Sometimes the advice slogans that pervade the media need to be taken with a grain of salt. “Buy term and invest the difference” is one of those slogans that pop up all over, presented as an obvious fact, yet it’s often poor advice. Cash-value life insurance policies are very powerful tools when used correctly.

Appropriate use of cash-value life insurance policies provides both insurance protection and tax-favored accumulation. Life insurance has the capability of being a very effective tax avoider, and there are major problems with the universal application of a “buy term and invest the difference” strategy.

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Understanding the “Buy Term…” Strategy

Should you always go for term life insurance? When is it smarter to get a permanent policy? Know the importance of life insurane and get the lowdown on cash-value life insurance. Here's why you should opt into this affordable life saver. #Lifeinsurance #CentSai #policyThe idea behind the “buy term life insurance and invest the difference” strategy is that instead of allocating a hefty premium to a permanent policy, you would purchase a lower-cost term policy and invest the difference. Advocates of this strategy point to higher available returns in the market, particularly as opposed to the stodgy returns of whole life policies. There are a couple of fallacies to this argument.

First, comparing market returns to whole-life returns is akin to comparing apples and gorillas.

They just don’t compare. Whole life policies are guaranteed vehicles. If you pay your premiums as you’re contractually obliged to do, you will have the cash value guaranteed by the policy at the future dates illustrated. Market investments don’t have guarantees. The assumption of risk naturally requires the opportunity for a higher return. But they’re not comparable strategies.

The “buy term” assumption is also based upon a close-ended scenario. What this means is that we look at it between your present age and some identified future age, typically around a normal retirement age. Implicit in this assumption is that, by some miraculous set of circumstances, your insurance need disappears at this time. Reality might not play along with this. Many people need life insurance past an arbitrarily selected date.

Types of Life Insurance

To compare life insurance policies, you need to have a basic understanding of the different types. We can classify them as either “term” or “permanent.”

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Term Life Insurance

Term insurance is for a temporary period — the policy’s term. This can be a very short term, such as a year, or a longer term, such as 20 or even 30 years. The younger you are when you get the policy, the lower the cost, relatively speaking. And the shorter the term, the lower the cost. Makes sense. You’re more likely to collect as you get older, hence the premiums get higher.

There’s a big downside, though:

As you get up in years, you’ll find fewer companies that will issue you a term policy, and eventually you’ll find that the option disappears.

Once you’re over 70, your chances of getting term insurance are pretty slim. If you do find it, the cost will be outrageous. Term is not a permanent solution. It is, however, a great solution for temporary needs.

Permanent Life Insurance

Permanent policies are designed to last your lifetime, hence the name. These policies include whole life, universal life, and variable universal life.

Whole life policies are the oldest of the permanent policies. They provide a death benefit that lasts your lifetime, generally with a level premium, although there are some variations. Whole life policies build cash value. They’re conservative and stable accumulation vehicles. These policies may not be the fastest way to build value, but they’re safe and predictable.

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Universal life (UL) is a permanent alternative to whole life. Universal life is also designed to last a lifetime. But with universal life, your investment account earns interest based on current rates. You have the potential for greater returns during periods of higher interest. In exchange for the opportunity, you assume a good deal more risk.

Variable universal life (VUL) is another form of universal life. In addition to the fixed interest option of traditional UL, VUL policies have investment options, similar to what you might see in a 401(k). You have the ability to earn market returns inside of a tax-advantaged investment vehicle.

When Do You Need Life Insurance?

Investing through a life insurance contract will generally only make sense when you need insurance. If you have no need for life insurance, the costs of the policy will likely make other options more attractive.

That said, need isn’t merely limited to providing for immediate family after your death.

You could need insurance to fund estate costs, provide liquidity to keep a business going after your death, buy out partners, or leave a legacy to a charity or institution that is important to you.

Permanent life insurance policies are long-term accumulation vehicles. They aren’t appropriate vehicles to use for goals that are coming up in the next few years.

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Permanent insurance policies aren’t cheap. The costs are high. With whole life, you generally don’t see the costs other than the annual policy fee. Meanwhile, UL and VUL are unbundled products. Their costs are clearly illustrated.

When you make a premium payment into a UL or VUL policy, your typical cost structure has a number of components. First is a premium expense charge or sales charge. This is a percentage of any premiums paid. There is also an annual policy fee, much like a whole life policy. This may be taken monthly or annually depending upon the insurer.

After these upfront fees, then the cost of insurance — the cost of providing the death benefit — is taken. The cost of insurance is an age-based cost. The cost per thousand dollars of death benefit that is in excess of your cash value increases as you age.

