Is Getting Permanent Life Insurance a Good Idea?
Permanent life insurance provides a death benefit no matter how long you live. Unlike term insurance, which is insures you for a limited period and does not build cash value, permanent insurance remains in place for as long as you live--provided premiums are paid on time. Common reasons for purchasing permanent life insurance include final expense and funeral policies, to pay expected estate taxes, and to split an illiquid estate equitably among heirs.
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Structure of whole life
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Permanent life insurance comes in two basic varieties: whole life and universal life. Whole life insurance features a guaranteed level death benefit and a guaranteed level premium for as long as you live. Premiums will never increase. The policy gradually builds up cash value. The cash value reflects the reserve amount the insurance company is legally required to set aside to pay expected death benefits. If you reach age 120, the cash value will equal the death benefit, and the insurance company will send you a check. If the company is a mutual company, the policy may earn dividends over time, which are credited to the cash value, and which may support increasing the death benefit.
Structure of universal life
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Universal life insurance features a level death benefit and a flexible premium, along with a cash value account to act as a reserve and to help pay premium costs later in life. The cost of insurance goes up along with your mortality risk as you get older. Typically, you overfund the policy in the early years to feed the cash value, which will help you pay premiums when you get older. Meanwhile you can earn interest on the cash value in the variable accounts, or, with variable universal life insurance, you may be able to get investment returns. Universal premiums are typically lower than with whole life insurance, but there are fewer guarantees. It is not unusual for universal life insurance policies to lapse later in life as increasing premiums eat up more and more cash value over time.
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Taxation of permanent life insurance
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Permanent life insurance receives extremely favorable tax treatment under the law compared to other savings vehicles. Although premiums are generally not tax deductible, cash value grows tax free, provided the policy is structured properly. Life insurance provides a tax-free death benefit to heirs. Meanwhile, the cash value buildup also grows tax-free, and you can generally access accumulated cash value tax-free to supplement your income, fund college, or for any other purpose you wish. There are no restrictions on how old you must be to withdraw your money. You may exchange one life insurance policy for another, or for an annuity, tax-free, under Section 1035 of the Internal Revenue Code. If you sell a life insurance policy, however, you may lose some of the tax advantages under so-called "transfer for value" rules. Life insurance you own is part of your estate, however. You may be subject to estate taxes on the death benefit of any life insurance you own in your own name.
Other advantages of permanent life insurance
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Life insurance does not go through probate, meaning it goes directly to heirs in days, rather than months. Life insurance also generally receives significant protection from the claims of creditors. Life insurance is not counted against the family as an asset when calculating need-based federal financial aid for higher education. Finally, there is no upper limit to the amount of money you may contribute to a life insurance policy. It is therefore useful as a tax-advantaged savings vehicle for those who are ineligible to make further contributions to IRAs, who are concerned about increasing taxes in retirement, and who are concerned about being targeted for lawsuits.
Disadvantages
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Permanent life insurance is a front-end loaded product. This means that all commissions are payable in the first year of the policy. The majority of your first year premiums go to commissions and sales expenses. It therefore takes several years for the policy's cash value to catch up with your total premiums. Life insurance is therefore not an effective short-term savings vehicle. If you are forced to surrender a life insurance policy, you may be subject to capital gains taxes on the cash value, minus the value of the premiums you have paid. If you aren't reasonably certain you can keep the policy in force for several years, a term insurance policy may be less expensive. Term insurance is generally much less expensive in the short run for temporary insurance needs.
Application
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Permanent life insurance is designed to provide large amounts of cash at death, no matter when that occurs. If you expect to be subject to the estate tax, if your estate has limited cash available to pay final expenses, or if you expect to hold a mortgage late in life, you may need a permanent policy. Permanent life insurance can also be an effective savings vehicle for retirement, emergency funds, education or any other need, due to its asset-protection features and its tax-free cash value buildup. It is also useful for farmers and business owners who have children interested in inheriting the business and other children not interested in the family business. A permanent life insurance policy allows children in the business to "buy out" their siblings who would rather have the cash.
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