What Kind Should You Buy?
Last updated on March 24,
Life insurance companies are brilliant at devising
new kinds of policies. But try to remember that whatever
the name on the policy -- universal life, variable life,
Irresistible Life, Irreplaceable Life, The Champion, The
Solution -- all are in fact variations on the two basic
kinds of coverage: term insurance and whole-life
insurance (also called cash value or permanent).
The case for term insurance
The fundamental purpose of life insurance is to
provide dependents with the financial support they would
lose if you died. If you're straining to buy enough
insurance to accomplish that goal, then term is what you
should buy. Dollar for dollar, term gives you the most
protection for your money. Period.
Beyond that important truth, the arguments for term
are the arguments against whole life. True, the cash
value in a whole-life policy could add to your financial
resources as the years pass, you can't get your hands on
the cash unless you surrender the policy (thereby
terminating your coverage) or borrow some of it.
Borrowing keeps the policy in force, but any unpaid loan
balance will be deducted from the face amount if you
die. To restore the full face amount of the policy,
you'll have to repay the loan, plus interest.
How expensive are these loans? Some companies charge
variable rates so that the interest they collect
reflects the current market. Others reduce dividends to
reflect the amount of the cash value encumbered by the
policyholder's loan, an approach called direct
recognition. Under direct recognition, in effect, the
more you borrow the less your policy earns. Either of
these approaches can make policy loans more expensive
than they appear. In any case, you can leave your
options open by starting with a term policy that you can
convert to whole-life coverage.
The case for whole life
One of the strongest arguments for whole life is that
the cash value in the policy builds up tax free, which
substantially boosts the compounding power of your
earnings. If you have maxed out on 401(k)
retirement accounts, and other tax-sheltered savings
and investment plans, then cash-value insurance provides
another option. It's entirely possible that a $250,000
policy bought at age 35 could accumulate a cash
surrender value of $100,000 by the time you reach age 65
-- a nice addition to your retirement nest egg if you
decide you don't need the insurance anymore.
Meanwhile, you can turn in your policy any time after
the first several years and collect the cash value, no
questions asked. The proceeds are tax free to the extent
that the cash value doesn't exceed the premiums you've
paid. Or you can borrow against the cash value and leave
the policy in force, with no requirement that you pay
the money back (although you will owe interest on the
loan, and if you die with a loan outstanding, it will be
deducted from the face amount paid to your
beneficiaries). It's safe to say that cash-value life
insurance has financed many a college education, even
though there may have been better ways to do it.