Laura answers a listener's question about life insurance policies.
Laura answers a listener's question about life insurance policies.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's question is from Ivy, who says:
"Hi, Laura! I'm happy I started listening last year and have learned a lot. An insurance agent wants me to buy an indexed universal life insurance policy. She suggested I use it for my child's college expenses instead of a 529 plan, but I feel uneasy. What do you think about who should buy cash value life insurance?"
Thanks for your question, Ivy! Life insurance, when properly used, is an incredibly versatile financial product. However, because there are so many types of policies and add-ons, they're often poorly understood. Plus, life insurance agents get paid a commission, so you must be wary of getting sold a product you may not need.
This post will answer Ivy's question by reviewing ways to use cash-value life insurance to protect your loved ones and provide growth and income when suitable.
Welcome back, everyone, and thanks for joining me. I'm Laura Adams, an author, personal finance influencer, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
If you're not already subscribed to the podcast, that's the best way to ensure you never miss an episode. There are now two weekly shows that come out on Wednesdays and Fridays. If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email using my contact page at LauraDAdams.com.
What are the primary types of life insurance?
There are several types of life insurance, but you can divide them into two main categories: temporary (or term) and permanent.
Term life insures your life for a specified period, such as 10 or 20 years. If you pay the fixed annual premium and die within the term, your beneficiary(ies) receives a guaranteed death benefit.
For instance, you might purchase a 20-year, $500,000 term policy with your spouse as the beneficiary. If you die before the policy expires in 20 years, your spouse will receive the death benefit of a $500,000 lump sum payment.
Term coverage is relatively inexpensive, especially when you're young and healthy. For example, if you're in your 30s, a 20-year, $500,000 term life policy might only cost a few hundred dollars a year.
But if you're in your 50s, the same policy might cost several thousand dollars a year, depending on your health. The older and less healthy you are, the higher life insurance premiums will be.
RELATED: How Much Does Life Insurance Cost?
Permanent life, the other main life insurance category, covers you no matter when you die, which makes it more expensive than term life. It's also more complex and has subcategories that I'll explain.
In addition to paying a death benefit to your beneficiary(ies), a permanent life policy is
also a financial investment. Generally, a portion of each premium you pay goes into an investment account that builds "cash value" on a tax-deferred basis–the complicated part of permanent life. But I'll break it down so it's straightforward to understand!
3 types of cash-value life insurance
The three main types of permanent, cash-value life insurance are whole, universal, and variable. Each gives you a tax-free death benefit no matter when you die and a tax-deferred cash accumulation inside the policy. However, the policies differ in how the cash value is generated.
How do you purchase life insurance?
When you apply for a term or permanent life insurance policy, insurers use many factors to evaluate you and quote a rate. The underwriting process varies by company but tries to estimate how likely you are to die and when. Some companies require a physical exam with a doctor or nurse, but some offer a no-exam rate, which could be higher than getting examined if you're healthy.
The older or less healthy you are, the more expensive coverage will be because you're more likely to die sooner rather than later. That's why it's better to get life insurance as soon as you have a dependent or know you want coverage because younger applicants pay less. And you never know when your health could decline, making you ineligible for life insurance or making a policy unaffordable.
Life insurers depend on mortality statistics, and they know that women tend to live longer than men, which means women typically pay less. Insurers also know that you could have inherited health risks, so they usually ask about your immediate family members' health or causes of death.
Your lifestyle also significantly influences what you'll pay for life insurance. For instance, smoking, drinking, using illegal drugs (or a history of drug use), or being overweight increases your rates.
What you do for work, such as being in high-risk occupations like mining or flying planes, can lead to higher premiums or even getting denied coverage—the same for hobbies like skydiving and mountain climbing.
There are other factors in life insurance rates you may not expect, such as your driving record. You'll pay more if you have a history of DUI or being in at-fault car accidents. Traveling to high-risk countries for pleasure or work can affect your insurability and rate. Plus, many insurers consider your credit history in your overall risk profile.
