[This post is educational only and is not investment or insurance advice. For a refresher on the full website disclosure policy, please visit this page.]
Not An Investment
I often hear that permanent life insurance is an investment. Usually, it is described as this by salespeople eager to earn a commission. Other times, it is policyholders telling me of the benefits. However, wherein the name “Permanent life insurance” does the word investment appear?
Exactly, it doesn’t.
Life insurance is not an investment, whether it is temporary – i.e., term – or lasts a lifetime – permanent, universal, variable, or whole.
Insurance is insurance – bought to protect against financially devastating events.
According to the Oxford Dictionary, insurance is a “Guarantee of compensation for specified loss … or death in return for payment of a premium,” while an investment is “Investing money for a profit or material result.”
But Olaf, aren’t you just mincing words? With permanent life insurance, your money goes in and is invested, later withdrawable!
Yes, this is true, but you are reducing your death benefit. Plus, the removed money, referred to as cash value, is investable, but only in quasi mutual funds that your insurance provider decides, usually with high fees.
Making matters worse, permanent life policyholders typically don’t begin to break even until ten years have passed. That means you are putting money into something that has no value for a decade, which half of the policyholders cancel by then! That means half of permanent life insurance policyholders would be better off lighting their money on fire to save on winter heating bills.
What about the touted tax-free benefits, though? While the payout is entirely tax-free for beneficiaries upon your death, your accrued cash value is only tax-free as a loan. Loans require repayment, which, if not done, become taxable to you or reduce your death benefit!
And about forced savings, no. Invest in your 401(k) or set up an automatic IRA plan; do not pay high commissions and ongoing fees for the privilege of disciplined saving.
While I may seem combative regarding permanent life insurance, I adamantly believe my viewpoint, which stems from prior insurance industry experience. But, rather than accepting my statements at face value, I encourage you to read along as I break permanent insurance down piece by piece to illustrate my reasoning.
Break-Even, Forced Saving, & Cancellation
By year thirty, abandonment increases to 80%.
[These cancellation rates are comparable at ten years for other forms of permanent life insurance and increase dramatically for some at 30 years, with a nearly 90% cancellation rate!]
Regardless of how you actuate the numbers, statistics are against permanent life insurance being a forced savings vehicle, often touted as one of its most significant benefits!
Instead, had this money been used to buy a term policy and the remainder invested in a modest 60/40 stock/bond portfolio, the policyholder would have had nearly $58,000 after ten years. Without further contributions, that money would have grown to $475,000 by the thirty-year mark.
Even with widespread inflation as of Q2 2021, cash sitting under your mattress is worth more than permanent life insurance after ten years for the average person due to the high cancellation rates seen at ten and thirty years, respectively. Some savings are better than forfeiting before breakeven, after all.
Thus, buying a term policy and investing the rest in a 401(k), IRA, or taxable brokerage account will be more meaningful for most people.
(Calculations assume an age of 38 and policy of $500,000, which is the median age in the US as of 2019. Pricing data for term/permanent policies are found here and was averaged for male/female, and annual return data is seen here using the ten-year rolling average.
“Investable” Cash Value – I.e., The Amount You Can Use
There are many types of permanent life insurance, and they all grow cash value differently. Some have guaranteed growth rates, while others track the prevailing interest rate. Specific policies may combine multiple factors to determine growth, while others are placed into quasi mutual funds with higher fees. Nonetheless, all are generally more expensive than traditional investment accounts, and the “investments” are limited to what an insurer decides.
Oh yeah, and your money is non-transferrable.
With traditional investment accounts, tens of thousands of investment choices exist, which are easily transferred from firm to firm. Plus, you can shop around for low or high-fee investments and accounts, so why pay more for less?
Loans Are Loans & Withdraws Are Taxable
Some proponents of permanent life insurance advocate withdrawing from the policy later in life, treating it as a savings or retirement account that is tax-free. This premise is untrue.
When individuals take a loan from their permanent life insurance policy, it must be repaid to keep tax-free status. If the loan is not repaid and the policy lapses, it turns into a withdrawal, which is taxed. Then, whatever portion you paid into the policy becomes a return of non-taxable money, while any growth becomes ordinary income and is taxed accordingly.
Furthermore, if you take a loan out and die before full repayment, the unrepaid amount escapes taxes, but the death benefit is therefore reduced. So, you get some money tax-free, but your loved ones receive a reduced insurance payout. For the wealthy, this will not matter. However, a smaller payout could lead to uncovered financial liabilities for those without other assets, negating the point of insurance!
When Permanent Makes Sense
With all of this said, in some cases, permanent life insurance can make sense. If you happen to maximize your 401(k), IRA, HSA, 529 Plans, and other tax-preferential accounts – and you have a high income – permanent life insurance may make sense. However, taxable accounts are tax-free at death due to the step-up in cost basis rule. So, unless you are wealthy enough to worry about the estate tax, which sits at over $12,000,000 per individual, permanent life likely is not beneficial.
[Some states have lower limits, such as Minnesota, which has a $3,000,000 threshold, but statistically, most individuals and households will never reach these limits.]
Saving for retirement is of critical importance, as is protecting your family in the event of premature death. However, these two concerns should not be combined and accomplished through a permanent life insurance policy for most people. Instead, a sufficient term policy and investing the rest in a 401(k), IRA, or taxable brokerage account makes more sense for most cents.
Do you agree with my take, or do you hold different views? Perhaps you have had a good or bad experience with permanent life insurance. Regardless, I would love to hear your thoughts in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time