When it comes to considering life insurance as an investment, you’ve probably heard the adage, “Buy term and invest the difference.” This advice is based on the idea that term life insurance is the best choice for most individuals because it is the least expensive type of life insurance and leaves money free for other investments. Permanent life insurance, the other major category of life insurance, allows policyholders to accumulate cash value, while term does not, but there are expensive management fees and agent commissions associated with permanent policies, and many financial advisers consider these charges a waste of money.
When you hear financial advisers and, more often, life insurance agents advocating for life insurance as an investment, they are referring to the cash-value component of permanent life insurance and the ways you can invest and borrow this money. (See 6 Ways To Capture The Cash Value In Life Insurance.) When does it make sense to invest in life insurance in this way – and when are you better off buying term and investing the difference? Let’s take a look at some of the most popular arguments in favor of investing in permanent life insurance and how other investment possibilities compare.
Arguments in Favor of Using Permanent Life Insurance As an Investment
There are many arguments in favor of using permanent life insurance. The issue is: These benefits aren’t unique to permanent life insurance. You often can get them in other ways without paying the high management expenses and agent commissions that come with permanent life insurance. Let’s examine a few of the most widely advocated benefits of permanent life insurance one by one.
1. You get tax-deferred growth.
This benefit of the cash-value component of a permanent life insurance policy means you don’t pay taxes on any interest, dividends or capital gains in your life insurance policy until you withdraw the proceeds. You can get this same benefit, however, by putting your money in any number of retirement accounts, including traditional IRAs, 401(k)s, 403(b)s, SIMPLE IRAs, SEP IRAs and self-employed 401(k) plans.
If you’re maxing out your contributions to these accounts year after year, permanent life insurance might have a place in your portfolio. For more on the tax advantages of permanent life, see Cut Your Tax Bill With Permanent Life Insurance.
2. You can keep your policy until age 100, as long as you pay the premiums.
A key advertised benefit of permanent life insurance over term life insurance is that you don’t lose your coverage after a set number of years. A term policy ends when you reach the end of your term, which for many policyholders is at age 65 or 70. But by the time you’re 100, who will need your death benefit? Most likely, the people you originally took out a life insurance policy to protect, your spouse and children, are either self-sufficient or have also passed away.
3. You can borrow against the cash value to buy a house or send your kids to college, without paying taxes or penalties.
You can also use money you put in a savings account that you control – one on which you don’t pay fees and commissions – to buy a house or send your kids to college. But what insurance agents really mean when they make this point is that if you put money in a tax-advantaged retirement plan like a 401(k) and want to take it out for a purpose other than retirement, you might have to pay a 10% early distribution penalty plus the income tax that’s due. Further, some retirement plans, like 457(b)s, make it difficult or even impossible to take out money for one of these purposes.
That being said, it’s generally a bad idea to jeopardize your retirement by raiding your retirement savings for some other purpose, penalties or not. It’s also a bad idea to confuse life insurance with a savings account. What’s more, when you borrow money from your permanent insurance policy, it will accrue interest until you repay it, and if you die before repaying the loan, your heirs will receive a smaller death benefit. (To learn more, read How Do 401(k) Loans Work?)
4. Permanent life insurance can provide accelerated benefits if you become critically or terminally ill.
You may be able to receive anywhere from 25% to 100% of your permanent life insurance policy’s death benefit before you die if you develop a specified condition such as heart attack, stroke, invasive cancer or end-stage renal failure. The upside of accelerated benefits, as they’re called, is that you can use them to pay your medical bills and possibly enjoy a better quality of life in your final months. The drawback is that your beneficiaries won’t receive the full benefit you intended when you took out the policy. Also, your health insurance might already provide sufficient coverage for your medical bills.
In addition, some term policies offer this feature; it isn’t unique to permanent life insurance. Some policies charge extra for accelerated benefits, too – as if permanent life insurance premiums weren’t already high enough. (Read A Closer Look at Accelerated Benefit Riders to learn more.)
Arguments in Favor of Buying Term and Investing the Difference
When you buy a term policy, all of your premiums go toward securing a death benefit for your beneficiaries, who are usually your spouse or children. Term life insurance, unlike permanent life insurance, does not have any cash value and therefore does not have any investment component. However, you can think of term life insurance as an investment in the sense that you are paying relatively little in premiums in exchange for a relatively large death benefit.
For example, a nonsmoking 30-year-old woman in excellent health might be able to get a 20-year term policy with a death benefit of $1 million for $480 per year. If this woman dies at age 49 after paying premiums for 19 years, her beneficiaries will receive $1 million tax-free when she paid in just $9,120. Term life insurance provides an incomparable return on investment should your beneficiaries ever have to use it. That being said, it provides a negative return on investment if you are in the majority of policyholders whose beneficiaries never file a claim. In that case, you will have paid a relatively low price for peace of mind, and you can celebrate the fact that you’re still alive.
Do you really hate the idea of potentially “throwing away” almost $10,000 over the next 20 years? What would happen if you invested $480 per year in the stock market instead? If you earned an average annual return of 8%, you’d have $25,960 after 20 years, before taxes and inflation. Considering the opportunity cost of putting that $480 per year into term life insurance premiums instead of investing it, you’re really “throwing away” $25,960. But if you die without life insurance during those 20 years, you’ll leave your heirs with almost nothing instead of leaving them with $1 million.
What if you bought permanent life insurance instead? The same woman described above who purchased a whole life insurance policy from the same insurance company could expect to pay $9,370 annually.The whole life policy’s cost for a single year is just slightly less than the term life policy’s cost for 20 years. So how much cash value are you building up for that extra cost?
– After five years, the policy’s guaranteed cash value is $19,880, and you will have paid $46,850 in premiums.
– After 10 years, the policy’s guaranteed cash value is $65,630, and you will have paid $93,700 in premiums.
– After 20 years, the policy’s guaranteed cash value is $181,630, and you will have paid $187,400 in premiums.
But after 20 years, if you had bought term for $480 a year and invested the $8,890 difference, you’d have $480,806 before taxes and inflation at an average annual return of 8%.
Sure, you say, but the permanent life insurance policy guarantees that return. I’m not guaranteed an 8% return in the market. That’s true. If you have no tolerance for risk, you can put the extra $8,890 a year in a savings account. You’ll earn 1% annually, assuming interest rates never go up from today’s historic lows. After 20 years, you’ll have $208,671. That's still more than the permanent policy’s guaranteed cash value of $181,630.
The Bottom Line
Using permanent life insurance as an investment might make sense for some people in some situations — usually high net-worth individuals looking for a way to minimize estate taxes.
For the average person, the odds are poor that permanent life insurance will be a good investment compared with buying term and investing the difference. For more on the topic, see Strategies To Use Life Insurance For Retirement.