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Buy Term and Invest the Difference?

3503494291_651161974f_nA 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.

5 Comments

  1. Wayne McCullough says:

    I happened across this posting today, 3 years after it was apparently posted, but probably still relevant, so I would like to comment. Having been in the insurance side of the business for over 40 years, which includes about 20 years experience with mutual funds and variable products, I dislike comparisons between products which are not apples to apples. I believe there are reasons to have permanent life insurance, term life insurance, and Roth IRAs as well as other investments. You leave out some things in your comparison, which I would just like to point out. And this all assumes that the client has to choose between the 2 concepts shown, which he does not. I generally recommend a combination of Term and Perm, with emphasis usually on the Term to keep until “the kids get grown” etc. First, you don’t mention what risk class you used on the life insurance, so it’s hard for me to compare exactly, but the first whole life quote I pulled up for a preferred nontobacco user was $115 less a month than the $660 you used. There is another risk class cheaper for even healthier clients, but I didn’t check that for comparison purposes. If your example was assuming a “standard” risk, or perhaps a preferred smoker, perhaps it was accurate. Secondly, I’m not sure where you get your 5% return on the Roth. It certainly is a reasonable long term rate that could be attainable, but it is not guaranteed. The whole life policy does have a guaranteed growth on the cash value over the 30 year period used. Thirdly, there are options with the life insurance over time that may be helpful to a client, such as stopping premiums at retirement and taking reduced paidup coverage, etc. I find many clients who like the idea of having some life insurance after retirement, and I fully realize that there is a school of thought who would disagree. But being 67 myself, and having that option, is good for me, so I have to believe others would agree, certainly not all. So, back to the points I made, the WL policy that I compared would have a premium of about $423 monthly guaranteed for life, and to compare with your total outlay of $538 appx ($80 to Term, and difference to Roth) I had to put that extra $115 somewhere, so I bought additional paidup insurance inside the whole life policy, just for comparison. I may or may not actually advise a client to do that, I might do a 529 outside or some other plan as well, but just to try to compare products head to head, I put it into the paidup additions option of the whole life. The numbers that I come up with have to be compared to your comparison fairly. Your 5% return on the Roth is not guaranteed at all, correct? We can argue if it is likely, fair or whatever, but it is not guaranteed in a contract, right? So, the comparison is inherently unfair to begin with, but look at the numbers. Guaranteed cash value is about $220,000, vs -0- in the Roth…. right? With some dividends which are not guaranteed in the life policy, which would be a more fair comparison to the 5% Roth, the cash value would be $248,000 or so. Obviously not as good as your 5% Roth, but again, one product/mix has a guarantee of $220,000 vs -0-. Can’t you see how some people, with lower risk tolerances, might prefer to go that way? Also, the guaranteed death benefit after 65 in the whole life is $640,000, and projected with dividends at $703,000. If the client died at 66 or later, how would that compare to the death benefit of your Roth/Term combo (valued at less than $400k). Every situation is different, and as I said, I don’t like to compare a whole life product to a Term/Invest mix because products are designed to do different things. I sell permanent life insurance to keep as a death benefit, not for the investment. But, with the guarantees involved vs the non-guar in your comparison, some might feel the WL didn’t do too bad on the investment side. Death benefits, Term is great for temporary needs, but not always right for every situation. Perhaps there is room for all products, when sold appropriately. So, I felt that I would put my 2 cents in for the sake of argument, and fairness.

    1. sraskie says:

      Hi Wayne,

      Thanks very much for the reply and for the objective look at the article. I will agree that the Roth does not have guarantees. I also agree that there are some instances where whole life may make sense.

      Again, thanks for the reply and I appreciate the comments!

  2. Kymberly says:

    awesome! What is your email? Thanks!

  3. Kymberly says:

    Love this posting! Huntley Wealth just developed a“Buy term (and invest the rest) vs. whole life” calculator”. It calculates term and whole life premiums to show the difference over 10, 20 and 30 years from an investment standpoint. The ultimate message is “buy term and invest the rest” is the better deal 95% of the time. I would love to hear what your thoughts are about this. Would you mind if I sent you a link to the calculator?

    Thanks!

    1. sraskie says:

      Sure! Feel free to email me. Thanks!

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