In our January article, we covered life insurance basics. This month, we probe further into permanent life insurance policies and the commonly asked question, “Is life insurance a saving vehicle?”.
After reviewing an individual’s financial data and goals, our most common response is that permanent life insurance is not a recommended savings vehicle. In our experience, the majority of individuals do not completely understand the key aspects of permanent life insurance and are often sold a policy rather than performing their own due diligence to purchase one.
Permanent life insurance is often sold as a tax-advantaged, savings vehicle providing tax-free income, which is only partially true.
Life insurance representatives are often very effective at presenting permanent life insurance policies as tax-advantaged products. In all fairness, permanent policies do grow tax-deferred, and policy interest and dividends are initially sheltered from taxation upon receipt if they stay in the policy. In addition, the funds that you pay into the policy (money invested in the policy or your cost basis) can also be withdrawn free of tax.
However, should you withdraw more than your cost basis in the policy, or the earnings of the policy, that money will be taxed at your ordinary-income tax rate (for many highly compensated individuals, this is likely to be the highest tax rate paid on investment income).
While life insurance is commonly sold as tax-free, it is only true if you take a loan against the cash value of your policy, which will need to be re-paid at some point in the future to keep the policy in-force and on which one will pay interest on the amount of the outstanding loan.
So essentially, to tap into the earnings of a permanent life insurance policy tax-free, a loan is required.
Permanent insurance policies are expensive to maintain.
Permanent life insurance is significantly more expensive than term life insurance. Depending on your age, amount of death benefit coverage, and the term, it could cost you significantly more dollars per month more to own a permanent policy compared to a term policy.
According to data tracked by the Society of Actuaries1 :
Approximately 33% of whole life policies are surrendered within 5 years and roughly 80% of policies are surrendered within 30 years.
Why is this? When you commit to making a larger, recurring premium payment, it may initially be affordable but could become a future financial burden not worth paying for.
What are alternative savings vehicles to permanent life insurance?
In our experience, investment brokerage accounts, company 401k plans, or Individual Retirement Accounts (IRAs), are generally much more effective savings vehicles for most individuals relative to permanent life insurance policies. Below, we present a side-by-side comparison of a brokerage account and whole life policy:
Whole Life Insurance Policy
Ability to take out loans?
Beneficiaries receive account value, with a step-up in basis
Death Benefit to heirs can be tax-free
Internal Fund Fees plus a professional management fee
Cost of life insurance coverage (mortality and expense)
Varies from ordinary income tax to long-term
capital gains tax depending on the type of investment
Tax-Deferred. While living, the cash value is taxed at ordinary
income tax rates above your basis (see above for more details)
In closing, for most individuals, the general suggestion is to purchase adequate term life coverage providing protection up to potential future retirement age. With the money that is saved in monthly premiums, you can fund other more tax-efficient investment accounts. In using this strategy, your net worth should grow long-term, such that you are able to self-insure by the time your term policy expires.
If you would like to discuss your specific needs further, please contact one of our trusted advisors at Schneider Downs Wealth Management Advisors.
Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.
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The Schneider Downs Our Thoughts On blog exists to create a dialogue on issues that are important to organizations and individuals. While we enjoy sharing our ideas and insights, we’re especially interested in what you may have to say. If you have a question or a comment about this article – or any article from the Our Thoughts On blog – we hope you’ll share it with us. After all, a dialogue is an exchange of ideas, and we’d like to hear from you. Email us at [email protected].
Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
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