The Game Changer for Buy Term and Invest the Difference

should i buy term or buy permanent insurance

Buy term and invest the difference

Should you buy term insurance and invest the difference or buy a permanent insurance policy?

This question is amongst one of the most common in the financial services community.

Depending on whom you talk to, it’s likely that you will find passionate supporters on either side of the argument.  Financial advisors with an investment bias often suggest that you buy term and invest the difference.  Insurance agents often side with buying a permanent policy (not surprisingly, these biases tend to favor how each of these individuals is compensated, but that’s a discussion for another day).

Regardless of where professional allegiances lie, it’s important to evaluate the conversation from a numbers perspective to accurately determine which option may be best.

Historically, the conversion attempting to answer which option may be best has been complicated by the projected tax assumptions input by the illustrator.  Insurance agents, using a combination of high future tax rates and tax-free income withdrawals were able to make permanent insurance policies look very attractive, as compared to the buy term and invest the difference alternative.

Unfortunately, varying user input (as it pertains to tax assumptions) made it nearly impossible to compare these two scenarios equivalently.

Fortunately, this has changed.

With the advent of the ROTH 401(k), we are now able to more fairly compare a permanent insurance policy solution to a buy term and invest the difference option.  Specifically, we can do this by equalizing the tax implications on both the contributions and the withdrawal.  Specifically, we see the following:

  • Contributions – ROTH 401(k) and permanent insurance policy contributions will be funded with after-tax dollars.
  • Distributions – ROTH 401(k) distributions and permanent insurance policy distributions (assuming they are taken correctly) will be tax-free.

(Previously, a ROTH IRA was available that could equally compare the two.  However, limits on annual contributions, eligibility, and phase-outs for earned income made it burdensome and unattractive for those looking to contribute substantial annual contributions.  The ROTH 401(k), assuming both a husband and wife are eligible and under age 50, can allow up to $36,000 of annual contributions).

An Example –

In an effort to illustrate the analysis, I will use myself as an example using the following assumptions:

  • Annual dollars available to allocate – $18,000
  • A 33-year-old male
    • Non-smoker, super preferred underwriting (this is a best-case scenario as it pertains to pricing for a male. This means that any other situation could make the life insurance example less than what is illustrated below)
  • A hypothetical 7% gross rate of return for both the investments and for the variable universal life policy

Illustrating a Permanent Insurance Policy

If the goal is to maximize income distributions in retirement, a specific life insurance design strategy should be considered.  Specifically, the strategy will be to buy as little life insurance as possible.  By keeping the amount of life insurance low, you will also lower the cost of insurance charges.  This strategy may lead to a greater buildup of cash value inside the life insurance policy.

Implementing this strategy, we will purchase a VUL (variable universal life) policy with a $600,000 initial death benefit (rounded).

Insurance companies are then able to illustrate how this policy may perform (please keep in mind, insurance illustrations are projections.  The policy may or may not perform as originally illustrated).

Looking at the illustration for the life insurance policy detailed above, we observe the following cash values

  • In 10 years – $236,420
  • In 20 years – $663,802
  • In 31 years – $1,519,409

Eventually, the goal of this policy will be to generate income in retirement.  If implemented correctly, it’s possible to “pull” tax-free income from this cash value.

Looking at the illustration, we see that the policy will pay out $114,000 per year for 20 years.

To summarize, the total amount of contribution to this policy will have been $558,000.  The cash value will grow to $1,519,409, and it will produce $114,000 for 20 years, tax-free!

Seems like a great idea! Right?

The point of today’s blog is to compare the two options.  Therefore, we can’t say quite yet if this is a great idea or not.  In order to come to that conclusion, we need to compare these figures, as illustrated by a VUL, to a ROTH 401(k).

Buy Term and Invest the Difference In A ROTH 401(k)

In order keep the analysis fair, in the buy term and invest the difference scenario, we should buy a $600,000 life insurance policy (amount equal to the original VUL policy), and we should buy a 20-year term insurance policy.

The cost of a 20-year term insurance policy for a $600,000 death benefit for a 33-year-old male, super preferred, non-smoker is $279/year (offered by the same insurance company as mentioned above).

