Insurance companies and insurance agents often market life insurance policies as an alternative to traditional investments (full disclosure, I am a licensed insurance agent). There is no doubt that some policies have characteristics similar to those of an investment, but is it good investment?
Basic concepts of life insurance
Before you can evaluate life insurance as an alternative investment, we need a basic understanding of how an insurance policy works. An important caveat, life insurance can be very complex. This article is not designed to analyze all the complex parts of an insurance policy, but enough to help us determine whether life insurance should be used as an investment or as a death benefit.
All life insurance policies have two essential components: the death benefit (what you receive) and the premium (what you pay). Insurance companies do not offer fonts for free. This may seem obvious, but after hearing many life insurance sales arguments over the years, I realized that one could suggest to someone that the police are essentially free. It never is.
Term Life Insurance
Basic life insurance, or term insurance, does not have a cash value component. You pay a premium to the insurance company each year and if you die during the policy period, the company sends a check to your beneficiaries. The death benefit payable is generally exempt from federal income tax. Term policies purchased many years ago had a premium that increased each year. This growing premium was compensating the insurance company because every year you are about to die, and so you are more expensive to insure. Today, most term insurance policies offer a uniform premium for 10, 15, 20 or even 30 years. As a general rule, the longer the uniform premium period, the higher the premium charged.
Permanent life insurance
Permanent life insurance (buy-in) policies are available in many varieties: whole life, universal life, adjustable life, variable life, indexed life, or a combination of these, each with its own risks and charges. Regardless of the type, the concept of using a permanent policy for an investment is the same. You pay a higher premium than you would pay if you simply bought a term insurance policy and the difference is essentially deposited in an underlying type of investment. Each year the cost to insure your life as well as other policy fees are deducted from the accumulation of cash and the balance increases within the police at the tax shelter. .
Under existing legislation, withdrawals of the cash surrender value of the insurance policy are generally considered first and foremost as a tax-free return of premiums paid to the plan and then a taxable profit (an exception being the case where the policy was considered a modified staffing agreement or "MEC", which is beyond the scope of this article All single premium life insurance policies are CMEs, most policies do not Once the contributions are fully withdrawn, the policyholder can borrow the policy earnings and pay no taxes since the loans are not taxable.The idea is to stop paying premiums in the policy At some point and let the cash value pay the insurance fee while you receive tax-free distributions from the plan.On death, the death benefit is used to repay the outstanding loan and any ground of will be paid to beneficiaries tax-free.
This favorable tax treatment is the main benefit of using a life net asset value as an investment. You can invest after-tax dollars in the policy and withdraw a significant amount of the tax-free cash value through a combination of withdrawals and loans. It is important to understand that 100% of the cash value can never be withdrawn because internal insurance costs must always be paid and the remaining cash value is usually the source of these payments. The main disadvantage of insurance as an investment is that you have to pay the internal insurance costs for the life insurance benefit. These fees increase with age and are deducted from your cash value each month and lower your effective rate of return on the investment component.
Rules to follow
Now that you have a basic understanding of life insurance, we can set some rules of thumb to determine whether you should consider permanent life insurance as an investment.
The first rule is that if you do not need insurance, do not buy insurance. There is simply no reason to pay the cost of insurance if you do not need it. And the older you are, the more the "do not do" becomes emphatic. Do not forget that the older you are, the more it costs to make sure. Maximize your tax-deferred retirement plans and contribute to a 529 college savings plan if college funding is required. If you like the taxation of life insurance policy, then invest your retirement dollars in a Roth 401 (k) or a Roth IRA, if you qualify for it. Contributions are paid with after-tax dollars, and qualifying withdrawals are generally tax-free – as is the life insurance policy, but without the associated life insurance costs.
Once you have capped your retirement plans, you can consider a tax-deferred annuity. Although these plans involve fees that do not exist in a stock fund, bond or mutual fund, they are not usually as high as insurance costs of a permanent life insurance contract.
If you need insurance, a cash value policy can be advantageous because you will pay the cost of insurance, whether you buy a term insurance policy or a permanent policy. But before allocating funds to a cash value policy, maximize contributions to your 401 (k) and / or IRA plans. And if you plan your children's education, nothing is better than a 529 savings plan. If, after paying the maximum amounts in these plans, you still have a cash surplus to invest, then consider a life insurance policy with surrender value. You can even combine a term policy with a cash value policy. Buy the minimum permanent policy that you can to maximize the money you want to spend there. Then fill the rest of the insurance need with a temporary policy.
An important caveat – if you need insurance coverage beyond 20 or 30 years that you can get with term insurance, then a permanent policy is the only choice. This, however, has nothing to do with the investment qualities of politics, but with the very structure of politics. If you want or need to provide coverage for a dependent, no matter when you die, no term insurance policy in the world can provide this coverage. For example, you may want to pay a death benefit for a child with special needs, whether you are 50 or 90 years old. This need can only be met by a permanent life insurance policy.
If you need life insurance and you have enough money to invest in, buying a cash surrendered life insurance policy can make sense to you as part of your investment strategy. However, be careful. Permanent life insurance and income taxation are complex. You should always seek the advice of qualified insurance and tax professionals to help you make an informed decision.
Clark D. Randall, CFP, is a financial planner and owner of Financial lights, a wealth management company.