Term life insurance is just that -- life insurance, and nothing
more. Your premium payments are applied 100% to the cost of the
insurance. As retirement approaches, your need for life insurance is
likely to decline, as children become able to support themselves (even
if your own little "rebel without a clue" may not yet be willing)
and retirement savings begin to approximate a lump-sum life insurance
payment. At this point, term insurance is easily dropped, without
penalty.
The second class of life insurance encompasses a wide
variety of financial products that are often lumped together under the
label "cash value insurance." Examples are whole life insurance, universal life insurance,
and variable life insurance. These products combine term life insurance with a
long-term, tax-sheltered savings plan.
The most important thing to understand about cash value policies is that they are designed to be held for life.
That is why we put that sentence in bold type. There are usually
significant up-front charges associated with setting up the savings
plan, investing the money, and paying the agent's commission. Even with
these charges, tax-sheltered savings can still catch up to taxed
investments and begin delivering a real advantage. But, it can take 10
to 20 years for the needle to begin moving your way. For this reason, please do not enter into a cash value insurance plan without doing a lot of homework.
In
a nutshell, here's how cash value works. A portion of your regular
premium payment -- roughly the amount of an equivalent term life insurance premium -- pays for your life insurance. The balance, minus management
charges, is applied to your cash value insurance savings account. To build
savings, premiums are higher than term life premiums, by roughly the
amount of your savings contribution.
The cash value insurance savings goal
-- at least as these policies were originally conceived -- is to
provide income to cover life insurance payments in your golden years,
when premiums become prohibitively expensive. When you buy the farm
(not literally, of course), any savings balance remaining is passed on
to your beneficiary either as a portion of the insurance death benefit
or in addition to it, depending on the policy type.
Be aware,
though, that it can be tough to spend your cash value savings if you
want to use them for something other than insurance payments. Pulling
money out of the plan will likely result in income taxes that negate
the fundamental tax-shelter benefit. Many policies allow you to borrow
against your savings at low interest rates, but you are still paying
for the use of your own money and the rules can be complicated,
especially if you have no interest in paying back the loans (returning
money to the plan).
Insurance companies profit handsomely from
folks who unwittingly buy into cash value plans and then drop them
early. Agents make more in commissions when they sell these plans than
they do from term life sales. These are not necessarily indictments of
the industry, as cash value plans provide a valuable consumer service
under certain scenarios. But they are reasons to be a very careful
shopper when it comes to cash value insurance.
One common sales
tactic is to stress that cash value policies are "permanent" and that a
payoff is "guaranteed," as opposed to those "temporary" policies in
which your money simply "disappears." Term life can be as "permanent"
as you choose to make it, via guaranteed renewable policies. And
equivalent amounts of money "disappear," to pay for insurance, whether
the policy is term or cash value. There can be benefits to a cash value
plan, but these are not among them.
A final note: Less scrupulous
agents may push cash value insurance with confusing presentations and
emotional arguments that don't hold up to careful examination. Getting
these folks to separate the two basic pieces -- insurance payments
versus savings plan -- can be like getting a politician to talk about
the real issues. Insist that agents explain these policies on your
terms, with the benefits broken down into these two pieces.