Return of premium riders refund term life insurance premiums paid over the life of the policy if policyholders do not die during the stated term. This effectively reduces their net cost to zero if the payout, known as a death benefit, is not paid.
Of course, adding one raises the overall cost of the policy. Whether or not to include a return of premium rider in your term life insurance policy depends on a number of factors including your risk tolerance and tax situation.
- A return of premium rider will allow term life insurance policyholders to recover premiums paid over the life of the policy if they do not die during the stated term.
- When making a decision about opting for the rider, the policyholder's investment risk tolerance and individual tax situation should be considered.
- Higher-income, risk-averse policy owners will likely find this option with its guaranteed rate of return more appealing.
How Term Life and Return of Premium Riders Work
Term insurance is less expensive than permanent life insurance. As the name implies, it provides coverage for a specified term, such as ten, 20, or 30 years. If you pass away during the term of your coverage, the death benefit goes to the beneficiary or beneficiaries designated in the policy. If you outlive the term of the policy, coverage ends and you stop making premium payments.
When you buy a return of premium rider, the life insurance policy refunds the premiums paid if you outlive the term. But this rider comes at an extra cost, so is it worth it?
Unlike most types of permanent life insurance, term insurance has no cash value, which means the only value is the guaranteed death benefit from the policy.
Weighing Costs and Benefits: An Example
Let's take a look at an example of how to weigh whether or not to add a return of premium rider to your policy.
John, a 37-year-old non-smoker, purchases $250,000 of term coverage for $562 a year. If a return of premium rider is added on, the cost jumps to $880, an increase of $318 annually. Without the rider, John will pay a total of $16,860 over the life of the policy. The additional rider will bring the total cost of the term policy to $26,400.
Will the refund of the premiums make it worth paying an additional $9,540 in the meantime?
Opportunity Cost Analysis
To find out whether the additional cost is worthwhile, you need to do the same type of analysis used to decide whether or not to purchase more expensive permanent life insurance or buy term insurance and invest the difference. The opportunity cost of adding the rider to the policy can be calculated using a reasonable set of assumptions.
For example, if the additional $318 in annual premiums for the rider is invested in a stock mutual fund inside a Roth IRA, in 30 years the fund will be worth a little over $38,906, assuming an annual growth rate of 8%. In this case, John would be better off investing the difference than adding the rider on to his policy. But this answer is deceptively simple because the calculation doesn't consider factors such as John's risk tolerance or tax bracket.
What if he has a low risk tolerance or income that is too high to allow him to contribute to a Roth IRA? Another option is to invest the money in a taxable certificate of deposit (CD) paying a 2% interest rate. If John is in the 32% tax bracket, this would grow to a little over $14,760 at the end of 30 years, after taxes. If he outlives the coverage term, the the return of premium rider would yield a higher overall return.
It is important to keep in mind that if a policyholder dies at any time during the term period, simply buying just the traditional term coverage and investing the difference will always provide the greatest return on capital, because in this case the policy owner's estate would not only receive the death benefit but can distribute the invested cash as well. If a policyholder thinks that there is a good chance that they will not outlive the term, then the return of premium rider would likely be inappropriate.
The payout from a return of premium rider is tax free because it is a return of principal.
The Bottom Line
Whether it is better to purchase a return of premium rider or invest the difference will depend on your risk tolerance and individual tax situation. For policyholders who can invest in tax-deferred or tax-free accounts and are comfortable investing in the markets, a basic term policy without the rider probably makes more sense. Higher income, risk averse policy owners will probably find the return of income rider with its guaranteed rate of return more appealing.