The conventional wisdom is that many young professionals don’t need permanent life insurance. The reasons include the high cost compared to term life insurance and the temporary need for life insurance during the time they are paying down the mortgage and saving for college educations. But permanent life insurance may be appropriate as part of diversified investment and life insurance portfolios.
Life Insurance Basics
Term life insurance is what it says it is. It is for a defined time period, such as 10 or 20 years. It costs less than permanent insurance. The coverage is gone once the term is over.
Term life insurance also should be both renewable and convertible. The term policy should be renewable for another term, although generally at a higher premium because your initial premium was established when you were younger and the chance of death of low. Term policies also should be convertible to a permanent policy (which would be at a preferred premium since you had the term policy previously).
Permanent insurance, on the other hand, is for life. It is paid for throughout life and a death benefit is paid regardless of age of the insured at death. This contract never expires so it doesn’t have to be renewable or convertible as long as the premium is paid.
Permanent life insurance combines a death benefit with a savings portion. This savings portion can build a cash value against which the policy owner can borrow funds, or in some instances, the owner can withdraw the cash value to help meet future goals, such as paying for a child’s college education.
The two main types of permanent life insurance are whole and universal life insurance policies. A whole life policy has a level premium (e.g., it stays the same) for the life of the policy. A universal life policy is more flexible than whole life in that it allows the policyholder to use the interest from his or her accumulated savings to help pay premiums. Under a universal life policy, the excess of premium payments above the current cost of insurance is credited to the cash value of the policy.
There are many varieties of universal life, such as guaranteed universal life, and indexed universal life. These policies often have higher crediting rates (meaning the guaranteed portion will grow more than a plain old whole life policy) and are based on underlying investments. For purposes of this discussion, we are talking about permanent life insurance and not a specific type of permanent life insurance.
The premium is more expensive for level premium whole life in the early years compared to term insurance as the policy builds value. It is cheaper in later years when term life insurance become much more expensive given the greater chance of dying when you are older.
Why Permanent Life Insurance?
I am solidly in the camp that questions the need for permanent life insurance when you can buy term life insurance and invest the difference between the premiums. With a term policy, you have more flexibility with the investment side and you aren’t tied down to an expensive premium in the early years when you probably can least afford it.
Notwithstanding this general concern, there are several reasons why young professionals may want to consider permanent life insurance for some part of their life insurance portfolio. Remember it is not a question of term or permanent, but you could have a combination of both types of policies.
1. Permanent life insurance policies enjoy favorable tax treatment. The growth of the policy’s cash value is generally on a tax-deferred basis, meaning that you pay no taxes on any earnings in the policy so long as the policy remains active. Provided you adhere to certain premium limits, money can be taken out of the policy without being subject to taxes since policy loans generally are not considered taxable income. Generally, withdrawals up to the amount of premiums paid can be taken without being taxed.
Permanent life insurance may be appropriate if you have already maxed out on your 401k contributions ($18,000/year) plus an IRA (either Roth or post-tax traditional IRA) and need additional tax-deferred places to save.
2. Another reason for permanent life insurance is to fund bequests of money to your children, grandchildren, or others without the erosion often caused by probate costs, inheritance taxes, income taxes, federal estate taxes, transfer fees, or the generation-skipping transfer tax. So if you have substantial income, and are planning for the next generation, permanent life insurance could be part of that solution.
3. Permanent life insurance can be used to fund charitable bequests without any erosion in principal. This feature may be key for those charitably inclined.
4. Whole life policies, through the combination of guaranteed cash values and dividend formulas, frequently pays higher effective interest on cash values than is available from tax-free municipal bonds.
Reasons Against Permanent Life Insurance
1. If you surrender a permanent policy within the first five to 10 years, it may result in considerable loss of cash. The surrender values reflect the insurance company’s recovery of sales commissions and initial policy expenses. So you must be very certain you want the permanent life insurance and can afford it for the first several years or else it will be a very costly mistake.
2. But be cautious that distributions of cash values by the policyholder are subject to income tax to the extent attributable to gain in the policy. So this again points to the fact that these policies are for the next generation or for a specific cause – college education that has a known cost that won’t exceed the savings component of the policy.
3. The overall rate of return on the cash values inside traditional whole life contracts has not always been competitive in a before-tax comparison with other investments such as IRAs and 401k plan. However, as part of a diversified life insurance portfolio, the safety of the principal, contractually guaranteed liquidity, and the cost of term insurance if purchased outside the policy are factored into the analysis, whole life often compares favorably to alternative types of policies as well as non-life insurance investments on an after-tax basis.
What Should You Do?
If you have fully funded your retirement plans (employer 401k, IRA) and want your money to grow tax free you may want to consider permanent life insurance. In addition, if you would like to further diversify your investment portfolio, permanent life insurance may be part of the solution.
Use one of the following two approaches:
One approach would be to have 20% to 25% of your life insurance needs in permanent life insurance. The remainder of your life insurance would be in term policies that expires after you mortgage and college financing needs are over.
Another approach would be to have a portion of your investment portfolio could be in permanent life insurance. For example, a 10% stake of your investment portfolio could be in permanent life insurance. By doing so, you are further diversifying your portfolio, not only in terms of investment selection, but in taxable status as well.
The key is to be careful when looking at permanent life insurance. In some instances it may be appropriate as part of a well-structured investment and life insurance plan.
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