There are several variations of life insurance plans, but they generally fall into two categories: permanent and term. Term policies function similarly to other types of insurance policies you may carry, like car insurance; you pay money each month (for a certain period of time or term, hence the name), and if something bad happens—in this case, your early death—there's a benefit paid out. Permanent life insurance, on the other hand, has an investment component, and allows policyholders to accumulate a cash value.
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.
Many financial advisors recommend against permanent life insurance due to expensive management fees and agent commissions, and instead repeat the common phrase "buy term and invest the difference." This advice is based on the fact that term life insurance is usually significantly less expensive than permanent life insurance, leaving money free for other investments that may offer a better return.
But in some situations, permanent life insurance can be a smart investment. When does it make sense to invest in life insurance this way, and when is life insurance not worth it? 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.
- Whether or not life insurance is a good investment for you depends on your individual finances as well as the length you'll need coverage.
- The investment portion of permanent life insurance grows tax-free. You can also borrow against the cash value to buy a house or pay for your children's college costs, tax-free.
- Alternatively, with term life insurance, all of your payments are put toward the death benefit for your beneficiaries, with no cash value and, therefore, no investment component; this means small premiums in exchange for a large death benefit.
Pros and Cons of Permanent Life Insurance
There are many arguments in favor of using permanent life insurance as an investment. However, many of these benefits aren’t unique to permanent life insurance. You can often get them in other ways without paying the high management expenses and agent commissions that come with permanent life insurance. Here are a few of the most widely advocated benefits of permanent life insurance.
1. You get tax-deferred growth.
This means you don’t pay taxes on any interest, dividends, or capital gains on the cash-value component of your life insurance policy until you withdraw the proceeds. However, you can also take advantage of tax benefits with a number of different retirement accounts, including IRAs, 401(k)s, and 403(b)s.
If you’re maxing out your contributions to these accounts year after year, investing in permanent life insurance for tax reasons may make sense.
2. You can keep most policies up to age 120, as long as you pay the premiums.
Another touted benefit of permanent life insurance over term life insurance is 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 in their 60s. But by the time you’re 120, who will need your death benefit? Most likely, the people you originally took out a life insurance policy to protect—your spouse and children—will either be self-sufficient or have also passed away. However, if you anticipate people being financially dependent on you beyond the length of a typical term policy (for example, a disabled child), this benefit may be attractive to you.
3. You can borrow against the cash value.
If you need money to buy a home or pay for college, you can borrow against the cash value of a permanent life insurance policy. Conversely, 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 penalties. Further, some retirement plans, like the 457(b), make it difficult or even impossible to take out money for such purposes.
That being said, it’s generally a bad idea to jeopardize your retirement by raiding your retirement savings for another purpose. 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 beneficiaries will receive a smaller death benefit.
4. You can get accelerated benefits if you get sick.
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 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 death benefit you intended when you took out the policy. Also, your health insurance might already provide sufficient coverage for your medical bills. (They may cost extra, too.)
Accelerated benefits aren't unique to permanent life insurance; some term policies offer them too.
Pros and Cons of Term Insurance
When you buy a term policy, all of your premiums go toward securing a death benefit for your beneficiaries. Term life insurance, unlike permanent life insurance, does not have any cash value and therefore does not have any investment component. If you're still alive when the term ends, the policy simply lapses and you and your beneficiaries don't see any money.
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 the peace of mind knowing that in the event of your death, your beneficiaries will receive a relatively large death benefit.
Term Life Insurance Example
A non-smoking 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 among 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 you’re still alive.
Permanent Life Insurance Example
What if the same woman described above had bought permanent life insurance instead? For a whole life insurance policy from the same insurance company, she could expect to pay $9,370 annually. So how much cash value would she build up for that extra cost?
– After five years, the policy’s guaranteed cash value is $19,880, and she will have paid $46,850 in premiums.
– After 10 years, the policy’s guaranteed cash value is $65,630, and she will have paid $93,700 in premiums.
– After 20 years, the policy’s guaranteed cash value is $181,630, and she will have paid $187,400 in premiums.
But after 20 years, if she had bought term for $480 a year and invested the $8,890 difference, at an average annual return of 8%, she would have $480,806 before taxes.
"Sure," you say, "but the permanent life insurance policy guarantees its return. I’m not guaranteed an 8% return in the market." That’s true. But even if the woman described above had put the extra $8,890 a year in a savings account with 1% interest, she would have $208,671 after 20 years, which is 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 certain high net-worth individuals looking to minimize estate taxes. But for the average person, buying term and investing the difference is usually the better option.