What Type of Life Insurance Is Better?
Life insurance needs come in two varieties: Permanent and temporary. Permanent needs include such items as final expenses, funeral costs and liquidity to pay estate taxes. Temporary needs include college funding or to guarantee payment of a debt, such as a mortgage. When the children are done with college, the life insurance need goes away, to some extent. The best life insurance policy is the policy that matches up with the need, that is affordable, and will be in place when the insured dies.
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Types of Life Insurance
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Just as life insurance needs are either temporary or permanent, so are life insurance policies. Permanent insurance policies include whole life, participating whole life (which earns dividends), universal life, variable universal life, and equity-indexed universal life. Temporary insurance policies include term insurance and return-of-premium term insurance.
Advantages of Term Insurance
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Term insurance policies feature the lowest premiums per dollar of coverage in the short run. For this reason, they are excellent vehicles for covering temporary insurance needs for young and healthy people on a tight budget, such as young families. For example, a young mother in her mid-20s may want to purchase a policy to replace up to 20 years of her income, to provide for her child if she should die. Many companies offer the guaranteed right to convert term insurance to permanent insurance for a set number of years. Term insurance can be used as a stepping stone to permanent where the need is permanent but the family or business cannot afford permanent insurance yet.
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Disadvantages of Term Insurance
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Term insurance premiums start out low but gradually increase throughout the insured's life. Term insurance policies do not build cash value. If the insured does not die while the policy is in force, premiums are lost. Return-of-premium policies do refund premiums paid, however, if the insured does not die during the term. Historically, only a small percentage of term insurance policies ever pay a death claim.
Advantages of Permanent Insurance
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Congress has long encouraged the purchase of life insurance by granting it a number of important tax benefits. Death benefits are tax free, cash value grows tax deferred, and in most circumstances, policy owners can access their cash value tax free by borrowing against their policies. For life insurance needs longer than a decade or two, permanent life insurance is frequently more cost-efficient than term policies.
1035 Exchanges
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If you decide you no longer need life insurance, you can exchange your life insurance policy for an annuity, tax free, under Internal Revenue Code section 1035. If your cash value is greater than the premiums you have invested, you essentially enjoyed the life insurance coverage for free.
Disadvantages of Permanent Insurance
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Premiums are higher on permanent insurance policies, at least in the short run. Also, insurance policies are generally front-loaded products. That means the bulk of commissions and transaction costs occur in the first year of the policy. As a result, it can take several years before cash value in permanent policies catches up to the amount of premium you have paid in.
Considerations
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Neither type of life insurance is always better. The best decision depends on the individual budget, time horizon, and the size and duration of insurance need. The best type of policy to own is the one that is in place when the insured dies.
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