We then need to deduct the cost of the term insurance policy from the $18,000 of available dollars.  By doing so, we learn that we can contribute $17,721 each year into a ROTH 401(k).

Assuming a hypothetical 7% gross rate of return, we can calculate the following future values.

  • In 10 years – $224,841
  • In 20 years – $726,481
  • In 31 years – $1,808,836

We then need to calculate the tax-free withdrawals in retirement.

If we assume the same $114,000 of tax-free distributions for 20 years, we can calculate a “left-over” value at the end of Year 20 of $2,326,138.

The Big Question – Comparing the Two

In summary, we can compare these two options by asking two simple questions.

Would you rather have $1.5 million that is subject to insurance company strings?

Or would you rather have $1.8 million that is totally liquid and available? And an additional $2.3 million 20 years later.

Continuing the Conversation – A full comparison

To me, the ROTH 401(k) seems like the overall clear winner.

However, with that said, a balanced argument will include a discussion of when the insurance policy may be the better choice.

In our analysis, the permanent insurance policy would be the better choice for your heirs if and when, you, the insured, dies before or early in retirement.

In this scenario, the beneficiaries of the deceased may receive more money via the insurance plan then they do via the ROTH 401(k).

The Details at Death

The beneficiaries of a permanent insurance policy (as we have designed it for this blog post) will receive the death benefit only (not the total of the death benefit plus the cash value).

With the permanent policy, the death benefit grows as the cash value grows.  Using our hypothetical example, in Year 10, the death benefit is $876,610, in Year 20 the death benefit is $1,764,732, in Year 31, the death benefit is $2,905,687, and in Year 51, the death benefit is $450,366.

Permanent Cash Value Death Benefit Total 
Year 10 $236,420 $876,610 $876,610
Year 20 $663,820 $1,764,732 $1,764,732
Year 31 $1,519,409 $2,905,687 $2,905,687
End of year 51 $260,752 $450,366 $450,366

 

Assuming someone buys term and invests the difference, the beneficiaries will receive the value of the investment account AND the death benefit.  In our scenario, in 10 years, the beneficiaries will receive $844,841, in 20 years $1,326,480, in 31 years $1,808,836, and in 51 years $2,326,138.

Buy Term/Invest Cash Value Death Benefit Total 
Year 10 $244,841 $600,000 $844,841
Year 20 $726,480 $600,000 $1,326,480
Year 31 $1,808,836 $0.00 $1,808,836
End of year 51 $2,326,138 $0.00 $2,326,138

 

The longer you live, the more and more likely it becomes that the ROTH 401(k) is a better choice.

What About Whole Life Insurance?

Because a VUL isn’t right for everyone, I took the liberty of completing the same analysis for a whole life policy.  For the whole life policy, we have used a current dividend scale (this means that the numbers are projected, not guaranteed).

In short, the whole life policy doesn’t even come close to the other examples above.

Specifically, for the same $18,000 and the same time frame, the whole life policy will produce $96,000 of income for 20 years.  $96,000 is approximately 15% less income than the $114,000 detailed above.

Whole Life Cash Value Death Benefit Total 
Year 10 $162,695 $1,344,429 $1,344,429
Year 20 $504,310 $1,638,433 $1,638,433
Year 31 $1,186,918 $2,140,733 $2,140,733
End of year 51 $166,929 $621,231 $621,231

 

In my continued effort to be fair, in this case, a whole life policy (while not my favorite, I fully disclose) will produce the highest guaranteed cash value of these 3 hypothetical options.

What Can We Learn From This?

When comparing buying term insurance and investing the difference to buying a permanent insurance policy, the numbers suggest that buying term and investing can mathematically lead to better long-term outcomes.

In addition, buying term and investing the difference may have other added benefits, such as tax deferral (assuming our ROTH 401(k) example) for the beneficiaries and more liquidity/access to the money.

The ROTH 401(k) option also eliminates the concern that tax-free withdrawals from life insurance could lead to a potential large taxable event if you don’t withdrawal correctly or withdrawal too much.