LEARN MORE: Build Better Credit–The Ultimate Credit Score Repair Guide
Life insurance and taxes
A benefit of permanent life is that your cash value grows tax-deferred, allowing you to skip taxes on investment gains inside the policy. If you withdraw cash, the portion from your premiums is typically tax-free because they get paid after taxes. But when you withdraw any investment earnings from your policy's cash value, it's taxable income.
Another interesting feature of some permanent life policies is borrowing or taking a tax-free loan against your cash value. However, taking a withdrawal or loan reduces the cash value and may also reduce the death benefit amount.
An insurance loan could become taxable if you don't pay the policy premium or surrender a policy for cash with an outstanding loan. Similarly, surrendering a policy for more than the premiums you paid would trigger income taxes on the excess amount.
However, the payout your beneficiary(ies) receive from a term or permanent policy after your death is typically not considered taxable income. So, your heirs don't have to report their life insurance proceeds on their income taxes.
LISTEN ALSO: Term or permanent–which type of life insurance is right for you?
7 reasons to buy cash value life insurance
Ivy asked who should buy a cash value policy. Here are seven reasons why having permanent life insurance could make sense.
Should you use cash-value life insurance for college planning?
Ivy mentioned paying for her child's education and how an indexed universal life policy compares to a 529 college savings plan. The benefits of a 529 plan vary based on your home state, so you need to compare them carefully.
Parents, insurance salespeople may encourage you to move money to certain financial products, like an indexed universal life policy, to shield it from financial aid calculations to qualify for more federal aid or cut taxes. I'm not saying there aren't good situations for doing that. However, it must be part of a comprehensive financial plan.
Therefore, to avoid being sold life insurance that you may not need, get a second opinion about it. Ideally, Ivy should meet with a financial advisor who can give her the pros and cons of investing for college using a cash-value life versus a 529 plan. Remember that a life insurance salesperson isn't a financial planner, even one who is an excellent and well-meaning agent.
The bottom line is that an insurance salesperson doesn't get paid to review your financial situation holistically; they get paid to sell policies. Buying a cash value life policy may be an excellent choice; however, I recommend Ivy hear that from an unbiased certified financial planner or CFP.
How much life insurance do you need?
I also want to mention that getting term life insurance through your employer may not be sufficient. You can buy additional term or permanent insurance on your own. Remember that your life insurance typically ends on the last day of the same month if you leave your job or get terminated.
A general rule of thumb is to buy life insurance with a death benefit at least ten times your annual income. For instance, if you earn $100,000 and have a family, you likely need at least $1 million in life insurance. Also, don't forget that the death of a stay-at-home parent would significantly affect the finances of most households, so they need life insurance, too.
What are the pros and cons of cash-value life insurance?
Ivy, the benefits of permanent life insurance go far beyond just a death benefit, which means it's worth considering. With IUL, you can accumulate tax-deferred cash value and take tax-free loans to pay future college expenses. However, unpaid loans reduce the cash value and death benefit and may have tax consequences, depending on the amount you take.
Cash value life insurance's downsides are that it's much more complex and expensive than term life insurance. Plus, with an IUL, if the underlying index market performance is poor over a long period, your cash value may grow slowly or not at all, depending on the floor rate.
Cash value life insurance is designed for long-term financial planning and may be unsuitable for short-term needs. It can be an excellent tool for diversifying your financial portfolio, giving balance to your overall investment strategy. Due to its flexibility and growth potential, permanent life can help with estate planning, creating retirement income, and paying for a child's college.
Ivy, keep asking questions and get guidance from a CFP about the pros and cons of an IUL before deciding if one is right for you. Since everyone's situation differs, cash-value life insurance benefits depend on your finances, family, and protection needs.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast. It's audio-engineered by Steve Riekeberg. Our Director of Podcasts is Brannan Goetschius, our digital operations specialist is Holly Hutchings, our advertising operations specialist is Morgan Christianson, and our marketing and publicity associate is Davina Tomlin.