Life Insurance – Understanding Term and Permanent Insurance

Is term insurance or permanent insurance better?

Is term insurance or permanent insurance better?

Life insurance is an important part of any financial plan.  When I purchased life insurance for myself, it felt like a very adult thing to do.  With my family growing (baby Z due in less than four weeks), I can say it is one of the smartest financial decisions I made.

When buying life insurance, there are two schools of thought.  Buy term insurance, or buy permanent insurance.

I certainly have my bias (buy term and invest the difference), but it’s a complicated subject that I am going to tackle in this blog post.

Let’s first review the two types of insurance (exciting stuff, I know; get that popcorn ready for this action packed discourse):

Term Insurance

Term insurance is simple.  You buy insurance coverage for a specified period of time (aka, the term). If you die during this period, the insurance company will pay the stated death benefit to your beneficiary.  If you don’t die, no death benefit gets paid (what a letdown, you lived).

During this period, your premium payment will not change (under most circumstances).

I compare term life insurance to car insurance or homeowner’s insurance.  If you don’t get into an accident or your house doesn’t burn down, do you get anything back? Are you mad about it?  I don’t think so.

Here are the important key phrases you should know about term insurance:

  • The Term – This is for how long you have insurance coverage.  The most common terms are 10 years, 20 years, or 30 years.
  • The Premium – This is how much you are paying.  Most companies will allow you to pay this amount annually, semi-annually, quarterly, or monthly.
  • The Death Benefit – This is the amount of money your beneficiaries will receive if you die.

Why Buy Term Insurance

You should buy term insurance because it is simple to understand and low cost.  Term insurance has a number of uses.  Most times, I see it used in the following scenarios.

  • You have a spouse and/or family, and need to be sure they have adequate financial resources (enough money) in the event you die.
  • You are a business owner and are seeking to fund a buy/sell agreement.

Permanent Insurance

Simply put, permanent insurance is complex.  If you know anything about me and my personal beliefs, the more complex something is, the more acutely aware you should be.

It’s called permanent because it is expected to last beyond a set number of years, hopefully until you die.

Here are the important key phrases you should know about permanent insurance:

  • The Premium – This is how much you are paying for the policy.  All else being equal, the premium for permanent life insurance policies will be higher than that of term insurance.  The “extra” premium (over what it would cost to buy term insurance) may go to building cash value inside the insurance policy.
  • The Death Benefit – This is the amount of money your beneficiaries will receive if you die.
  • The Type – It is important to know what type of permanent insurance is being pitched.  Each type of insurance has different benefits and drawbacks that need to be considered.  Specifically, you may run into whole life, universal life, indexed universal life, variable life, and variable universal life.
  • The Cash Value – Permanent life insurance policies may build cash value.  You can compare accumulating cash value to filling a bucket of water.  The faster you turn the spigot on, the faster the bucket will fill up with water. Permanent insurance works the same.  The more money you put in, the faster the cash value will accumulate.  The cash value can be accessed via a withdrawal or loan (potentially a tax free loan).  If you are purchasing a permanent life insurance policy, you should expect very little cash value accumulation in the policy for at least 10 years or more.

Why Buy Permanent Insurance?

Permanent insurance should be purchased if you have a permanent need.  You may consider permanent insurance in the following scenarios:

  • You have an estate planning need.  Are you worth 10MM or more?  Now this isn’t the only estate planning need, but it is the most common.
  • You are a business owner who is looking to fund a key man, buy/sell, or executive compensation need.
  • You are looking at permanent insurance as an investment alternative.
    • DISCLAIMER: Generally, I am not a big believer in this strategy.   However, if you have maxed out other tax deferred options, have adequate additional savings, and still have extra income, there may be a way to design a policy that can act as an investment.

How Do I Know What to Buy?

Consider who will be financially impacted if and when you die.

Who is dependent on you?  Will this person be dependent of you forever?  Or is their dependence only temporary? Answering these questions will help pinpoint which insurance is better suited for your needs.

For my family, it made sense to buy term insurance.  A subsequent blog post will address the steps I underwent in making my insurance buying decision.

 

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

 

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4 Responses to Life Insurance – Understanding Term and Permanent Insurance

  1. Mark Zajac October 17, 2014 at 4:11 pm #

    Good discussion. What would happen in the event that you, and your beneficiary, die in a single event (i.e. car accident)? Would anyone receive the death benefit?

    • Daniel Zajac, CFP®, AIF®, CLU® October 18, 2014 at 7:56 am #

      Mark – Insurance policies will allow you to name a contingent beneficiary in addition to the primary beneficiary. If the primary beneficiary is deceased (prior to or simultaneously with the insured), the contingent beneficiary will inherit the death benefit of the insurance policy.
      If no contingent beneficiary is named, the insurance proceeds will flow into your estate and your will dictates who gets the money.
      If you don’t have a will, state laws will determine how your assets are to be distributed.

      So what does this all mean? Make sure your primary and contingent beneficiaries are up to date. This makes things very easy upon your death (at least financially), as assets with beneficiaries escape probate. And make sure you have a will so you don’t have to rely on the state rules for distribution of a deceased persons assets (which likely are’t exactly what you want to have happen).

  2. Bob Raymond November 7, 2014 at 12:41 pm #

    Dan:

    Good, succinct write-up. I would add that TERM coverage would be considered an expense on the balance sheet; primarily used for an inexpensive solution to a specific need.

    PERMANENT coverage is actually an asset class on the balance sheet. However, for individuals with heavily leveraged estates, special care must be taken to address potential liquidity issues.

    Also, everyone needs some sort of life coverage. Even if your taxable estate is small, final expenses and probate costs can be substantial. Proper risk management involves accounting for these.

    • Daniel Zajac, CFP®, AIF®, CLU® November 7, 2014 at 2:43 pm #

      Thanks Bob – And I agree.

      Liquidity (whether estate liquidity or business liquidity) is all to often overlooked. In these cases, permanent insurance can be a viable strategy to allow for an efficient transfer of the asset(s).

      I hope to cover these issues more completely in future posts.

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