September is Life Insurance Awareness Month (LIAM), and as a big producer I like to joke that I love Life Insurance so much that I would name my second son Liam after the month.
I’m used to hearing all the pros and cons about life insurance. However, I see few real rational discussions about it from unbiased individuals.
If you can invest 10 minutes to read the following article, I am pretty certain we would agree it was a good investment for you.
I HATE Life Insurance!
There is probably no other financial product that creates as much of a visceral reaction as life insurance. The name conjures up images of Ricardo Montalbán selling relaxing vacations on a fantasy island, pushing a product that is not quite what was advertised. It is for old people, or people with kids, and is all about death and nasty thoughts that we want to avoid.
Let’s take a moment though to be adults.
Life insurance is a tool, nothing more or less.
George Lopez may find humor in it. Yet he see its value.
It has been around for thousands of years in various forms.
It is the single most tax advantaged financial planning tool on the planet.
If you come from a well-off family, they have probably been buying life insurance in huge quantities as a planning and leverage tool.
I have mathematical proof that cash value life insurance from a strong mutual company on an after tax, risk adjusted basis is the most efficient wealth accumulation tool on the planet.
Let me say this again more slowly. I did the calculations and had them verified by many professional institutional money managers: cash value life insurance from a strong mutual company on an after tax, risk adjusted basis is the most efficient wealth accumulation tool on the planet.
Before we get into how life insurance works, let’s address something.
You will die. It is a fact, we have yet to discover a situation where it can be verified to be not true. We are truly sorry. Now that we agree upon this fact, we can have a more rational discussion as to how the life insurance tool works and where it makes sense to use it.
Many life insurance agents are like craftsmen with only a single tool—the hammer. Yes, it can be used in many ways, but a hammer cannot on its own be used to build a house. Even Thor doesn’t always use just his hammer, and neither should the hammer of life insurance be the only financial tool you have. If someone has only one financial product in their planning bag of tools, run away like “Cheech” Marín from a flashing red light.
Life insurance in its oldest form worked like this: when you died, the tribe came together to take care of your family. Maybe that was not really life insurance but it’s similar in that death triggered an outcome of your family being taken care of.
Then, when money was created, life insurance was what you paid in, and when you died (while still paying), your family got money—to help take care of them.
If you stopped paying in, they got nada. Pretty simple.
This was essentially what we call term insurance today. Back in the old days (yes, before Snapchat) there was no real “underwriting”, which is how they assess the risk of an individual. Everyone was lumped together in a pile and considered equally with no regard for age or health habits. Not so today.
Today term insurance is pretty easy to understand: you pay money to the insurance company (the premium) and if you die while the term is in force (a term of X years or until a certain age, as long as you pay) then they pay your named beneficiary the amount specified. Simple.
But now they use actuarial science to determine prices. Smoking is the worst thing you can do, because from a medical point of view it is almost guaranteed to screw you up big time by killing you earlier. So you pay more.
Same for health issues like diabetes, cancer or being overweight: all of these drive the price up. The insurance company can say “nope, you’re too great of a risk. We can’t give you insurance.”
But once they give it to you they can’t yank it away, unless:
- they stop selling it in your state
- give up that entire line of business
- you get past the term that they guarantee, or
- you don’t pay your premium.
Term insurance is by far the most cost effective way to buy a lot of life insurance for a limited amount of money for a limited amount of time.
And in many ways term insurance is a commodity, because if you are dead (which is when they pay), there is no dispute of that said fact. There are some variations with the period guaranteed and the rates, as well as some of the side benefits like convertibility to permanent coverage and disability waiver of premium (where they pay your premiums and keep policy in force if you become disabled). Term insurance is so cheap at this point there really is no reason to not have enough coverage, but unless you have a ton of debt and/or spouse/kids, you probably don’t need any supplemental term coverage (beyond what your employer gives you for free) because you have limited financial obligations if you are dead.
Permanent or whole life insurance is guaranteed to be around for your whole life, hence the name. Unlike term insurance that runs out at some point, permanent insurance is there as long as you are.
