Orlando Harmon
Life insurance is often sold as an investment opportunity, but is it a good idea? Life insurance policies that double as investments are usually permanent policies, like whole life insurance, which lasts your entire life, rather than term life insurance, which is valid for a set number of years. Permanent life insurance policies enable you to invest in conservative investments like mutual funds or exchange-traded funds (ETFs). However, investing in life insurance is generally a bad idea because the returns are poor and there are much better ways to invest your money.
| Characteristics | Values |
|---|---|
| Purpose of life insurance | To replace your income if anything happens to you so your loved ones are provided for financially. |
| Types of life insurance | Term life insurance, Whole life insurance, Universal life insurance, Variable universal life insurance, Indexed universal life insurance |
| Whole life insurance | A type of permanent policy that lasts the entire life of the policyholder. |
| Universal life insurance | A permanent plan that gives you flexibility. You can increase or reduce your premiums, cash value, and death benefit as needed. |
| Variable universal life insurance | With this type of permanent life insurance plan, you can invest your cash value into different kinds of funds and indexes of your choosing. |
| Indexed universal life insurance | Indexed universal life insurance also allows you to invest the cash value component, which can grow based on stock performance. |
| Pros of life insurance investment | The cash value can act as a stream of income during retirement. Your cash value grows tax-deferred. Accessing the cash value in the form of a loan or partial withdrawal can be useful if you need help paying for a large expense, like a mortgage or a college education. |
| Cons of life insurance investment | Some plans can be pricier than others. If you don’t choose the right type of life insurance policy, you may end up getting more coverage than you need and paying more for premiums. |
What You'll Learn
Whole life insurance
- Protection for your family: Whole life insurance offers a death benefit that can provide financial security for your family in case of your death. This benefit is fully guaranteed from the first payment, making it a good way to leverage your money.
- Cash value growth: Whole life insurance offers guaranteed cash value growth that is not subject to market risk. This steady and dependable growth can complement fixed-income investments in your portfolio. You can also customize your policy by setting a premium-paying period to accelerate cash value growth.
- Replacement for your human capital: Whole life insurance ensures the replacement of your "human capital," which includes wages, benefits, Social Security, and other forms of compensation you would typically expect to receive. This makes it a fail-proof way to provide for your family if you're no longer around.
- Retirement and asset safeguarding: Whole life policies guarantee the accumulation of cash value over time. This cash value can be used to pay for major expenses or to supplement your income during retirement. It allows you to avoid selling portions of your portfolio when prices are low, giving your other assets time to recover.
- Reinvesting dividends: When purchasing whole life coverage from a mutual company, you may be eligible to receive dividends. You can use these dividends to purchase additional coverage, providing more death benefit protection, increasing cash value accumulation, and enhancing dividend-earning potential. Alternatively, you can choose to receive the dividends in cash or use them to pay future premiums.
However, there are also some potential drawbacks to consider before investing in whole life insurance:
- High premiums: Whole life insurance tends to be much more expensive than term life insurance. The higher cost may not be justifiable if you are purely interested in life insurance coverage and do not need the additional investment component.
- Slow cash value growth: In the initial years, a significant portion of your premiums will go towards fees, commissions, and administrative costs. It can take a decade or more for your policy to build up enough cash value to borrow against.
- Low rate of return: The average annual rate of return on the cash value for whole life insurance is typically between 1% to 3.5%. You may be able to earn higher returns by investing in other assets such as stocks, bonds, or real estate.
- Lack of control over your portfolio: With whole life insurance, the insurance company declares the dividend or interest rate and manages the investments. This lack of control may be unappealing to seasoned investors who prefer to make their own investment decisions.
- Tax implications: Withdrawing cash from your policy or surrendering it may have tax implications. Any withdrawals that exceed your policy basis may be subject to income tax. Additionally, surrendering your policy or taking out a loan against it may result in tax consequences.
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Universal life insurance
The cash value of a universal life insurance policy grows on a tax-deferred basis, so no taxes are owed on current earnings or interest. The death benefit is also paid income-tax-free to beneficiaries. Policyholders can borrow against the cash value of their policy without tax implications, although interest will be charged on the loan amount, and any unpaid amounts will be taken from the death benefit. It is also possible to make withdrawals from the cash value, but these may be taxed.
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Variable universal life insurance
However, it's important to carefully assess the risks before purchasing a variable universal life insurance policy. The return on the cash component is not guaranteed year after year, and it is possible to lose money. If your cash value balance is too low, you may need to pay higher premiums to keep your policy active. Variable universal life insurance policies can also charge high fees because you're paying for both life insurance and investments.
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Indexed universal life insurance
One of the key features of indexed universal life insurance is that it offers permanent, lifelong coverage when premiums are kept up to date. It also provides flexible premiums, a death benefit that may be adjustable, and the potential for growth of the cash value through an equity index account. Policyholders can also allocate part of the cash value to a fixed-interest option, which offers a minimum interest rate guarantee but may also cap gains.
The accumulated cash value in an indexed universal life insurance policy can be used to lower or potentially cover premiums without reducing the death benefit. Some policies may also allow policyholders to select multiple indexes. The percentage allocated to the fixed and indexed accounts is decided by the policyholder, and the value of the selected index is recorded at the beginning of the month and compared to the value at the end of the month. If the index increases during the month, interest is added to the cash value.
While indexed universal life insurance offers several benefits, there are also some potential drawbacks. These policies are more expensive than term life insurance due to higher premiums and fees. They may not be suitable for individuals who are not high-net-worth, as the fees and premiums can make them less affordable. Additionally, there is a cap on the maximum amount that can be earned, and the policies are based on a possibly volatile equity index. If the index performs poorly, the cash value's growth will be impacted.
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Variable life insurance
- They reduce your policy's cash value.
- They may reduce your death benefit.
- By reducing your policy's cash value, they increase the likelihood that your policy will lapse.
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Frequently asked questions
Whole life insurance, universal life insurance, variable universal life insurance, and indexed universal life insurance are some types of life insurance policies that can be used as an investment.
The cash value can act as a stream of income during retirement and can be withdrawn tax-free up to the policy basis. It also grows tax-deferred, which means you don't need to pay taxes on the funds as they grow in the account.
Some plans can be pricier than others, and if you don't choose the right type of life insurance policy, you may end up getting more coverage than you need and paying more for premiums.
You can take out a loan from your life insurance policy using the cash value as collateral, withdraw funds from your policy, or supplement your retirement income by saving up enough cash value.
