You’ve probably heard that if you have loved ones who depend on you financially, having a life insurance policy is crucial. And that’s definitely good advice. However, not all life insurance plans are created equal. When shopping for a policy, it’s worth considering term life insurance instead of whole life insurance. While the latter might work for certain individuals, for most people, signing up for whole life insurance is a decision that they will likely regret.
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Term Life vs. Whole Life
To begin, let’s clearly outline the key differences between a term life policy and a whole life policy. Term life insurance, as the name suggests, covers you for a specific period, known as your term. Typically, this duration is around 30 years. Throughout this time, you pay your premiums on a monthly, quarterly, or yearly basis (depending on your chosen policy). In return, your heirs are guaranteed a predetermined death benefit if you pass away.
Reading: Why not to buy whole life insurance
On the other hand, whole life insurance provides coverage indefinitely, as long as you keep paying your premiums. Additionally, a portion of each premium contributes towards the cash value of your policy, which grows over time.
It’s this cash value that makes whole life insurance appealing. You can borrow against it, withdraw funds from it, or surrender your policy to collect that cash value (minus the policy surrender fee).
It’s important to note that the cash value of your policy is not the same as your death benefit. The death benefit is the amount of money your beneficiaries will receive upon your death and is a separate component of the policy.
The Downsides of Whole Life Insurance
If you struggle with managing your finances but can commit to paying premiums in the long run, then a whole life policy could act as a form of forced savings. It provides an option to tap into the cash value of your policy in the future. In other words, if you doubt your ability to consistently save for retirement but trust setting up automatic billing for insurance premiums, then whole life insurance might seem like a reasonable choice.
However, besides this potential advantage, permanent life insurance is generally not the best option if your financial goals are to secure affordable life insurance and invest your money for growth.
Firstly, it’s important to understand that, for the same death benefit, your monthly premium for a whole life policy will be significantly higher than that of a term life policy. Whole life insurance offers coverage for your entire life, which justifies the higher cost. However, this makes it less affordable. PolicyGenius reports that whole life insurance can cost six to ten times more than a comparable term policy. This significantly increases the likelihood of being unable to afford premiums in the future. If this happens, you may be forced to drop your coverage, leaving your loved ones vulnerable.
Advocates of whole life insurance, especially those who sell it, claim that it’s an excellent investment opportunity, not just insurance. They argue that the cash value of the policy is guaranteed to grow, with the added benefit of tax-deferred growth. However, tax-deferred growth is not exclusive to whole life policies. There are several other popular retirement savings options, such as IRAs and 401(k)s, that offer potentially higher rates of return over time, as long as you make wise investment choices.
For instance, let’s consider a 40-year-old man who wants coverage to financially protect his wife and children in case of his untimely death. He has two options: a 30-year term life policy with an annual premium of $500 or a whole life policy with an annual premium of $3,000, both offering the same death benefit. By choosing the term life policy, he would save $2,500 annually in premiums. If he then invests that amount steadily in stocks, generating an average annual return of 7% (which is below the stock market average), he would accumulate over $236,000 in 30 years.
To emphasize, this 7% average annual return is considerably higher than what the cash value of a whole life policy is likely to achieve.
Even if he were to invest his $2,500 annual savings more conservatively, with an average annual return of 3%, he would still accumulate around $119,000. If he invests this money in an IRA or 401(k), he would benefit from the same tax-deferred growth promised by a whole life policy, and in certain cases, like a Roth IRA or 401(k), the growth would even be tax-free.
Now, you might be thinking, “What if I choose term life insurance and my coverage runs out?” That’s a valid concern. However, if you opt for a 30-year term policy in your mid-30s or later and are still alive and well when it expires, you become eligible for Social Security and penalty-free withdrawals from an IRA or 401(k). If you pass away, leaving a spouse behind, they can receive Social Security survivor benefits which, spread out over time, could easily mirror the death benefit offered by your life insurance policy.
Most importantly, life insurance is primarily designed to replace the financial support you provide to your loved ones if you’re no longer there to do it yourself. When your children are young, they rely on your income, and your spouse likely does too. By the time you reach 60 or older, you’re likely well on your way to retirement, if not already retired. At this stage, you no longer require life insurance to replace the income you no longer generate. And with proper investment strategies, as mentioned earlier, your financial situation should remain secure.
Is Whole Life Insurance Ever a Good Idea?
As mentioned earlier, permanent life insurance can serve as a means of pushing yourself to save money and provides lifetime coverage. However, whole life insurance is so prohibitively expensive that unless you are in a very stable financial position, you risk being forced to cancel your coverage at some point due to unaffordability. This negates any benefits the policy might have offered you or your loved ones.
Typically, it takes 15-20 years for the cash value of a whole life policy to surpass the total premiums paid. This is because a significant portion of those premiums goes towards fees, commissions, and other expenses associated with providing the policy. So, if you cancel your policy at, say, age 12, you won’t reap any benefits.
In summary, if you have the means to pay substantial whole-life premiums over time, you also have the means to invest those funds in tax-advantaged retirement plans according to your preferred investment strategy. While early withdrawal from retirement funds for other financial needs is generally not advisable, you do have some flexibility with these accounts. For example, you can withdraw from an IRA to buy a house or borrow from a 401(k) when necessary. Therefore, locking your money into a whole life policy makes little sense when term life insurance offers greater financial freedom.
Remember, it’s important to consider your specific financial situation and goals before making a decision about life insurance.