But like most financial choices we confront, there are exceptions. So rather than just accept a blanket pronouncement that whole life insurance is always the bad choice, let’s look at the pros and cons so you can decide for yourself what type of life insurance to buy.
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Term vs. Whole Life
As a quick refresher, term life insurance is as basic and inexpensive as it gets. You’ll get life insurance for a set term at a set premium. If the insured dies during the term of the policy, his or her beneficiaries will receive the death benefits. If the term expires, the policy terminates. There is no cash value to the policy. It’s the type of life insurance my wife and I have carried since we adopted our children seventeen years ago.
In contrast, whole life insurance includes not only death benefits but also an investment component. In effect, the insurance company charges significantly more than the cost of the actual insurance and invests the extra premium in stocks, bonds, or both. Unlike term insurance, whole life does not have a set term; the insured can keep the insurance for life. And whole life policies have a cash value that is returned to the insured if the policy is ever canceled. Whole life policies, also called permanent insurance, include universal and variable life insurance.
At first glance, whole life policies seem very attractive. But there are some significant disadvantages that should be weighed before purchasing a whole life policy.
Without question, the single biggest disadvantage is cost. The actual cost of any life insurance varies based on a number of factors. These include your age, whether you smoke, the length of a term policy, the amount of insurance, and your health. But the cost of whole life insurance can easily exceed a term policy with the same death benefit by thousands of dollars a year. As a general rule, expect whole life policies to cost five to 10 times more than a comparable term policy.
Because of the excess premium funds the investment component for a whole life policy, it may seem worth the cost. There can be some tax advantages, and some view it as a forced way to save for retirement. Some insurance agents sell whole life insurance to clients by stressing that a portion of the premium is invested in bonds, money-market products, stocks, and other financial products that collectively serve mainly as a retirement fund. Again, this might sound fantastic as forced savings takes the savings responsibility out of your hands. But there are two big disadvantages to keep in mind.
First, you have little control over the investment choices made by the life insurance company. It’s not like a 401(k) or IRA where you can choose where to invest your money. And second, the fees taken out of the premiums you pay are extremely high. While I like to keep my investment expenses below 0.5%, fees for whole life insurance investments can and do exceed 3% at times. So if you are considering a whole life policy, make sure you understand the fee structure first.
Assuming that you are paying your monthly premiums, a whole life insurance policy will cover you for your entire life. The idea of ceaseless life insurance coverage comforts many customers. Typically, term life insurance policies won’t cover you after age 65. And once the term expires on a term policy, the premiums typically increase substantially.
Whole life insurance differs from term life insurance in its provision of both a death benefit and a savings account. A portion of your life insurance payment is set aside in a savings account often meant to serve to fund retirement. Insurance agents refer to this as “forced savings.” You can withdraw or borrow against the cash value of your savings portion of your insurance policy. In addition, if you outlive the life of the policy, you can receive cash back, which acts as another security feature to ease consumers minds.
The primary thing to understand about permanent life insurance is that it is not an investment. You’ll often hear universal life insurance described to you as “similar to an IRA” or as an investment with “guaranteed returns.” This couldn’t be further from the truth.
Permanent life insurance carries high fees, and your higher premiums can eat into your returns. Dave Ramsey put it best: “‘Cash value’ life insurance is one of the worst financial products available.” You should be maximally contributing to your 401(k) and an IRA before you even begin to consider a whole life insurance policy, and even then, it’s likely not the best fit for you.
“Permanent” life insurance is exactly as it sounds, and you’re penalized heavily if you withdraw from your policy early. This is a policy you’re taking out for life, so compare it to other common insurance commodities like car insurance. You change your car insurance as your car ages, dropping coverages or changing deductibles. Do you want to lock yourself into a policy that remains in effect until you turn 100?
Be sure to weigh all of your options before choosing a life insurance plan. And remember that the best option for you today may not be the best option for you in ten years.
Whole life insurance has both pros and cons:
- Whole life costs much more than term life insurance
- The investment portion of the policy typically charges significant fees
- The insured often has limited control over investment choices
- Ideal if you need insurance throughout your life
If you are still on the fence, perhaps the first step is to compare the cost of different life insurance options. And if you do need to seek advice, get it from a fee-based adviser, rather than somebody who stands to make a nice commission if you purchase an expensive policy.