Whole or Term Life Insurance: Which Is Better?

The right choice between whole and term life insurance depends in large part on the circumstances of the person making the decision. Term life policies are ideal for people who want a lot of coverage but do not want to pay a lot for premiums each month. Whole life customers pay more in premiums for less coverage, but they have the security of knowing they are covered for life at a set premium, assuming they keep up with their monthly payments. Some customers prefer whole life insurance because these policies accumulate cash value and can be used as investment vehicles. As many financial advisers point out, however, the growth rate of a cash value life insurance policy is often paltry compared to other financial instruments, such as mutual funds and exchange-traded funds (ETFs).
Term Life Insurance

Term life insurance, as its name indicates, provides a policyholder with coverage for a fixed term, or period of time. Common terms for these policies are 10 and 20 years. Because the majority of term life policies never pay a death benefit, insurance companies can offer them much more cheaply than whole life policies, every one of which eventually pays, and still make money.

The younger a person is when he takes out a term life policy, the cheaper his premiums. The reason is an obvious one. A person is statistically less likely to die between the ages of 25 and 35 than between the ages of 50 and 60.

A popular time to take out a term life insurance policy, particularly one with a 20-year term, is upon having children. The cost of child-rearing is steep for food, toys, clothing, and doctor and dentist appointments, not to mention saving for college, an expense that, when charted over time, bears the trajectory of a space shuttle launch.

When a child loses a parent, especially one who is the household’s sole or primary breadwinner, the financial consequences can be grave. For this reason, parents often choose life insurance policies with hefty death benefits, sometimes in excess of $1 million, during the years their children are financial dependents.

Purchasing a whole life policy with a $1 million death benefit costs thousands per month. The average person who can afford that amount probably is not in dire need of life insurance. Moreover, most people find a death benefit that high unnecessary when their children are grown and able to support themselves. At that point, the purpose of life insurance generally shifts to simply covering burial and funeral expenses.

Term life insurance makes the most sense for someone who needs a large death benefit but only temporarily. A term life policyholder pays a small fraction of what a whole life policyholder pays for the same benefit amount. He can take the excess each month and invest it in stocks or bonds, a technique typically much more effective at creating long-term wealth than buying cash value life insurance.
Whole Life Insurance

Whole life insurance gives policyholders the security of knowing they are covered for the rest of their lives and their premiums, as long as they pay them on time each month, are never going to rise. The trade-off, however, is the death benefit these policyholders receive for their premium dollars is far less than what their peers with term life insurance receive.

While many people strongly favor term life insurance and its lower premiums and higher death benefits, others cannot stomach the idea of paying a life insurance premium every month for 10 or 20 years and then, assuming they are still alive, which is the most likely scenario, having nothing to show for it at the end of the term. Financial planners stress that the small premium for term life insurance purchases security and peace of mind, while leaving plenty of money left over, funds they would need for insurance premiums if they had a whole life policy with the same death benefit, to invest in other instruments, such as mutual funds or ETFs, and accrue wealth.

However, many people are incapable of looking at it that way. They want to know their money is going toward something permanent. For these people, whole life insurance is the better buy, despite their financial advisers likely trying to talk them out of it.

Another type of whole life insurance is final expense. Marketed to people age 65 and up, final expense policies offer a modest death benefit but one that is usually sufficient to pay funeral and burial costs. The typical final expense customer is not wealthy; many live on fixed incomes, such as Social Security. They purchase final expense insurance to keep their next of kin from having to pay out of pocket for their funeral and burial costs.
Whole Life Insurance as an Investment

One advantage of whole life insurance, at least in the eyes of some, is it can be used as an investment vehicle in addition to providing the security of life insurance. Most whole life policies build cash value; as the policyholder pays his premiums month after month, the value of the policy grows, similar to an investment portfolio. If the policyholder reaches a point in life at which he no longer needs life insurance protection, he can redeem his policy and claim its cash value. However, financial advisors often recommend against purchasing whole life insurance as an investment vehicle. Instead, for their clients seeking life insurance protection and wealth creation, they recommend buying term life insurance and using the monthly savings to invest in mutual funds.
Convertible Term Life

Convertible term life insurance offers the best of both worlds. This is a term life policy at the end of which the policyholder has the option to convert it to a whole life policy and receive guaranteed approval. If he elects this option, his premiums increase significantly, since whole life insurance is much more expensive than term life insurance. The advantage is he does not have to undergo a medical exam like new customers. Any long-term medical conditions he develops during the term life period cannot be used to adjust his premiums upward.

