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Understanding life insurance: What policy type is best for you?

by Jason Van Steewyk | Contributor
May 18, 2020

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If you have someone depending on you, you need life insurance. But what type of life insurance is best for you? Here is a primer on the different types of life insurance available today, and whom they may be best suited for.

Broadly speaking, there are two types of life insurance: Term and permanent. Permanent insurance allows the policy owner access to the reserve the insurance company maintains to pay the expected death benefit with – usually called the policy’s “cash value.” Term insurance is only in force for a certain length of time and has a different application than permanent insurance. The policy expires at the end of the term, and there is no residual life insurance benefit.

Term insurance

Term insurance is designed to be very affordable for young people. However, premiums increase as you get older. There’s no cash value that accumulates within term policies – at least none that the policy owner has access to. However, that disadvantage is more than offset for most people by the sheer affordability of the policy.

Because you can buy a very large death benefit for a very low monthly premium, term is often the preferred solution for younger people buying their first policy to protect their families. If the insured is in good health, a monthly premium between $20 and $100 is often enough to replace 10 to 20 years of full-time income in the event the insured dies.

You can buy a policy with an annually increasing premium, a five-year level premium, a 10-year level term and even a 20-year level premium.

At the end of the term, your premium will increase.

Most experts recommend buying a policy that’s non-cancelable and guaranteed renewable. That means that the insurance carrier cannot cancel your policy, and you can renew your policy at the end of your initial term, regardless of your medical status. The insurance company can only charge you the premium they charge other people your age at the rating you were when you bought the policy.

The disadvantage to term insurance is that eventually the premium increases – and if you live long enough, the policy will become less and less affordable. Many states prohibit term policies from continuing past age 70 for that reason. There is no cash value with term policies. If the policy expires, the premium is lost (though some carriers offer a return of premium rider with term insurance).

Only a small percentage of term insurance policies ever pay a claim – which is the main reason why they are so affordable for young people.

Permanent insurance

Permanent cash value insurance comes in many different varieties. However, all of them allow access to the policy cash value. They are also all designed to be sustainable over your entire lifetime. Term insurance is designed to expire before life expectancy. Permanent life insurance is designed to exceed it. As a result, permanent insurance has a higher premium in the early decades of your policy. But it’s also much less likely to lapse or expire without paying a death benefit.

As long as the cash value remains in the policy, it grows tax-free, similar to a Roth IRA.

Meanwhile, you can access the cash value for any purpose you like, generally tax-free, as long as the policy remains in force. Specifically, you can access cash from your life insurance policy in the form of withdrawals or tax-free loans.

The cash value in permanent insurance policies can be very useful later in life. You can use it as a source of emergency liquidity, as a buffer to your retirement accounts that you can tap in the event of a bear market, or as a way to supplement your retirement income. To maximize income in retirement, you can convert a life insurance policy to an annuity when you no longer need the life insurance death benefit.

If you do take withdrawals or loans from your policy, however, you’ll reduce the cash value and eventual death benefit of your policy. If you take out too much, the policy could lapse, as well, which would result in a taxable event.

Whole life insurance

Whole life is the most stable form of permanent life insurance, with the most guarantees. As long as you pay premiums as agreed:

  • The death benefit is guaranteed for life.
  • Cash value accumulation is guaranteed.
  • Premiums are guaranteed level for life.
  • You can also purchase a policy that is guaranteed fully paid up by age 65, with no more premiums.

Premiums are higher than other types of life insurance, but there is also less risk. Cash value is not subject to market volatility. The guaranteed rate of accumulation is conservative. But it generally compares very favorably to interest rates on money markets and CDs, on an after-tax basis.

Whole life is a great choice for those who can afford the premiums, who have a long-term outlook, who want a permanent death benefit and who want to get more out of their conservative, low-risk/cash portions of their overall portfolio. Cash value in a life insurance policy provides a death benefit; cash in a money market doesn’t.

Universal life

Universal life insurance features a flexible premium. You can pay whatever premiums you like, when you like. Any cash value accumulates based on current interest rates. The insurer debits the cost of insurance from the cash value each month or each year. If interest rates fall, you will need to contribute more premium to keep the policy in force.

