A topic often argued in the financial service world, especially in the life insurance sector, is whether or not an individual should buy term and invest the difference or buy a cash value life insurance policy. How this argument generally goes is on one side you’ll have someone arguing that an individual should buy a cash value life insurance policy. This individual (generally a commissioned salesperson) will argue that buying a cash value life insurance policy (such as whole life) is a better option for a client since it generates cash value over time and “forces” the client to save. Often they’ll argue that the client wouldn’t save for retirement otherwise.
On the flip side of that argument you’ll have someone (perhaps from our office) suggest the client should buy term life insurance and invest the difference in price from the whole life policy and the term life policy in a qualified savings plan such as a Roth IRA. Before we look at some numbers let’s look at how whole life and Roth IRAs work. We choose to compare these two vehicles as both are considered to have tax-free growth, tax-free withdrawals (assuming the whole life policy is not a MEC) and pass tax-free to heirs at death.
Whole life policies are life insurance policies with a cash savings component. Generally, premiums are level and fixed throughout the policy duration – which is to usually to age 100. In the early years of the policy more of the premium paid funds the cash value account (since the cost of insurance is low) and in the later years less goes to the cash account and more premium is used to fund the cost of insurance.
As long as premiums are paid, the coverage lasts the client’s entire life. Should the client live to age 100, the policy endows and the client will actually receive the entire death benefit, consisting entirely of their own cash value. Should an individual need or want cash from the policy, they are allowed tax-free loans or withdrawals. Death benefits are passed to the beneficiary tax-free.
Roth IRAs allow an individual to save up to $5,500 ($6,500 if age 50 or older) annually. After-tax money goes into the Roth and the money grows tax deferred and qualified distributions are tax-free. The Roth IRA also passes to the beneficiary tax-free.
A key difference between the two products is access to funds. For example, if the client wanted to cancel or surrender the whole life policy in the early policy years, they would incur a surrender charge and forfeit a percentage of the cash value. Surrender periods can last up to 10 years.
Roth IRAs allow access to the principal at any time without penalty. This is because the principal has already been taxed. Earning may be subject to taxes and penalties, depending on the client’s age. Another big difference is one vehicle is life insurance and the other is a tax-qualified retirement plan. They should be kept separate.
Using quote information from a nationally known insurer we gather two quotes; one 30 year term and one whole life. The term quote was for a 35 year old male as was the whole life quote. The 30 year term premium was $80 monthly and the whole life premium was $660 monthly. The face amount for both was $500,000.
The difference between the two policies is $580. Of course, our 35 year old male cannot exceed $5,500 annually ($458.33 monthly) to his Roth IRA so we use the monthly contribution of $458.33. This still leaves over $121 for him to save or invest elsewhere (maybe a 529 for his kids?). So the term is $960 annually and the whole life policy is $7,920! By the way, the salesperson makes about 50% commission on each policy.
From the Roth IRA we assume a 5 percent rate of return over a 30 year time horizon. We also do not assume any indexed contribution increases. In 30 years the client has $381,449 in his Roth. Arguably this would be more considering indexed increases. However, this is quite a bit less than the $500,000 death benefit in the whole life policy should the client pass away.
The 30 year term has now expired. The client is still paying $660 monthly to his whole life policy. However, less premium dollars are funding the cash account and more are funding the cost of insurance. We would argue that at this age, the client could reasonably “self-insure”. That is, use funds from the Roth to fund burial and final expenses; a strategy planned and used by many term insurance holders. In addition, they don’t have the monthly expense of life insurance premiums from a whole life policy.
Let’s assume that the client retires right at 65 and no longer makes any Roth contributions. Withdrawals are now tax-free from the Roth. Let’s also assume that the client decides to not take any withdrawals. If the money in the Roth at age 65 simply sits and continues to earn 5 percent over the next 35 years (until the client is age 100) the Roth grows to $2,104,078 or $1,600,000 more than what he’d receive from the whole life policy. Should the client die right at age 100 his heirs receive the amount tax-free, just like they would in the life policy. And, earnings in the inherited Roth continue to grow tax-free. Life insurance death benefits, while initially tax-free, receive no tax-free benefits on the growth of the original death benefit.
Let’s look at another option. Let’s assume the client has access to a Roth 401(k). Now he can save the entire $580 per month. Using our new monthly contribution to the Roth 401(k) he has saved $482,710 by age 65. If he lets it sit until age 100 (we assume he rolls over to a Roth IRA before age 70 to avoid RMDs) his amount at age 100 is $2,662,635.
This is pretty strong evidence that buying term and investing the difference does make sense for most individuals.