Typically, life insurance is an investment in you or your family’s future, but it also can have features that can help you set aside money now that you can access for future needs.
Common investment types like stocks or mutual funds allow you to put funds towards something that may appreciate in value as the investment matures.
While you may think of life insurance premiums only as a way to fund a death benefit, many life insurance policies allow you to put a portion of your premium towards a cash value that can grow. Your insurance policy’s cash value can also be withdrawn from or used as a loan, allowing you to use the funds as you like – even to put them into other investment vehicles.
Life insurance policies such as variable life insurance or equity indexed life insurance allow you to use that cash value directly within traditional investment vehicles like indexed stocks or mutual funds. Let’s take a closer look at how life insurance as an investment can be part of an efficient financial strategy.
Similarities between investments and life insurance
With the cash value from a permanent life insurance plan, you can use your policy to build further stability for your savings and retirement. This happens through some similarities between life insurance policies and investment accounts, such as:
Interest
Savings accounts, retirement accounts, and permanent life insurance policies all accumulate interest.
Dividends
Like some investment options, certain life insurance policies pay dividends over time.
Tax benefits
Like some retirement accounts, you can make tax-free withdrawals from a permanent life insurance policy, provided the withdrawal does not exceed your cash basis in the policy. You can also take out tax-free loans from a permanent life policy.
Even with these similarities in mind, the differences between life insurance policies and conventional investment options are significant enough that you should not mistake one for the other.
Differences between investments and life insurance
The differences between traditional investments and life insurance can put into perspective just how different these two financial options are. Life insurance policies contain several stipulations that make saving through them different from investing:
Limits to use
The money you’ve paid towards a permanent life policy mostly goes towards the policy’s death benefit. While cash value will build over time, you will not be able to access most of the money you’ve paid towards the policy until it matures or the death benefit is paid out.
Withdrawals and loans
When you withdraw money from your life insurance policy, a certain amount will be deducted from your death benefit, which is the main purpose of your policy. In some cases, it is also possible to take a loan on the basis of the accrued cash value of the life insurance policy.
Different types of life insurance policies and whether they can act as investments:
There are several types of permanent life plans that offer investment-like qualities:
Whole life insurance
Whole life insurance plans offer lifelong coverage as long as premiums are paid. While some of the premiums you pay go toward the death benefit, a portion will also go toward building cash value.
Your insurance company invests money in the cash value account, and you’ll have the opportunity to withdraw it during your life in the form of loans, withdrawals, or a policy surrender. The money invested in a whole life insurance policy will earn a fixed rate of interest and, therefore, have guaranteed returns, making it easy to understand how much the policy will be worth over time.
Term life insurance
Term life insurance is a policy that lasts for a specific period of time and pays a death benefit to the beneficiaries in the event that the policyholder dies within that time period. Since they don’t accrue cash value, term life insurance policies are not a good investment strategy. However, at the time of expiration, it is generally possible to convert a term life policy into a whole life policy, which can then have a cash value accumulation.
Variable life insurance
With variable life insurance, the policy’s cash value operates like a brokerage account regulated by the Securities and Exchange Commission. You can then use this cash value to invest in securities, bonds, and mutual funds.
Universal life insurance
Universal life policies offer lifetime coverage till the death of the policyholder, provided premiums are paid on time. These policies have the added benefit of flexible premiums within certain limits, as well as cash value accumulation. Depending on how this cash value is invested by the insurer, the value of your policy can increase or decrease.
Variable-universal life insurance
Some policies offer a mix between the benefits of variable life insurance and universal life insurance. This means you get the opportunity to invest cash value from a variable plan while also retaining some of the flexibility of a universal plan.
Indexed universal life insurance
This kind of policy takes the cash value of your universal life insurance plan and allows your insurance company to invest that money in an index or fund that mirrors a stock market. While you’ll still retain the ability to transfer money between your death benefit and your cash value, you’ll also be able to grow your cash value based upon the growth rate of the market index your insurer has chosen.
Despite these options being available, potential investors should first consider whether there are investment alternatives that can offer more value to their financial plans in the long term.
Investment alternatives to life insurance
There are several investment alternatives to life insurance plans, including:
401(k)s beyond
With many employers offering matching programs for 401(k)s, and with a higher rate of return than permanent life insurance, investing in a 401(k) will prove less costly to your financial plan overall than purchasing and growing a permanent life insurance plan.
IRA
IRAs offer a more stable manner of growing your savings than a permanent life insurance policy does. While withdrawals from IRAs are also tax-deferred like permanent life insurance savings withdrawals, the upfront costs of permanent life insurance plans can make saving money more difficult for most families than contributing to an IRA.
