Life Insurance: Not Just a One-Trick Pony

You might ask, "Do I need life insurance?" to ensure financial security for their loved ones in case of unexpected events. When you think of life insurance, what comes to mind?

If you’re like most, you think of life insurance to maintain income for your loved ones should you pass away. But life insurance can do a lot more than just that!

As its name implies, life insurance is meant to help your family cope with the loss of income when you die by paying out a death benefit. It can also be used to save for retirement! Some life insurance policies have a cash value component.

This means some of your premiums go toward funding the death benefit, while the rest gets added as a cash value to the policy. That cash value can even accrue interest.

Considering these added benefits of life insurance, it can be a very serious financial tool. Whether you’re ultra-wealthy or middle-class, life insurance benefits should factor into your financial plan. While life insurance can help you save for retirement, it’s important to know how different types of life insurance work and what pitfalls to avoid when shopping for a policy.

There are several different categories of life insurance that will give you different benefits both while you’re living and after you pass away. If you have a policy through your employer, it’s likely term life insurance.

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Term Life Insurance

Term life insurance is a contract between you and the insurance company with a defined period — the term — often spanning a decade or two. If you die within that time span, the policy will pay a death benefit to the person or people you designate in the policy. Premiums for term life insurance are usually based on your age, your health as well as how much the policy will pay should you pass away.

Depending on the policy, determining your health status could include required medical examinations as well as answering questions involving whether your smoke, what medications you take and may even include evaluations of your driving record or your debt situation! Once the term ends, you can choose to renew under recalculated premiums, let the policy expire, or sometimes you can convert it to a permanent insurance policy.

These are the main term life insurance benefits:

1. Cost-effective for the term: Term life insurance is generally less expensive than whole life insurance as it covers a specific period without building cash value, making it a cost-effective choice for individuals seeking substantial coverage at a lower cost.
2. Opportunity to renew: Depending on the company, you may be able to renew your policy for an additional term.
3. Simple to understand: Term life policies are straightforward. You pay premiums for the policy term, and if you pass away during that time, your beneficiaries receive the death benefit. There are no investment components or cash values involved.
4. Based on your lifespan, health and needs: Choose a term length matching your financial needs, like your mortgage duration or until your children become financially independent. This ensures you don't pay for coverage longer than necessary.
5. Can be converted to Whole Life insurance: Term life insurance policies often allow conversion to whole life without a medical exam before expiration. This can benefit policyholders whose health has changed, making a new policy costly or unattainable.
6. Temporary coverage if needed: It's suitable for those needing insurance to cover temporary financial obligations like children's education expenses or a home mortgage.

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Whole Life Insurance

There are several key differences between term life and whole life insurance. While term life insurance lasts for a specific period of time, whole life insurance does not, which puts it in the category of permanent life insurance. As long as you keep paying the premiums, the policy never expires.

Also unlike term life insurance, whole life insurance has benefits for you, the policyholder, while you’re still alive. Term life insurance will pay a death benefit if you pass away, and that’s all it will do. If you’re still alive when the policy’s term expires, it won’t pay out and the insurance company will keep all the premiums you paid.

Whole life, on the other hand, has what’s called a cash value component in addition to the death benefit. While part of your premiums goes toward funding its death benefit, the rest go towards that cash value component. That component is your money.

You can withdraw it or borrow against it while you’re still alive, but there’s an important thing to consider if you do this. Your death benefit will be reduced by the amount you withdraw or owe the policy from a loan.

The cash value component also accrues interest. Some policies have a low guaranteed interest rate while others have non-guaranteed rates that can be higher depending on how the funds, they’re invested in perform. That cash value component means a whole life policy can be part of your retirement planning because it will have money you can use to fund your living expenses once you stop working.

Whole life premiums are usually locked in. You’ll pay the same premium the first month as you will the last month, even if there are decades between them. Because of that, whole life policies are often much more expensive than term life policies for younger people, but then become less expensive than term life policies if you keep the term life policy for longer than the initial term period.

Term life becomes more expensive as you age to mitigate the increased risk that older people carry while the policy is in effect. On the other hand, with a whole life policy, the company knows it is much more likely you will die when the policy is active.

They know they will have to pay a death benefit, simply because the policy never becomes inactive as long as you keep paying premiums! By charging you higher premiums, the insurance company is hedging its bet that you will live long enough for them to make more than they pay out when you pass away.