However, the cost of insurance can exceed your cash value accumulation rate, which would cause your cash value to decline over time, unless you contribute more premium.

With universal life, you must contribute enough premium to the policy to keep it in force. You have to stay ahead of the cost of insurance. When the insurance costs reduce the premiums to zero, the policy lapses. However, many universal life policies have a no-lapse guarantee. As long as you pay your no-lapse premium, your death benefit will remain intact for the duration of the policy. You will then have to pay income tax on any amount you took out the policy over what you put in over the years.

However, if you have enough money in the cash value, you can skip premiums as needed.

Universal life policies allow you to change your premium and your death benefit without having to get underwritten for a new policy.

Universal life may be a great match for people who want a permanent death benefit, but who have uneven incomes. It can also be a good choice for people who earn enough to aggressively fund the policy to accumulate cash value quickly. Universal life insurance is sensitive to changes in prevailing interest rates, however. If interest rates fall, you may have to contribute additional premium.

Universal life, to include variable universal life, may be a good option for people in higher tax brackets, since accumulation of cash value is tax free, loans are tax-free, and withdrawals up to the owners’ basis in the policy are tax-free.

Variable universal life

Variable universal life is similar to universal life, except there’s no guaranteed accumulation rate for your cash value. Instead, your cash value accumulation is based on the performance of the subaccounts that you select. Your selections may perform well, and you will get an increase in your cash value and your death benefit. However, your subaccounts may lose money, as well.

Variable universal life, or VUL, may be appropriate for those who are comfortable taking on market risk within their life insurance, and who don’t need a specific minimum death benefit.

Expenses within VUL policies are high, relative to mutual funds. So these subaccounts will not grow as efficiently as a comparable index mutual fund.

Equity-indexed universal life

This is a relatively recent innovation in life insurance. Like other forms of universal life, EIUL features a flexible premium. As with variable universal life, you can choose to invest in a variety of subaccounts, in the hope of generating returns that are better than you would get in a money market. With EIUL, however, you get a guarantee that your subaccount will not lose money. In return, however, your upside will be more limited. You won’t get the full market return of the index your subaccount is designed to track.

Single premium life

Single premium life is just that: a life insurance policy paid in full with a single premium.

Depending on your age and health, you may get a death benefit of three to 10 times your single premium payment. The death benefit is guaranteed for life, as long as you don’t make withdrawals from your cash value. However, you can tap your cash value if you need it.

Some single-premium policies are hybrid long-term care policies: They allow tax-free access to the death benefit in the event you need long-term care. These policies have become more popular in recent years, as the insured gets both long-term care insurance and life insurance protection with the same dollars.

Single premium life does not get the same favorable tax treatment of cash value withdrawals as standard whole life and universal life insurance. Instead, they are taxed as modified endowment contracts. However, many single premium life policies have a return of premium feature.

These contracts may be good for those with significant amounts of cash sitting idle in savings or money markets who want to get more value for their dollar.

Dividends

If your carrier is a mutual life insurance company – that is, one owned collectively by its policyholders, as opposed to stockholders – then you may receive a non-guaranteed annual dividend. Many people credit these dividends against their premiums or credit them to their cash values. These can enhance the returns on your cash value. Each dividend credited will increase your cash value and your death benefit.

Dividends can be withdrawn tax-free. The IRS considers them a return of premium among the collective owners, rather than income.

Dividends are not guaranteed, though many carriers have paid dividends every year for decades – some since before the Civil War.

The bottom line

Which life insurance is best? There’s no single one-size fits all answer. In many cases, a combination of policies is best. In other cases, you may wish to design a policy with a relatively small death benefit so you can fund it aggressively and build cash value as quickly as possible.

The right approach will take into account your age, health, budget and long-term financial plans and needs. The best kind of insurance to own is the kind you can afford, and the kind most likely to still be in force when the insured dies.

Alliance America can help

Alliance America is an insurance and financial services company. Our financial planners and retirement income certified professionals can assist you in maximizing your retirement resources and help you to achieve your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling 888-864-2542 today.

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