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Welcome to Get Smart about Investing. What does life insurance have to do with investing? Well, it depends on what type of life insurance you have. Term life insurance has no investment component. It’s just plain life insurance. Permanent cash value life insurance on the other hand, has an investment component and a life insurance component, so it is like a combination of life insurance and investments. Some individuals buy cash value life insurance primarily for financial protection and the investment component was a secondary benefit. Other individuals buy cash value life insurance as a way to invest for retirement.
Regardless of why you bought it or how it was sold to you, understanding permanent cash value life insurance is very important because 70 percent of all life insurance policies sold are permanent cash value policies. You need to make sure that you understand the different types of life insurance and have the right type of coverage for your situation. Let me give you a little background on life insurance to get us started. Basically, there are two different types of life insurance: term insurance and permanent cash value insurance. The main difference between them is how long the coverage is. Let’s look at each.
Term insurance is very straightforward. It covers you for a specific period of time, usually 10 or 20 years and there is no investment component. You pay premium each year and if you pass away, your beneficiaries would receive the death benefit. For example, let’s say you pay $1500 each year for 20-year term life insurance that has a death benefit of $500,000. If you passed away, anytime during the next 20 years, your beneficiaries would receive $500,000. If you didn’t pass away by the end of 20 years, your policy would be over and you would no longer have life insurance. The life insurance company, in this case, makes a profit from the $30,000 of premiums you paid over the 20 years.
For many people, term insurance represents the better choice because most people have a temporary need for life insurance, typically when they are raising children. For example, if you had two young children and something was to happen to you, your spouse would have a huge financial burden to bear between raising the kids, trying to pay the mortgage, saving for college, and saving for their own retirement. In this situation, having life insurance would be essential. On the other hand, once the children have completed college and the mortgage has been paid off, in many cases there no longer is a need for life insurance. Thus term insurance covers you during the time you need it and terminates when you no longer need it. As you can see, term insurance is very straightforward. In addition, because the coverage is temporary, the cost for term insurance is significantly lower than permanent cash value life insurance.
Permanent cash value life insurance, on the other hand, covers you for your whole life as long as you continue to pay the premiums each month. Even if you are 85 years old when you pass away, as long as your policy is still in effect, your beneficiaries would receive the life insurance proceeds. Cash value policies also have a savings component to them, where a small portion of the premiums you pay are set aside and invested for you. As this investment portion grows, your policy builds up a cash value that you could use, which is where it gets the name cash value life insurance.
The most important reason for buying cash value life insurance is not as an investment; rather, it’s if you need life insurance coverage past the age of 65 or 70. For example, perhaps you want to provide money for a surviving spouse during retirement if you passed away or you want your family to have enough money for your burial. Some wealthier families need money to cover the costs of estate tax. Or perhaps you will need to provide for a disabled adult child if you were to pass away. These would all be situations where you would need permanent coverage that lasts until you die. In these examples, it wouldn’t matter if you died at 60 or 80 because the need would still be there.
If you do not have a permanent need for life insurance, you should not buy a cash value policy - you should be buying term insurance. In addition to covering a permanent need that you may have, it is true that there is a savings/investing component to these policies. A portion of each premium is set aside, which can serve as a form of forced savings. These savings are then invested for you and the money grows tax-deferred. In other words, your gains are not subject to any taxes each year, which allows your account to grow faster than usual, similar to the way a retirement account works. Keep in mind that while the tax-deferred component is an advantage, it is the same advantage that you can get by investing in your company retirement account or IRA.
Over 70 percent of all life insurance policies sold are cash value life insurance. Let me say directly that many of these people do not need permanent coverage. The reason so much cash value life insurance is sold is that insurance agents get paid five to 10 times more in commissions for that than term insurance. If the agent had a choice of making $500 selling you term insurance or $5,000 selling you permanent cash value insurance, which one do you think they would recommend?
I’m Greg McGraime and Now You Know!