Savings and CD accounts
Although savings and certificate of deposit accounts may grow at a slower rate than the cash value of a permanent life insurance plan, their upkeep costs significantly less and they carry much lower risk than variable life or even indexed life insurance policies.
Anyone seeking to invest money to prepare for their future should consider these options. Keep in mind, also, that none of these options are exclusive. While permanent life has a cash value component, term life insurance (or any life insurance) is part of comprehensive financial plan to provide a healthy mix of coverage.
Factors Influencing the Decision:
With a limited amount of money and several investment options available, it is important to consider some important factors. Depending on the stage of life, taxable income and family status, a person can have specific needs that their investments need to meet. The foremost factors to keep in mind are:
Financial goals
Meeting your financial goals is the foremost reason that anyone invests money. If you’re looking for swift wealth creation, you may find the long time horizon and modest rate of returns that the cash value component of life insurance policies inadequate for your needs. In this case, looking into other investment vehicles like stocks, bonds, or assets (like property) may suit your needs more.
Conversely, if your financial goals are long-term and you want to end up with a large sum of money only at the end of that time period, then a life insurance policy can fulfill your needs. It is also important to note that other investment vehicles do not offer any death benefits. However, most investments will get passed on to the official beneficiary if their holder dies.
Risk appetite
Risk tolerance is another crucial factor since individuals can be more or less open to having the value of their investments fluctuate. Generally, a riskier investment can have potentially higher returns but can also lead to losses. Relatively safer investments tend to offer relatively lower rates of return but with a higher probability that the investment will pay out what it promises.
With the number of investment options available, it is possible to find one that matches your risk appetite. Even within life insurance, there are programs like variable and indexed universal life policies, which offer the safety of a guaranteed death benefit combined with the potentially higher returns (and risk) of stock market investments.
Insurance needs
The main benefit of life insurance is that it essentially guarantees a lump sum payout should the stipulations of the policy be met, which, in this case, is the death of the policyholder. If the financial protection of your dependents is a strong concern for you, life insurance can help mitigate that concern significantly. Other market investments may not offer such guarantees even if they do offer higher rates of return.
Potential future income
If you have a steady income that you know you will have for the next several years, you may consider certain investments that may be too risky for someone who doesn’t have a steady income. Someone investing their life savings should look for options that are less risky, while someone investing a small portion of their monthly income can take on relatively more calculated investment risks that could earn them higher returns.
Finally, consulting a financial advisor before deciding on an investment strategy can help you gauge your financial goals and risk tolerance. The right investment made in a timely manner can lead to significant wealth creation, while a careless investment can result in a significant drop in wealth. Above all, it is crucial that you completely understand the mechanism and potential risks of the investment you make. This is also something that a financial advisor can assist you with.
Risks and Caveats:
As with any other investment, buying a life insurance policy entails some amount of risk, and it is important to understand the limitations of the policy you are buying. In general, the main risks to keep in mind regarding life insurance policies include:
Cancelled policy
In case premiums are not paid in a timely manner, or the policyholder breaks the conditions of the policy in any other way, the life insurance policy in question could be canceled. This could lead to foregoing the premiums that have already been paid. A canceled policy also means that no death benefits will be paid out in case the holder passes away.
High premiums and additional fees
Premiums are paid repeatedly over several years and increase depending on factors like age and health status. High premiums can sometimes become a financial burden, so it is important to consider whether you can regularly pay the premium amount over an extended period when considering an insurance policy.
Market risks
Despite their guarantees, insurance companies are also susceptible to market risks. Though rare, it is possible for an insurance company to shut down, which might result in policyholders not getting the payouts they were promised. This is why it is important to purchase policies from trusted and well-reputed insurance companies.
Complex conditions
Insurance policies are complex instruments that contain several detailed conditions and caveats. It can, therefore, be difficult to understand everything that the policy entails without the help of a financial advisor. Certain conditions, if not met, can also result in policy cancelation, resulting in a significant loss in case the policyholder has been paying premiums for a long time. Fidelity Life has trained life insurance agents that are available to help make sense of the complexities of life insurance. Call us today to help you understand what life insurance policy is best for your needs.
Tax Implications and Benefits
One of the most distinctive and useful features of a life insurance policy is that it can help the holder get significant tax advantages. This can occur in multiple ways. For one, the cash value component that builds in a life insurance policy is tax deferred. This means that the cash value accounts are allowed to grow over time without being taxed every year, helping them compound faster.
