It’s the age-old life insurance question: Should you buy term or permanent life insurance? Some personal finance experts would have you believe the choice is clear. They believe term insurance is always the right solution; others say permanent is, but is it really that simple? Common sense dictates few issues are ever that black and white.
The first thing you need to understand is that there is no one-size-fits-all solution. The kind of life insurance that’s right for you depends on your unique financial goals and circumstances. It’s also important to realize term and permanent life insurance are very different products and are intended to meet different needs. To determine what the best solution is for you, begin by making sure you understand the key differences between term and permanent life insurance.
We have collaborated with Kyle Johnston, CLU, CFP on this post to help lay out some considerations. You can learn more about Kyle at http://www.kyle-johnston.com/
TERM LIFE INSURANCE
As the name suggests, term life insurance provides your loved ones with financial protection for a specific “term,” or period of time (e.g., 10, 20 or 30 years). Term insurance is the most affordable type of insurance. It allows you to get the greatest amount of coverage for the lowest initial premium. You can view term life insurance in the same fashion as car or homeowners insurance – an expense you pay, hoping you never need to use the insurance policy. Most people purchase term insurance with the plan of covering needs that are anticipated to disappear over time, such as a mortgage, business debt or the cost of raising children through their college years.
Most term policies have level premiums, meaning your premiums will remain the same for the life of your contract (e.g., 20 years). The other type of term insurance is called “annual renewable term.” With these policies, you are essentially renewing your policy on an annual basis. Annual renewable policies will start at a lower premium; however, the premium will gradually increase each year. Term policies pay a benefit only if you die during the term. If you outlive your policy, it will expire and your coverage will end.
Where term insurance covers a certain period of time, permanent life insurance provides protection for your entire lifetime. No matter when you die, as long as your premiums are paid, your beneficiaries will receive the proceeds. Permanent policies also build equity called “cash value” that accumulates on a tax-deferred basis – similar to assets in most retirement and tuition savings accounts.
The bottom-line – tax savings only exist within a permanent policy. There are zero tax benefits to term insurance. With permanent insurance – all earnings within the “investment” component of your policy grow without tax and can be accessed via a loan at any point in time. Here are some key tax-savings opportunities to consider:
- Bolster your retirement security. For many people, the money in their 401(k)s or IRAs is the mainstay of their retirement savings strategy. When you retire, you may need more income than your pension plan, 401(k) or Social Security can provide. You can use the cash value in a permanent life insurance policy to help supplement your retirement income.
- Fund education. If you have a child and plan to send him/her to college, you may have a 529 plan. The money you put into a 529 plan grows tax-free, and withdrawals are tax-free, too, as long as the funds are used for qualified education expenses. Though not a substitute for a 529 plan, a permanent life policy can be another vehicle to help fund a child’s education. Like a 529 plan, the cash value in a permanent policy grows tax-free, and withdrawals can be tax-free, too, provided they don’t exceed the amount you have paid in premiums. Additionally, the cash value in a life insurance policy is not included in federal college financial aid calculations – an important consideration given that roughly two-thirds of all undergraduate students receive some form of financial aid.
- Transition ownership of a business. If you’re a business owner, you want to make sure your family gets fairly compensated for your share of your business when you die. To accomplish this, many business owners set up buy-sell agreements and fund them with permanent policies purchased on the lives of each of the owners. When an owner dies, life insurance proceeds are used to buy out the interests of the deceased owner at a previously agreed-upon price. The remaining business owners don’t have to scramble to come up with the money to buy out the share of the deceased owner, and surviving family members get compensated fairly and promptly.
What we recommend:
- At a minimum you should have term life insurance if you are married and/or have kids that are dependent on your income.
- Go through the process of determining the “right amount”.
- If you need additional tax-savings vehicles above a 401k or IRA that grow on tax-deferred basis, you may want to consider a permanent insurance product to achieve that goal.