Permanent insurance costs a lot more than term for the same amount of death benefit coverage. Like 5-15 times. But typically the prices are level (term generally increases in cost over time, because more 45 year old die than 25 year old) and there is what is called the “interpolated terminal reserve” or “cash value”, which is an asset designed to level the cost of the policy and allow you to stop paying premiums eventually.
This cash value is currently tax free growth under Section 7702 of the Internal Revenue Code through special named exclusions in subsections 101 (a) and (j). This is legalese/accountant speak to say that the government endorses life insurance by giving it special tax treatment. After tax dollars going in, no taxes on the growth, and as long as you follow the rules you can get the majority of the cash out tax free too. It’s similar to a ROTH IRA in many ways.
Top 5 Reasons to NOT Buy Permanent Insurance
Disclaimer: I own permanent insurance. And I have sold it. Lots of it. But only if it made sense for the client as part of their overall strategy. And I always received more questions on this basic strategy and tool than all the more complex parts of a plan combined. So, to help clarify when this component actually makes sense, let’s look at the situations when it does not fit into a client’s portfolio. None of these are in and of themselves knockout criteria, but if there are more than one then, permanent insurance really probably is not an appropriate thing for you to own.
- Don’t owe anyone/don’t care. If there are no debts to cover, and no one financially dependent upon you, then there is no insurable need. Pretty simple. Remember that people do fall in love and have kids, and that charitable support of an organization does create a dependency situation, so the leveraging potential of the death benefit to continue this support does make sense. But if you are not worried about taking care of or helping anyone else, now or ever, then insurance is generally not an appropriate use of money.
- Not young and healthy. The tax leverage of life insurance is generated by the internal tax free build up and income tax free death benefit, both of which are paid for via the internal insurance charges.
These charges are mainly driven by age and health. So, if you are of advanced age or poor health, the costs of these components may overwhelm any tax advantages and disqualify permanent life insurance as a tool. If the plan however is to ultimately use the death benefit, then, even at advanced ages, this can make sense as a leveraging tool. Obviously, this generally does not apply to a Young American by definition.
- No tax need. Many high income individuals and corporations use the cash value as an accumulation tool since the internal cash grows tax free until touched and then may be accessed tax free.
Individuals in low tax brackets that can reasonably expect to not have income tax issues may not need the tax free build-up of the policy as they have multiple other alternatives that may make more sense such as Roth IRA’s.
- Not enough time. Permanent insurance is sometimes called “whole life insurance” because it is designed to cover that time: the whole entire lifetime. In reality, anything over 20 years really qualifies as an acceptable amount of time to allow the policy’s acquisition charges to be amortized and the tax free build up to work. Calculations of the “buy term and invest the difference” model, assuming bond proxy rates or of 4%-7%, generally show the superiority of the cash value insurance approach over extended periods. But, if you are covering a need of five or ten years (e.g. a business loan, college for a high school student, etc) then term insurance is the appropriate insurance coverage as it is designed for short term needs. Aligning coverage to time horizons like this is critical. If you are in your 20’s time is on your side, if you are in your 60’s probably not so.
- Not enough money. This is the main reason to gravitate towards term insurance over permanent coverage. If the calculations show that the individual needs $2.5 million of death benefit to do what they want if they are no longer around, I would have them buy that amount of coverage. Doing it as permanent insurance could be prohibitively expensive. Instead of taking the route of the less ethical insurance agents and settling for a quarter million of higher commission permanent coverage, a true professional like myself would make sure the client gets the full amount of death benefit to protect their wishes even if it is not the optimal solution or yields the agent significantly less money. It is the right thing to do.But if you are a Young American and your debts are only car, school loans, and some consumer debt, this shouldn’t apply to you.
This is not an all-inclusive list of reasons to not use permanent insurance when it makes sense, but these five points cover the vast majority of the logical arguments against its use.
Palma Financial Services, Inc. can prove from a mathematical basis that on an after tax, risk adjusted basis, cash value life insurance is the most effective wealth accumulation tool available, but the advanced mathematics is useless if you have a fundamental disagreement over whether or not Life Insurance makes sense. Emotional arguments for and against the use of it abound, but in the final analysis cash value life insurance is a great tool that will buy you flexibility for the future.
Contact us today for a risk-free consultation to leverage our tax planning expertise which has benefited many entrepreneurs and families for over 20 years.