mutual funds will grow faster in a traditional or Roth IRA than they can inside a universal or variable life policy because of the additional fees that they charge.
Factors to Consider
One of the key questions that a potential buyer of life insurance needs to ask themselves is whether they know that they will need coverage when they die. If you have no debt, then coverage may not be necessary unless you need to provide for your family or other dependents after you’re gone.
Accelerated benefit riders can also play a major role when it comes to choosing term versus whole life insurance. If you want to add a long-term care rider to your life policy, then a term policy will be cheaper, but the coverage may expire before you need it. A cash value life policy with this rider may be a better option despite the additional cost, as the cost of the policy with the rider will probably be far less than paying for nursing home or managed care expenses out of pocket.
If you co-own a business with partners, you may need to have a buy-sell agreement in place so that they can purchase your share of the business when you die using the life insurance proceeds from a cash value policy. This can ensure the smooth transfer of ownership of the business. Term insurance could also be used for this, but remember that you have to have the policy still in force when you die.
Permanent insurance should also be used if your taxable estate exceeds the estate tax threshold on either the state or federal level. In 2017, the federal estate tax threshold was $5.49 million per person and $10.98 million per couple. This will provide your estate with a liquid means of paying your estate tax, because your heirs might otherwise be forced to sell off a portion of your assets to meet this obligation.
If you have a lifelong dependent or loved one, such as a child with special needs, a cash value policy can provide an important safety net to meet his or her financial obligations once you’re gone. A special needs trust can be established that the policy will pay into at your death in order to provide for him or her for the rest of their life. Cash value life insurance can also be a good idea if you would like to equalize your heirs’ inheritances. For example, if you own a business and have designated one of your children to carry on the business after you’re gone, then you could take out a life insurance policy naming your other children as beneficiaries to compensate them when you’re gone.
Cash value policies are also useful in estate planning because they can guarantee that your heirs will receive an inheritance, regardless of all other factors. And small cash value policies such as those marketed by Gerber and Colonial Penn can be used to provide life insurance coverage for funeral bills and other final expenses, so that your heirs won’t have to bear these costs.
Term life insurance is better when you know that you will only need coverage for a set period of time, such as until your kids are still dependent on you or your mortgage is paid off. Many young families buy term life insurance because they need a bigger death benefit with more affordable premiums to pay off items such as the mortgage and student loan debt. Consumers who can’t medically qualify for standard coverage often purchase mortgage term life insurance to cover the cost of their homes because this type of insurance does not require any underwriting. (Of course, this type of coverage is also just about the most expensive type of term coverage available in the marketplace today.)
There are a variety of factors that will determine which type of life insurance is best for you, such as your disposable income, debt obligations and financial needs and objectives. Be sure to shop around online and in person to get several life insurance quotes from several different life insurance companies before you purchase any type of coverage, because this will give you a good idea of what’s available. Your financial advisor or life insurance agent can also help you to find the policy that best fits your needs.