For most of us – life insurance is a way for our heirs to replace our income in the event that we succumb to an early death. However, I’ve recently heard quite a bit of chatter from “experts” that whole life insurance should be used as an investment vehicle. We sent our Penny Hoarder team out to investigate….
(Side note: our investigation team is an intern and the office mascot, Franklin the labrador retriever. Nevertheless, what they’ve found is fascinating.)
In one corner we have the personal finance gurus like Suze Orman and Dave Ramsey that speak of whole life insurance like it’s the devil. In the other corner, we have investment bankers and CNBC hosts that often insist that whole life insurance absolutely be apart of our investment portfolio. Quite frankly, all of these people have their own agenda, so who do we trust?
Before we issue a ruling, it’s important to first understand the difference between the two most popular types of life insurance – term and whole life. The simplest answer is that with term life insurance a death benefit is only paid to your heirs upon your death. However, whole life insurance not only pays out your policy benefit upon your death, but it builds up a cash value that can be cashed out or borrowed against while you are still alive.
With term insurance, if you stop paying the premiums, your policy is canceled and voided – end of story. Conversely, if you stopped paying premiums on your whole life policy you’d receive a check for the current cash value of your policy.
At first glance you might say to yourself that whole life insurance sounds a lot better. Who wouldn’t want the policy with a cash value, right?
Well, it’s not necessarily all it’s cracked up to be. To better understand the benefits and risk of each type of insurance, lets do a side by side life insurance comparison…
Whole life insurance is expensive. Like hella expensive. In fact, whole life insurance can often be as much as ten times as expensive as term insurance because you are paying for not only the insurance, but the investment portion of the policy.
One of the selling points you’ll often hear with whole life insurance policies is that the interest you earn is tax deferred. That’s true, but there are numerous other investment vehicles that can defer taxes on your earnings including IRAs. In less you’re consistently maxing out on your allowable IRA contributions, I fail to see how this is a valid reason.
The problem with investing in whole life insurance is that the insurance company often charges huge fees that reduce the investment return. Our friends over at SmartMoney.com recently explained:
“These policies come with high fees and commissions, which sometimes lop off as much as three percentage points from the annual return. On top of that, there are up-front (but hidden) commissions that are typically 100% of your first year’s premium….
To get a real sense of the value of term, let’s compare a term policy and a universal (whole) life policy. Say a 40-year-old nonsmoking male has a choice between a $250,000 Met Life universal policy with a $3,000 annual premium and a same amount of renewable term coverage with a 20-year fixed premium of $350. At the end of one year, the universal policy, assuming it paid 5.7% per year, tax-deferred, would have a cash value of exactly zero (cash value is the amount you would get back if you canceled the policy).
But say he had instead invested $2,650 (the difference between $3,000 and $350) in a no-load mutual fund that averaged a total return of 10% annually. At the end of the first year, he’d have $2,841, accounting for taxes on the earnings at a 28% rate. At the end of 10 years, he would have accumulated more than $46,000 in after-tax savings in the mutual fund. Over the same period, the cash value of the policy would have climbed only to $31,819.”
In less you own your own island and are in desperate need of a tax shelter, stay away from whole life insurance. Stick with term life insurance, from a place like Lifebroker. There are better ways to invest your money…