Should I Buy a Whole Life Insurance Policy?

[caption id=”attachment_780" align=”alignleft” width=”300" caption=”Photo Credit: TimNichols1956, via StockFreeImages.com”]

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By Jason Van Steenwyk

When it comes to financial planning topics, nothing is surer to spawn off a spirited debate among “experts” than bringing up the wisdom of owning a whole life insurance policy. Prominent television personalities such as Suze Orman and Dave Ramsey have railed against them, arguing that they do no good for the consumer, but they do pad insurance agent commissions.

Others have a more sober view — they see lasting value in the permanent life insurance contract, the many guarantees that come with whole life insurance, and, of course, the unique tax advantages of using life insurance not just for the death benefit, but as an important part of an individual, family or small business savings plan.

And still others, such as R. Nelson Nash and Pamela Yellen, advocate dividend paying whole life insurance as a sort of panacea alternative to traditional financial planning.

Who’s right?

Well, as with so many things, it depends on your situation. But Orman and Ramsey have it wrong: Whole life insurance does what it does exceptionally well: Provide a guaranteed tax-free death benefit when the insured dies, no matter when the insured dies — while generating a guaranteed cash value at a modest but steady rate of increase. Term insurance doesn’t do that. Neither does anything else. Things are very simple when you boil it down to the death benefit. And the cash value is nothing more than the discounted present value of the expected future death benefit — minus some commissions and startup and underwriting costs. Whole life insurance, properly presented and sold to solve the right problems, is definitely not a bad financial product. Indeed, it is an excellent one.

But is whole life insurance the panacea that Nash and Yellen argue? Both of them peddle a life insurance selling system predicated on the use of the tax-free buildup of cash value and dividends within a participating whole life policy at a mutual life insurance company that does not practice direct recognition?

No. Not by a long shot. It’s not even a great fit for some people who need permanent life insurance. But it does make very good sense in certain situations.

So should you buy a whole life insurance policy? Consider it under the following circumstances:

  • You want or need to pass on cash — liquid, hard, tax-free cash — to someone when you die, no matter how long you live. This could be family, or this could be a business partner, giving him or her the liquidity to buy out your interest in the business from your heirs.
  • You need to fund a buy-sell agreement with a business partner.
  • You need to take care of an heir with special needs.
  • You need to protect assets from potential lawsuits and your state provides favorable treatment to permanent life insurance cash value.
  • You are buying the policy on a young child. These plans are very efficient when taken out on children, and provide a way to guarantee their insurability later in life, when they set out to have families of their own — no matter what illnesses or youthful indiscretions they may commit in their teenage years that would make it difficult to get life insurance later.
  • You expect you may have an estate tax liability when you die. The life insurance can pay the estate tax.
  • You want your strategy to “self-complete” if you get disabled, and you can afford the waiver of premium rider. This rider guarantees that if you’re disabled, the insurance company will continue to pay your scheduled premiums for you. No mutual fund or annuity can do that, and your accountant won’t do it for you either. But it can be an invaluable feature for a college fund, which guarantees that your college savings plan is compete, whether you live on and in good health, whether you die prematurely or are disabled prior to age 60 or 65, depending on the policy.

The above instances only refer to death benefit planning. The primary purpose of life insurance is not to supplement your retirement income, pay for college, or buy boats, but to deliver a fast tax-free death benefit to the insured’s beneficiaries. Period.

But a contract that guarantees this payment definitely has value, and you can tap that cash value in the meantime for anything you like. Think of it from the insurer’s point of view: It’s the safest loan anyone can make. They know that no matter what happens, they can pay themselves back out of the eventual death benefit.

But is life insurance cash value an efficient way to pay retirement or college expenses?

Sometimes. But you need to be in a stable situation with some free cash available every month or year to feed the life insurance policy. If cash value buildup is important to you, you would get the smallest permanent death benefit you can find, and stuff as much cash into it each year as the law allows without allowing the contract to become a modified endowment contract.

The small death benefit keeps expenses low. And when expenses are low, more of your premiums get converted to cash value.

Your whole life insurance policy will pay you — internal to the policy — in two ways: You get a guaranteed crediting rating on your cash value every year — close to what you’d earn in a CD or money market (remember, this is “safe money,” not “risky money”), except it’s tax free.

You will also receive dividends, which is nothing more than your share of the profits from a mutually owned insurance company.

As long as you don’t overcontribute, you can pull dividends out, then borrow everything else at interest, tax free. If your life insurance company does not practice direct recognition, you will still get the crediting rate and dividends on your cash value, and even on the money you borrowed.

The result: Your life insurance policy becomes the source of extremely low-interest cash, when you need it. The cash is normally tax-free, as long as you don’t over contribute or surrender the policy outright, at which time your withdrawal. Meanwhile, the cash value and dividends pile up, over time, tax free, and your death benefit increases, tax free. If you borrow against it, you can pay it back if you want, or just take a lower death benefit, after you pay back your loan plus interest.

It acts like a sort of high-expense Roth IRA on steroids: There are no income limitations, and no requirement to wait until you are age 59 ½ or over to start pulling money out.

So does it make sense to use life insurance to supplement your retirement income, build a college fund, or do anything else that requires the amassing of large amounts of cash?

Consider overstuffing a life insurance policy, or executing a “Bank on Yourself”-type strategy if the following circumstances apply to you:

  • You can easily afford the premiums. Premiums for these plans are much, much higher than term insurance premiums in the short run (though not in the long run).
  • You understand the contract
  • Your carrier does not practice direct recognition
  • You have maxed out your contributions or do not qualify for IRAs, Roth IRAs, a 401(k) program, or other tax-advantaged retirement programs.
  • You want to accumulate money somewhere where it does not count against your kids for the purpose of calculating need-based financial aid for college. Assets in CDs, mutual funds, retirement accounts, cash and 529 plans count against you under the federal system
  • You want to retire prior to age 59½ and don’t want to pay a 10 percent penalty on withdrawals.

These plans help in the long run — if you can keep them in force. If you have to lapse the policy, though, it’s going to hurt. If you lapse in the first few years, you may well be underwater — you will have paid in more than you receive. If you surrender the policy outright, you are taxed on any gains over and above your premium contributions.

Whole life insurance has its place, but it is a commitment. It’s not something you can flit in and out of, like a mutual fund or stock. Whatever life insurance premium you commit to, make sure it is something you can easily afford. The smaller policy that stays in force is better than the bigger policy that you have to lapse.