There are several important benefits of whole life insurance that make it a valuable part of long-term financial planning:

1. Complete lifetime coverage: Whole life insurance guarantees lifelong coverage for the insured if premiums are paid. This permanence provides peace of mind knowing you are covered regardless of longevity.
2. Cash value accumulation: One of the unique benefits of whole life insurance is the accumulation of cash value. Part of the premium payments goes into a cash value account, which grows over time at a guaranteed rate set by the insurance company. This cash can be borrowed against or withdrawn during your lifetime, so you can have a source of funds for emergencies, retirement, or anything else.
3. Fixed premiums: The premiums for whole life insurance are typically fixed and don’t increase as you age. This predictability makes budgeting easier and helps avoid the potential financial strain of rising insurance costs in old age. This can make it more affordable for older persons.
4. Tax-free death benefit for Whole life insurance: Whole life insurance can be a key component of estate planning. The death benefit of whole life insurance is generally paid out tax-free to beneficiaries and can be used to cover estate taxes, provide for heirs, or donate to charity, ensuring that your financial legacy is distributed according to your wishes.
5. Dividend earnings: Whole life policies often pay dividends if the insurance company performs well financially. These dividends can reduce premiums, increase the death benefit, or be cashed out, adding financial benefit to life insurance.

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Indexed Universal Life Insurance

There’s another, newer type of permanent life insurance called indexed universal life. Like whole life insurance, indexed universal life insurance has a death benefit component and a cash value component.

Unlike whole life, indexed universal life has the potential for higher earnings. That’s because it’s tied to a given stock market index such as the S&P 500. As the index experiences gains, so does the cash value component of the indexed universal life insurance policy.

A particularly nice thing about indexed policies is that generally, they rise as the market goes up, but do not drop when the market does. They merely stop rising. Of course, because there’s no such thing as a free lunch, this means they will not rise in a direct 1:1 ratio with the market they’re indexed to, but instead at a lower rate. This is to mitigate the risk of market declines to the insurance company.

The result is that you will make less in gains with an indexed universal life insurance policy than you would if you invested in the same market directly. However, you do not risk losing your principal and gains should the market experience a downturn as you do with a direct investment. While this policy can indeed offer higher returns, insurers charge fees for managing your money, which can rapidly deplete the cash value associated with this type of policy.

These of some of the primary benefits of life insurance with an index universal policy:

1. Adjustable payments for premiums: This type of life policy benefits you by having flexible premium payments within certain limits. This can be helpful when your financial situation changes, like during a job transition or major life event.
2. Potential for higher returns: A major benefit of this life insurance policy is that its cash value is tied to a market index. It has a floor preventing losses in a down market, but a cap on maximum returns. This structure balances risk and potential for higher returns than traditional whole life policies.
3. No direct risk with market investment: Although the cash value is linked to market indexes, the money is not directly invested in the market, so you have some breathing room when it comes to risk. This means that the cash value will not decrease due to market losses, offering a level of security during economic downturns.
4. Tax-deferred growth: This life policy's cash value grows tax-deferred, allowing capital gains to accumulate without the drag of annual taxes as long as the money remains in the policy.
5. Flexible death benefit: You have the ability to choose between a level death benefit and an increasing death benefit. This flexibility allows policyholders to adapt their coverage based on their changing financial goals and family needs.
6. Loan and withdrawal option: Policyholders can access the accumulated cash value through loans or withdrawals for expenses like college tuition, home down payment, or emergencies. However, these actions can reduce the death benefit and cash value, so careful management is advised.

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Choosing the Right Plan for You

There are many more life insurance products available, so how should you approach choosing which plan is right for you? The first consideration is to determine what purpose the life insurance policy needs to serve.

Are you more concerned with making sure your loved ones get a payout if you should pass away, or are you more concerned with building wealth? If it’s the former, you want a product built around the death benefits. If it’s the latter, you want a product that focuses on the cash value component.

That can sometimes be problematic based on how the agent selling you the policy is paid. Agents are often compensated by earning a commission based on the size of the death benefit, so there’s a natural tendency for the agent to want to make that benefit as large as possible. Sometimes this comes at the expense of the cash value component. That overinflation of death benefits costs you some of the potential retirement savings value of that policy.

That brings up another potential pitfall. If an agent is only in the business of selling life insurance policies, they tend to only recommend life insurance policies for any goal you might have, even if there are other avenues that would be more appropriate for your situation.

In general, if someone exclusively recommends life insurance policies for all aspects of your financial plan, that’s a warning sign that you may not be getting exposed to the best available options. It would be a good idea to seek a second opinion from a financial advisor. At Asset Preservation Wealth & Taxes we regularly help clients find the most prudent options for all aspects of financial planning, including life insurance.

As with most aspects of financial planning, choosing the right life insurance policy for your situation is complex. You should always consult with a professional before making any decision.

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Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.

The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Stewart Willis, providing such comments, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment, legal or tax advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Personal investment advice can only be rendered after the engagement of Foundations for services, execution of required documentation, including receipt of required disclosures. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Any statistical data or information obtained from or prepared by third party sources that Foundations deems reliable but in no way does Foundations guarantee the accuracy or completeness. Investments in securities involve the risk of loss. Any past performance is no guarantee of future results. Advisory services are only offered to clients or prospective clients where Foundations and its advisors are properly licensed or exempted. For more information, please go to https://adviserinfo.sec.gov and search by our firm name or by our CRD # 175083.

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