Even if the entire cash value life insurance is taxed at a later stage, which is quite likely, it ends up costing the policyholder less than if the cash value life insurance were taxed every year. This is also a significant benefit that life insurance policies have over most other investments, which tend to be taxed more regularly. Similarly, the death benefit paid out to the beneficiaries in case the policyholder dies is not subject to income tax.
Life insurance can also be used as a tool for estate planning since it simplifies the process of a policyholder passing on wealth to their beneficiary. The death benefits of most insurance policies can be directly transferred to the beneficiaries upon the death of the policyholder without having to go through the complications of probate. This means that life insurance policy death benefits are also not affected by any debts that the deceased may have had. [1]
Real-Life Scenarios:
In order to determine how a life insurance policy can fit into your long-term financial planning, it is important to consider practical scenarios. Since there are several investment options available, finding the optimal mix of returns, risk, and time horizon of payouts can help you and your dependents maintain a certain level of lifestyle.
Using a combination of market investments and life insurance policies can actually result in lower risk and higher returns in the long run. Additionally, certain life insurance policies give you the flexibility of utilizing your policy’s accrued cash value account once you retire or letting it accumulate so that it can be passed on to your dependents and beneficiaries at a later time.
Consider a person in their 30s or 40s on a regular income with the following financial goals:
- As a parent, they want access to funds in the future in order to pay for their children’s college.
- They want to build a nest egg that can financially support them in case of emergency during retirement.
- They want to leave behind a certain sum of money to their dependents.
Now, a person such as this can make use of a combination of life insurance and other investment vehicles to achieve their financial goals and provide future stability to their dependents. Using a variable life insurance policy with an affordable premium relative to their monthly income, this person can build wealth through the cash value life insurance component and secure a death benefit. As the cash value of the policy grows over time, they can take a loan out against the policy in order to cover large expenses like college fees for their children. The policy may also give the holder the option to invest some of the wealth in the cash value account in the stock market.
Provided the premiums are paid in time, by the time this individual retires at the age of 65, the accumulated cash value of the policy would be significant. Some of this wealth can be withdrawn in case of an emergency, which is especially useful if the person does not have any retirement income. Finally, depending on the amount of the cash value that’s been utilized, the policy will also provide a death benefit for the policyholder’s beneficiaries.
In another scenario, if a person has sufficient capital to cover major expenses and wants to focus more on leaving behind their wealth to beneficiaries, they can also enroll in a life insurance policy that builds cash value. The cash value is accessible only during the policyholder’s lifetime. If they pass away, the beneficiary or beneficiaries will only receive the death benefit. Since money grows tax-deferred in the cash value account and the death benefits are income-tax-free, this is an efficient way of passing on wealth to dependents and saving money in the process.
Thus, a life insurance policy can help fulfill multiple financial goals as well as streamline estate planning. As stated above, the best strategy is generally using a mix of insurance policies and other investments, which can include riskier stock market trades or fixed-income assets like bonds. It is worth remembering, however, that since circumstances vary based on several factors, getting advice from financial advisors in such matters is highly recommended. [2,3]
Can you use life insurance as an investment for retirement?
Life insurance can provide a financial lifeline that’s an investment in your future to help support your retirement plan. Having peace of mind that a policy will protect loved ones if the unexpected happens can ease the burden of having to set aside additional money for end-of-life expenses or legacy planning. A life insurance policy can provide loved ones with enough money to cover estate taxes, pay for funeral costs, or receive an inheritance. By investing money into a life insurance policy that provides an adequate death benefit, you can rest assured that loved ones will be financially cared for, even if other financial investments aren’t enough to support them.
How to build a lifelong financial plan
Building a sound financial plan to last your life should include a healthy mixture of investments in life insurance coverage, savings, and retirement accounts.
Every life insurance customer has unique needs For some, the savings afforded by a permanent life policy will provide flexibility to their financial strategy to match the consistent security of a term life policy. Regardless of your options you should always consult a financial and tax advisor before making any investment.
Article Sources:
- USA TODAY. “Are life insurance premiums tax-deductible?, https://www.usatoday.com/money/blueprint/life-insurance/are-life-insurance-premiums-tax-deductible/”
- Morgan Stanley. “How Insurance Can Help with Retirement Planning, https://www.morganstanley.com/articles/insurance-and-retirement-planning”
- Ernst & Young. “How life insurers can provide differentiated retirement benefits, https://www.ey.com/en_us/insurance/how-life-insurers-can-provide-differentiated-retirement-benefits”
