Life Insurance as an Investment

The following is a guest post from Clarifinancial.

Is investing in life insurance right for me?

The popular media has a problem using life insurance as an investment because they say “buy term invest the difference.” But to a well-trained financial advisor or life insurance agent, that argument might not go far enough. What are the risks and dangers of using life insurance as an investment?

Tax advantages of life insurance

A quick read about this strategy shows you it hinges on life insurance tax advantages. Those tax advantages really start to play a role in 10 years, 30 years, or longer. But what are those advantages and could they ever be jeopardized?

Cash value in permanent life insurance policies grows tax-deferred. That means you don’t owe taxes on it now, but you probably will later. This is not the same as tax-free. You may hear the phrase “tax-free income,” but you should hear something closer to “potentially income tax free.”

You get money out of the policy by pulling it out. The general purpose of any investment is to eventually pull more money out than you put in. But when you take money out beyond your cost basis, you put yourself in a risky situation – from a tax standpoint.

If the policy ever lapses, the money you have taken beyond what you put in is considered ordinary income in the year the policy disappears. It doesn’t matter how long you have been getting checks. If the policy goes away, all those checks become taxable in the same year. And guess what – you’re probably in a higher tax bracket because of it too.

That would completely wipe out the tax advantages of investing in life insurance. But how could that happen?

Universal life insurance

There are a few variables in a universal life insurance. The interest credited and the internal costs. If you are considering life insurance as an investment tool, you probably understand the method of interest crediting and are comfortable with it.

You should also consider that life insurance companies have control over mortality and administration costs. These internal costs can sometimes have a bigger swing over the cash value in a policy than the interest rate.

You have no control over these internal costs. Only the life insurance company can change this. You are at their mercy.

Whole life insurance

Whole life strategies rely on dividends from a life insurance company. The important thing to keep in mind is that dividends may change each year – go up, go down, or even disappear entirely. It’s all over the fine print in the sales literature and it should be in the insurance agent’s language too.

What doesn’t matter is if the life insurance company has paid a dividend in the past. What matters is if they will pay a dividend in the future. Any smart investor knows past performance is not an indicator of future performance. Yesterday’s hits won’t always be the great hits of tomorrow – much less 10 years, 30 years, or even longer down the road.

This is a long-term investment strategy whose success or failure can change in any given year, depending on the whim of the life insurance company.

Risks and dangers of investing in life insurance

But why would an insurance company ever reduce dividends or increase internal costs in a life insurance policy? Financially strong companies may want to increase profitability on old policies to keep their books solid. Or imagine we go through a period of tough times and changing capital markets. An easy place to get money is from customers who already agreed to pay more.

You may have some control over your life insurance contract, but not complete control. You share the success or failure of your investment with a single life insurance company. This is not the same as business risk. Many life insurance companies are still very solid, even while some life insurance investments may not do well. But it is a unique risk investors who do not rely on life insurance don’t have to worry about.

I’m pretty certain everything is suitable for someone, but like any long-term investment, it makes sense to consider the unique risks and benefits for you. As for me, I’ll stick to boring life insurance for ordinary reasons.

Comments

[jim]

Lot of good points in this one.

[MikeS]

I used to sell life insurance. As the author says you can always pull your basis out tax-free. Above and beyond that you have to loan yourself the money to avoid taxes. If the policy ever lapses, you will owe taxes on the money you loaned yourself. If you want life insurance the day you die, buy some form of permanent policy. If you simply want to cover your earnings while you work, buy term. There are many other ways to invest your money before I would consider a life insurance policy for investment. This is coming from someone who owns a permanent policy.

[Evolution Of Wealth]

The biggest problems I see when using life insurance as a "investment" is the way people structure the funding of the policy. Unfortunately for the general public, there are too many miseducated insurance agents. They don't understand how the policies work and how to fund them correctly. There is a reason why banks and corporations use these policies all the time to for benefits purposes; they work when done properly.

[MasterPo]

The premiums for a whole life or universal policy are staggering compared to term insurance of the same face value. And with interest rates and market returns so low now it won't be easy building cash value.

OTOH, whole life cash value insurance is the prime non-qualified vehicle businesses use as an incentive to execs and senior managers.

But it is expensive.

[mikegardner64]

How about non-term insurance has a lousy rate of return? Buying term and investing the difference in a Roth IRA will get you a tax-free return, something universal and whole life can't promise. The only people who think universal and whole life is a good thing are people who are selling it and make huge commissions off of it.

[Aaron @ Clarifinancial]

Thanks for the comments everybody. It's great to see the discussion.