What’s left after all these costs is what makes it to your cash value. But there are still some expenses after that. In a VUL policy, each investment option will have management expenses that you need to be aware of and consider.

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The Tax Advantages of Life Insurance

Permanent life insurance policies have the potential to be a fantastic tax vehicle if used properly.

The typical scenario for accessing funds from a UL or VUL is to first make one or more partial surrenders to recover the policy’s cost basis. You can take your entire basis back out without tax consequences.

Calculating Your Basis

Your basis will generally be the sum of your premiums paid, minus any prior surrenders or other premium returns. In a whole life policy issued by a participating company, dividends would reduce your basis. Keep in mind that UL and VUL policies are generally non-participating policies, and dividends aren’t a factor for non-participating policies.

Once you have surrendered your basis, you switch to loans to further access the cash value of your life insurance policy. Receipt of a loan is not a taxable event. As long as you maintain the policy in force, your loan remains non-taxable and is ultimately paid off by your death benefit. This is huge. Let’s go through it once more, a little slower.

Once you have taken out the cost basis on your life insurance — the net sum of what you paid into the policy — you switch to loans to access your cash value.

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Taking Out a Loan

When you take a loan from the policy, there are no tax implications. You simply get to use the money. When you die, the loan is paid from your tax-free death benefit. You got to spend a portion of your policy’s gains during your lifetime.

No one ever pays tax on those gains. No. One. Ever.

That said, there’s a caveat: The policy needs to stay in force until you die. If you have taken a loan from a policy and the policy lapses or you surrender it, you might have a taxable event. If you’ve removed the basis through partial surrenders and are borrowing out of your gains, you can be quite certain that surrendering or lapsing the policy will cause a taxable event.

Life insurance policies are fantastic tax vehicles when used correctly. Used incorrectly, they can cause you trouble.

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Common Errors in Using Cash-Value Life Insurance Policies

One common error is trying to do too much with too small a policy. If you want significant cash value accumulation, you’ll need a large death benefit. No way around that.

Another common error is trying to use insurance to fund a near-term goal. If your children are teenagers, it’s probably too late to fund their education with life insurance. It takes time to build cash value.

Underfunding is also a major error. Funding UL and VUL policies at their lower limits is inefficient and will lead to low accumulation values. This creates the potential to have a policy that lapses or needs additional infusions of cash. The most efficient way to fund accumulation goals with these policies is to fund them at the maximum level that retains their tax-advantaged status.

Another common error is trying to fund education by placing life insurance on a small child. Look at your forecast future cash values. In most cases, they’ll be relatively insignificant by the time the child needs the funds.

The last of the major errors is trying to accomplish too much with one vehicle. An insurance policy can help fund your children’s education, a second home, or your retirement. It could even help to leave a legacy. But “all of the above” isn’t a correct choice. You can effectively help accomplish one or perhaps two major financial goals, but not all of them. Not with any one product, and certainly not with one life insurance policy.

You also need to be cautious of overfunding policies. This isn’t a common error, but it’s something to be mindful of. There are limits to the amount of money you can put into a life insurance policy and retain that tax-favorable treatment. Work with your agent to avoid letting your policy become a modified-endowment contract and losing that favorable tax treatment.

There’s an additional consideration, as well: What happens if you live too long? Most policies have an age at which they mature. This used to be around 95, but it has moved out to be typically age 100 or more. Whatever the cutoff, you’ll need to know well in advance what happens and what the financial implications are if you live past this age.

Final Thoughts on Cash-Value Life Insurance Policies

Circling back to where we started, buying term life insurance and investing the difference will be an appropriate answer for a limited number of people. That’s the problem with general advice: It may or may not apply to you.

For those who may have permanent insurance needs, there are other options. Anyone who would rather use the insurance company’s money to pay for their funeral has a permanent need. Anyone looking to maximize their legacy for future generations or charitable causes has a permanent insurance need. And it’s not an either-or situation.

For some people — perhaps for most people — the optimal solution is a base level of permanent insurance to meet permanent needs supplemented with a term policy to cover temporary needs. For many people, there are real temporary needs associated with raising children, and those needs diminish once the children are out on their own. That’s what term is best suited for: temporary needs.

But for those who need more retirement funding than their plans allow, have specific legacy goals, or find themselves in a variety of other situations with long-term considerations, permanent insurance policies can offer an attractive way to combine accumulation with tax advantages unique to permanent insurance. It’s not for everyone, but only you can determine if it’s right for you.

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