 

Understanding Taxes on Life Insurance Premiums

Tax implications are important to consider when buying life insurance. The Internal Revenue Service (IRS) imposes different tax rules on different plans, and sometimes the distinctions are arbitrary. The following guide is meant to elucidate some of the tax implications surrounding life insurance premiums.

A person shopping for life insurance has many things to consider before making a decision. First, there is the distinction between term life insurance and whole life insurance. Term life provides coverage for a set number of years, while a whole life policy is effective for life. A policyholder also must calculate how much coverage he needs. This depends largely on why he is buying life insurance.

A person who is only concerned with covering burial and funeral costs for his next of kin may opt for a death benefit of $20,000 or less. By contrast, someone with several dependent children, all of whom he hopes to send to college, often desires $500,000 or more in coverage. Further complicating the buying process is the sheer number of life insurance companies from which to choose. The Internet has made this process somewhat easier, with several sites dedicated exclusively to comparing quotes from dozens of life insurance companies side by side.

Paying Taxes on Life Insurance Premiums

Unlike buying a car or a television set, buying life insurance does not require the payment of sales tax. This means the premium amount a policyholder is quoted when he obtains coverage is the amount he pays, with no percentage amount added to cover taxes. With that said, certain situations exist in which a policyholder is required to pay taxes on insurance premiums.

Employer-Paid Life Insurance

When a person’s employer provides life insurance as part of an overall compensation plan, the IRS considers it income, which means the employee is subject to taxes. However, these taxes only apply when the employer pays for more than $50,000 in life insurance coverage. Even in those cases, the premium cost for the first $50,000 in coverage is exempt from taxation.

For example, a person whose employer provides him, for the duration of employment, with $50,000 in life insurance coverage in addition to his salary, health benefits and retirement savings plan, does not have to pay taxes on his life insurance benefit because it does not exceed the threshold set by the IRS.

A person whose employer provides him with $100,000 in life insurance coverage, by contrast, has to pay taxes on part of it. The premium dollars that pay for the $50,000 in coverage he receives in excess of the IRS threshold count as taxable income. Therefore, if the monthly premium amount is $100, the amount that is taxable is the amount that pays for the additional $50,000 in coverage, or $50.

Prepaid Life Insurance

Some life insurance plans allow the policyholder to pay a lump sum premium up front. That money gets applied to the plan’s premiums throughout the plan’s duration. The lump sum payment also grows in value because of interest. The growth of that money is considered interest income by the IRS, which means it can be subject to taxation when it is applied for a premium payment or when the policyholder withdraws some or all of the money he has earned.

Cash Value Plans

Many whole life insurance plans, in addition to providing the insured with fixed death benefits, also accumulate cash value as policyholders pay into the plans with their premium dollars. A portion of the premium dollars enter a fund that accumulates interest. It is common, particularly with plans that have been in force for many years, for the cash value to exceed the amount the policyholder has paid in premiums. Therefore, people use this type of life insurance as an investment vehicle along with taking advantage of the protection it provides their families in the event of an untimely death.

While many financial advisers remain steadfast against using life insurance for investment purposes, claiming the returns, historically, have been extremely weak compared to mutual funds and other investments, the fact remains the cash value of most whole life insurance policies grows over time. Because this is considered income to the policy holder, it has income tax implications.

The good news for a whole life policyholder is he does not have to pay income taxes each year on the growth in his plan’s cash value. Similar to retirement accounts, such as 401(k) plans and IRAs, the accumulation of cash value on a whole life insurance policy is tax-deferred. Even though this money qualifies as income, the IRS does not require the policyholder to pay taxes on it until he cashes out the policy.

If and when a policyholder elects to take the cash value of his whole life insurance policy, the amount he is required to pay taxes on is the difference between the cash value he receives and the total he paid in premiums during the time the policy was in force. For example, if he pays $100 per month for 20 years, or $24,000, and then cashes out the policy and receives $30,000, the amount subject to taxes is $6,000.

Another feature of whole life insurance is that, in many cases, the policyholder is allowed to take out a loan against the cash value of his policy. There is a misconception that the proceeds from this kind of loan are taxable. That is not the case, even when the loan amount exceeds the total premiums paid into the policy. Taking out a loan simply reduces the cash value of the policy and, if applicable, reduces the death benefit paid.