Term Life vs. Whole Life Insurance
A life insurance policy is for the ones you leave behind. It should be one of the most important items on everyone’s to-do list if it is not in place already. Most of us have car insurance and homeowners insurance for asset protection. Besides protecting our assets, these insurances are required by the lenders such as banks or financial companies. That is not the case with life insurance; it must be done voluntarily and often overlooked. Life insurance is critical for your loved ones in the event that you are no longer there, especially if you are the primary breadwinner.
When to buy life insurance?
You should buy life insurance as soon as someone becomes dependent on your income regardless of your age. Although, buying any type of life insurance at a younger age will save you on annual premiums. Your dependents could be your partner or your children, or your parents. For example, Joe is 25 years old, just got married. If Joe’s partner is dependent on his/her income, Joe needs life insurance to protect his loved ones in the event of an unfortunate outcome. In most cases, you will need life insurance when you are a young family until you accumulate enough wealth to be “self-insured”. Meaning, the income from your investment is enough to sustain your family’s life-style without you working. After you become financially independent, you may not need life insurance.
Term Life vs. Permanent Life Insurance
Term-life insurance is for the limited term with a fixed cost. It is one of the simplest to understand. As the name suggests, the insurance is for a limited term; typically 10, 20 or 30 years. Your family would get death benefit if you pass away within the insurance term limit. However, your family gets nothing if you live beyond the term limit.
In contrast with term-life insurance, the permanent life insurance stays in effect until your death as long as you pay premiums. In addition, there is a potential for savings (earning interest) with permanent life policy. Here is the brief note on three major types of permanent life insurance.
- Traditional whole life:
- Premium and death benefits are fixed
- Earns interest similar to savings account rate of return, in terms of dividends paid by insurance company
- Universal life:
- Premiums and death benefits are adjustable
- Earns interest similar to money market rate of return
- Variable life:
- Premiums and death benefits are adjustable
- Savings can be invested in stocks, bonds and/or money market
The permanent life policy would provide a death benefit when you die or return the built-up cash when you “surrender” the policy early. In most cases, if you surrender policy within five years or so, you may lose most of your investment due to high upfront cost of commission and other expenses. However, if you keep it for a couple of decades you may receive most of your money back with the rate of return associated with the policy.
Term Life vs. Whole Life Cost Comparison
The whole life policy is considerably more expensive than the term-life policy. For instance, the cost of a $1 million 30-year term life policy for a 30 years old male with good health (non-tobacco) would be approximately $650 per year. In comparison, the premium for the same $1 million dollar whole life policy would be approximately $8,500 a year.
For a young family, $650 a year is much more affordable than $8,500 a year. In addition, whole life policy is a lousy investment choice. Even the variable life insurance policy tied to the stock market index is not a good investment vehicle. Because this type of policies have a cap on maximum return regardless of the equity return.
In general, buying a term-life insurance and investing the difference in broad based index funds is more advantageous. Here is the comparison.
| Term-Life | Whole-Life | Difference | |
|---|---|---|---|
| Policy Amount | $1 million | $1 million | – |
| Premium Per Year | $650 | $8,500 | $7,850 |
| Total Premiums (30 Years) | $19,500 | $255,000 | $235,500 |
The difference of $7,850 per year in the above example if invested in a broad based stock index fund with 6% annualized return would have grown to $657,844. In comparison, assuming all your whole life insurance premium goes toward cash value growth, $8,500 per year in the above example with 2% annualized return would have grown to $351,725. Of course, not all your premium would go towards cash value growth as there are commissions and expenses associated with whole life insurance.
The investment account of “investing the difference” grows twice as much than the cash value growth of a permanent life insurance. Therefore, for most of us, Term-Life is the most effective and affordable option.
How much life insurance to buy?
It depends. You need to take your current savings, debt, and expenses into account. It also depends on whether your partner could carry the household in your absence. Assuming your family is entirely dependent on your income you need enough life insurance to maintain your family’s current lifestyle. The general guidelines is to get an insurance policy with 10 to 20 times your annual salary. As long as duration is concerned, you will need insurance until your kids are in college and/or your mortgage or other debts are paid off.
Case for Whole Life Policy
There may be a case where buying a whole life policy makes sense. For example, if you have a larger estate than the current IRS estate tax exemption, buying a whole life policy may make sense. In this case, the whole life policy would help your heirs pay estate tax after your death. This is particularly helpful if the majority of your estate is invested in non-liquid investments such as real estate or a business. Per IRS, the estate and gift tax exemption is $11.58 million per individual and $23.16 million for a married couple for 2020. Meaning an individual can leave $11.58 million to their heirs without paying any federal estate or gift tax. If your estate is over the exempt amount, the top federal tax rate is 40% plus any state tax. In such a case, purchasing a whole life policy makes sense.
Whole Life Insurance for Kids?
Do you need life insurance for a child? It is not necessary in most cases since you do not rely on your child’s income. Instead consider investing in a college 529 plan or a custodial account.
Summary
Consider buying a term-life policy to protect your loved ones from financial hardship. Keep life insurance separate from investment. The whole life policy is typically a lousy investment vehicle; I would rather invest in broad based index funds or ETFs to maximize return on my investment. Even Though it feels like “throwing money away” when you buy a term-life policy because you do not get a return unless you die, it is the right choice for most of us. Insurance Information Institute is a good resource to learn more about life insurance.