Term Insurance vs Permanent Insurance
Which is the Better Option
Life insurance planning is a topic that is often very confusing for the average individual. There are various different types of insurance products available, and it is not always clear which solution is the most suitable for an individual to select. In order to make an educated decision, it is imperative to obtain at least a basic understanding of how life insurance products work and what form they are issued in. There are two basic forms of life insurance, term coverage and permanent coverage. While often times financial professionals will advocate convincingly for one or the other, neither is always correct.
Term Insurance is a type of coverage that is issued for a specific term, as the name would imply. Coverage will typically range from 10-30 years in duration. At the end of the policy period, the policy simply expires leaving you without any coverage and no cash value accumulated. The premiums which are paid directly to the insurance company are substantially less than that of a similarly issued permanent insurance coverage.
Permanent Insurance itself comes in multiple forms. They are Variable, Universal and Whole Life policies. Each of these policies are designed to accumulate a cash value component that can be viewed as an investment towards retirement, as well as a source of funds to pay for the policy premiums later in life. The cost to cover the policy premiums are typically significantly more than a term policy with an equal amount of corresponding insurance coverage.
The younger the age of the insured at issuance, the stronger the argument for term coverage will be. The principal behind this argument is that there is no need for life insurance unless you have a financial dependent. Insurance is a contract of indemnity. There is little reason to even issue any life insurance if you are not married, have no children or any other dependents. However, it is imperative that a younger couple with minor children carry adequate insurance to care for their dependents. The cost of insurance is much more impactful on their budget in their early years of accumulating wealth. In the event that they have excess cash flow above the cost of insurance premiums, the case for using life insurance as a savings mechanism is not very strong. More often than not it will pay to redirect any additional cash flow towards increasing 401k or other employer driven retirement savings options. If those features have been maximized, than other tax sheltered savings options such as an IRA or Roth IRA should be explored. If an individual should pass away at a younger than traditional age, their dependents would inherit both the death benefit of the insurance policy as well as the benefits of the additional retirement savings.
As you get further on in years, there may be a number of circumstances when the benefit of term is not as clear. In the case of an individual or couple who may still have dependents, term may not offer a long enough coverage period. Term insurance most often does not extend past 80 years of age. In the event that a pension benefit stops with the death of a spouse, leaving the other spouse without a sufficient income source…permanent coverage should be considered. While ideally it would be preferable to use the extra cash flow to save more money towards such an event, often times this may not have been done and it is essentially too late to rewind the clock. While it is not uncommon for Americans to live into their 90’s today…what if the spouse with the pension benefit passes away at age 81, just after his term insurance coverage expired. If the surviving spouse were to reach age 95, they would be forced to deal with a significant period of time in which they may not have a sufficient income stream. As you age, the amount of necessary coverage to replace such a benefit declines with the shorter life expectancy. In such a case, a permanent policy can also be tailored with a decreasing death benefit as the years go by to keep policy premiums under control.
Small business planning is another area in which permanent insurance policies can be of a benefit. When business partners enter into an agreement to form a partnership, it is fairly common to create was can be known as a Buy/Sell Agreement, or for multiple partners a Cross Purchase Agreement. These are agreements in which two or more partners establish an agreement to buy out the others interest in the business upon death, disability or some other circumstance in which the other party can no longer provide their contribution to the business. In most cases the surviving partners do not wish to inherit their deceased partners heirs to the estate as a new partner. The insurance allows them the funding to buy out the deceased parties interest from their beneficiaries. While term insurance can theoretically suffice for this need, in the case of an older partner who remains active…the limitation on time with a term policy can be problematic. Additionally, the economic value of the business entity may be growing, which requires additional insurance coverage over time. In order to avoid underwriting risks in future years, a universal policy can be structured with an increasing amount of insurance to compensate for this concern.
Tax benefits can often be cited as a reason to utilize permanent insurance. This is certainly true in the case of the minimization of estate taxes through what is known as an Irrevocable Life Insurance Trust. This is an estate planning technique which typically requires insurance to continue in perpetuity. Considering the recent increases in the estate tax thresholds, this technique has become much less common.
Another tax benefit often cited is the ability to shelter money for the purpose of college planning and financial aid by hiding money outside the view of FAFSA applications for Federal student aid. This is not the most economical method to shelter money as the cost of insurance is much more expensive than other forms of tax shelters such as some low expense versions of variable annuities issued without a sales charge by some prominent mutual fund companies.
More recently, a number of hybrid type life insurance products have been developed. One example is a term insurance policy that offers a convertibility feature to a permanent policy at the end of the term. This is extremely attractive to younger individuals. It permits you to issue 30 years of term coverage at only a nominally higher premium over traditional term. However, if you should be diagnosed with a serious or terminal condition just before the end of the term, insurability may be difficult if not impossible when trying to issue a new policy. This convertibility allows the insured to continue the policy without evidence of insurability as a new permanent policy. They would be subject to the higher premiums associated with permanent insurance if they opted to convert, or they could simply let the term expire if there was no need for the additional coverage.
One of the more interesting new coverage options available for those approaching retirement is the hybrid universal insurance coverage coupled with a long term care policy. They can offer the ability to pay for a long term care benefit, that if needed will simply be a draw against what would otherwise have been a death benefit. Most often these policies should be issued for the LTC benefit itself, with the life insurance coverage being a secondary benefit to make sure the policy premiums are not simply wasted…which can be a concern with traditional LTC care policies. While this approach is more expensive than buying a traditional LTC policy, there is at least a guarantee of some form of a return on the insured’s money, whereas traditional LTC can be very expensive coverage that is never utilized and pays nothing back to the policy holder or their beneficiaries.
Ultimately, insurance planning…not unlike all forms of financial planning is specific to the individual circumstance. There are no absolute product solutions which apply to us all. It is important to educate yourself on the topic before committing to a contract, because most insurance professionals are compensated on a commission basis. The more expensive product they sell you, the more money they will make. In some cases the more expensive product may be necessary, but that is not always the case…and typically not the case in the majority of circumstances.
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