What Role Does Life Insurance Play In Financial Planning?
Can buying life insurance be a good investment?
The basic benefit of life insurance is that it provides money to one’s beneficiaries when the policyholder passes away. But there are many different types of life insurance policies, and the costs and benefits vary considerably.
Permanent life insurance policies cover the policyholder for their entire life and build cash value beyond the death benefit. Term life insurance provides a death benefit for a specified period of time and does not accrue cash value.
The common wisdom among many financial advisers is that people should buy term life insurance, which is much less expensive than permanent life insurance, and invest the difference in other types of investments. Hence, the common phrase, “By ‘term’ and invest the difference.”
The fact of the matter, however, is that many people do buy permanent life insurance as an investment. Whether or not it is the best use of the investor’s money depends on a number of factors.
The scenarios discussed in this article apply in the United States. Readers are encouraged to consult their accountants about tax considerations related to buying insurance.
Permanent Life Insurance Benefits
In the United States, one benefit of permanent life insurance is that the cash value accrued is not taxed until the policyholder withdraws those earnings. The same is also true of retirement accounts such as IRAs, 401k plans and 403b plans. But there is a maximum amount of money that one is allowed to contribute to these retirement accounts in a given year. An investor who wants to invest beyond the maximum allowed by his retirement accounts could accomplish this by also having a permanent life insurance policy.
The holder of a permanent life insurance policy can also transfer a policy’s death benefit income-tax-free to beneficiaries, according to retirement planner George D. Lambert, writing in Investopedia. The same cannot be said for other investments.
When a beneficiary inherits an IRA, tax-deferred annuities and qualified retirement plans, they can pay up to 35% to the IRS, according to Lambert.
Lambert further notes that earnings that grow within a life insurance policy are one of the few items that do not increase the tax on the owner’s Social Security income when they start receiving Social Security benefits.
As the cash value in the policy increases, it is possible to borrow that money without incurring taxes or penalties. This is not true for most retirement accounts such as annuities or 401k plans, which often incur a 10% penalty in addition to income taxes.
It is important to note that interest accrues on the borrowed money in a life insurance account until it is repaid.
Accelerated Death Benefits
Depending on the policy, a policyholder can receive a portion of the death benefit before they die if they develop certain medical conditions. These are known as accelerated benefits, which can be used to pay medical bills. These benefits are deducted from the death benefit that will go to the policyholder’s beneficiaries upon the policyholder’s death.
Some policies charge extra for accelerated benefits.
Such benefits are also offered under some term life insurance policies.
Another benefit of permanent life insurance is that unless the policy is surrendered prior to death, the policyholder is insured for life. A term life insurance policy, by definition, lasts for a specific period of time.
These are important benefits of permanent life insurance, but they will not apply to everyone. As noted above, permanent life insurance is considerably more expensive than term life insurance.
The Case For Term Versus Permanent Life
Personal finance expert Amy Fontinelle, also writing in Investopedia, offers the example of a 30-year-old female in excellent health who paid $9,370 annually for a permanent life insurance policy with a $1 million death benefit.
After five years, the policyholder paid $46,850 in premiums and the policy generated $19,880 cash value.
After 10 years, she paid $93,700 in premiums and the policy brought $65,630 cash value.
After 20 years, she paid $187,400 in premiums and the policy delivered $181,630 cash value.
(These cash values are offered as an example and do represent all policies, as cash values will vary based on the returns the insurance company was able to generate.)
Had that same investor bought a 20-year term life insurance policy with a $1 million death benefit, the policy would have cost $9,600 in premiums ($480 per year) and the investor would have had an extra $8,890 to invest every year. She would have saved $177,800 in premiums after 20 years.
Had she invested that $177,800 and gotten an 8% annual return for 20 years, she would have had $480,806 before taxes and inflation. Even if the $177,800 earned only a 1% annual return over 20 years, she would have had $208,671, which is still greater than the $181,630 cash value from the permanent life insurance policy.
Fontinelle concludes that permanent life insurance as an investment usually makes sense for high net worth individuals looking to minimize estate taxes.
Factors To Consider
Liz Davidson, a financial educator writing in Forbes, points out that the decision to buy life insurance should be based on three factors.
The first is how much life insurance one needs to take care of their beneficiaries in the event something happens to them.
The second consideration is how long one needs the insurance. One reason permanent life insurance is more expensive than term life insurance is that it covers the policyholder for their entire life. Many people do not need life insurance in their older years when their children are grown. But some need assets to cover their final expenses to spare their heirs from this expense.
Some people also have dependents who will need the death benefit once the policyholder passes away.
Davidson further points out that individuals who have a taxable estate worth more than $5 million can use the death benefit to pay their estate tax and not pass that burden on to their heirs.
Life insurance policies can play an important role in financial planning, but the type of policy a person needs will depend on their individual circumstances.
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