@Mikegardner64 some people do not qualify for Roth IRA's and agents often compare the lower net returns of life insurance policies to things like bonds. This argument works well in a sales situation for some well-trained agents, however it ignores other risks that aren't so apparent, thus the article.

[JoeTaxpayer]

To Mike's point, even if one can't Roth, and even if the low cap gain rates go away, the (call it) 33% tax is still far less than the lifetime of fees these insurance policies cost.

I've always felt that insurance and investments should be separate, only combined at part of planning for a large estate or an equitable distribution of assets on the death of the holder.

On the other hand, there are those so irresponsible with money, the only way to get them to save is with a vehicle that bills them every month. The fees they pay over the years are the cost of their own character.

[Jclimber]

@Mikegardner64 - Everybody can qualify for a Roth IRA now by contributing to a non-deductible traditional IRA and then immediately converting it to a Roth IRA (conversions have no AGI limits as of 2010).

If you don't have any IRA's now then do as above. If you do then it's more complicated as gains on the converted amounts are considered taxable income. And your entire IRA pot is used in calculating the tax (401k's are excluded). Google "Roth IRA Conversion" for tons of info (or see IRS. Pub 590).

[Kirk Kinder]

The biggest proponents of insurance as an investment are those selling the policies. Sure, there are situations where permanent policies work: Irrevocable Life Insurance Trusts where the people want to leave their assets to charity and still provide for heirs; for key man or partnerships in business; to cover estate taxes; or where people want the permanent insurance (not for investment).

@JoeTaxpayer: the forced savings is a justification used by salesman all the time. The problem is folks who have trouble saving on their own usually have trouble saving for the premiums as well. The lapse rate in permanent policies is huge. I need to find the chart, but almost 70% lapse within five years. These are usually the people who were sold insurance as a forced savings plan.

[MasterPo]

To Mike's point:

The reason for insurance is not for yourself but for whoever the beneficiary is. Except in the cases of using it as a non-qualified benefit to senior level business people, if you need a retirement tax-deferred savings vehicle than an IRA or annuity is better to go for at the start.

IOW, if you need temporary insurance now get term; If you need insurance for all your life get whole life; And if you need retirement savings get an IRA or annuity.

But don't try to mix apples and oranges.

[Mr. A]

Not everyone can convert to a ROTH in 2010. Some states will not allow it and charge exorbitant annual penalties at the state level. Look at Wisconsin for starters.

There are policies out there that you can protect yourself from company changes. They are called overloan protection riders and will keep the policy inforce until death. Yes there is a cost, but there is a cost to everything. If you are concerned about the policy lapsing than pay for the rider.

One can make a case for anything, I think its best to research your opinion and then stay the course. There are far to many personal factors for each client/investor for someone to easily say one class of products is good or bad.

[Evolution Of Wealth]

It's been brought up that permanent life insurance is the prime funding vehicle for executive compensation plans and extra benefits. Why do they use life insurance for this? If it's as bad as everyone saying here, then why would companies, that have access to any and every investment vehicle, choose to use permanent life insurance?

[rxjohnk]

Many of you seem to be confusing the "vehicle" (Whole Life, in my case) and the "investment" (mostly real estate for me). The "vehicle" should ALWAYS be whole life if you are looking at building cash value, but the investment can be whatever you want it to be. The next venture that I am investing in is a new business start up.

I put the money into my whole life policy, but that is not "the investment". While long-term returns in a whole life policy might be equivalent to bonds, that is pretty meager in comparison to other options available... So I choose to invest mainly in real estate. This gives me the benefit of tax-free gains in my life insurance policy, since the policy is not taxed. Despite what "Clarifinancial" states, you can borrow out more than your basis - no loan of any kind is taxable - and owe no taxes unless your policy lapses. If you die with outstanding loans, you and your heirs STILL owe no taxes on the proceeds.

My policy doesn't rely on dividends, because I am the one paying the dividends - Yes, since I borrow the money out, I am also paying the interest that becomes the dividend at the end of the year. In effect, instead of letting the insurance company invest the money to pay dividends, I am doing it myself!

Here's how I do it: I borrow the cash value out of my policy and lend it to my rental company, usually at about an 8% interest rate. Then my rental company pays me back, and I pay my policy back. The rental company can deduct the interest paid to me personally as a business expense, and I show only a very small personal gain, as I can write off the interest paid to the policy against the interest I earned from my rental company.

Whole Life policies are not for everyone, but for anyone who spends significantly less than they make, they can be a viable tool for achieving real wealth.

John K.