However, for those who are seeking additional options beyond what is allowed due to ROTH 401(k) limits and for those who are seeking alternatives to the traditional investment models, permanent insurance may be a wise choice.  If you find this to be true, then it should be designed appropriately to maximize cash value.

However, the analysis suggests the argument for a permanent life insurance policy as a first financial planning decision may be misguided.  Furthermore, those choosing to buy term and invest the difference into a ROTH 401(k) may win in the long term.

The above figures and examples are hypothetical and are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

Tax services are not offered through, nor supervised by Lincoln Investment or Capital Analysts.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

 

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14 Responses to The Game Changer for Buy Term and Invest the Difference

  1. David March 29, 2016 at 11:22 am #

    Seems like something is off about this analysis. On the permanent insurance side, you are buying insurance for a person’s whole life. On the BTID, you’re only paying for 20 years of term coverage, making the analysis a bit lopsided (since you drop the insurance charges for one analysis, but not the other).

    You’re also comparing two different risk/reward profiles.

    You could just as easily illustrate a hedging strategy where the returns are 20% annually and have it beat the BTID strategy.

    …but I’m not sure what any of this would prove.

    • Daniel Zajac, CFP®, AIF®, CLU® March 29, 2016 at 11:50 am #

      Thanks David – The dropping of insurance coverage and the subsequent drop of the cost of insurance is a difference between BTID and and purchasing permanent insurance. I’m not sure this difference makes the conversation lopsided or if its just part of the discussion.

      Yes, the decision to buy term and invest the difference may be a different risk profile than the decision accumulate cash value in a whole life insurance policy. What is suitable and appropriate for one may not be suitable and appropriate for another. I believe this is reflected in the hypothetical examples and projections included in the post.

      Further discussion could include comparing a whole life policy with no dividends to a investment portfolio at a lower rate of return.

      • David March 31, 2016 at 8:33 pm #

        No, it definitely makes it lopsided. In one scenario, you’re comparing paying insurance charges to age 100-120. In the other, you’re only paying insurance charges for 20 yrs.

        The thing is, WL bundles not just the insurance charges but also the money management fees for the GIA.

        So, you need both the investment fees and insurance charges on the other side for a legit comparison…all the way out to mortality age.

        Re-run it with a term to age 100 and see what you get.

        I don’t think any whole life will yield 7%. It plays in the bond fund arena, not equities.

        • Daniel Zajac, CFP®, AIF®, CLU® March 31, 2016 at 9:28 pm #

          I think with buy term invest the difference, a key point is that you do drop the insurance after a certain amount of time. Possibly because you don’t need it anymore and/or because you’ve accumulated assets, and in effect “self-insured”).

          agreed – and that is reflected in a lower income projection and cash value build up

          • David April 1, 2016 at 7:45 am #

            Usually when people do an cost-benefit analysis like this, they equalize costs on both sides.

            Lopsided analysis is fine, but you can’t draw a conclusion from it which says one is better than the other. Because that’s not what this analysis tells you.

  2. Jim March 31, 2016 at 2:11 pm #

    thanks for the article, daniel – great analysis

    the problem i see with permanent life insurance is that it’s sold as being a way to generate “tax-free” income in retirement, but correct me if i’m wrong, but it’s only tax-free to the extent of the premiums paid into the policy (your basis) – does that $114k amount in your illustration include earnings, and if so, won’t you be paying taxes on the “earnings”?

    on the other hand, the total withdrawal from the Roth 401(k) (basis + earnings) both come out as tax free

    what am i missing here?

    seems to me that the one way to make the argument for the permanent policy is if you have way more than $18k to sock away each year

    the OTHER thing i rarely see discussed is investing in a straight up brokerage account, where your earnings aren’t taxed until you sell your investments or receive dividends (which you can do at any time without penalty, yadda-yadda) and then your “earnings” are taxed at the capital gains rate, not as income – the big problem is that a brokerage account isn’t protected from creditors

    these are the things that keep me up at night… 😉

    (your blog rocks, btw! thanks for the great content)

    • Daniel Zajac, CFP®, AIF®, CLU® March 31, 2016 at 7:09 pm #

      Jim – first, thanks for the positive feedback on the blog. Much appreciated.

      Now to your questions. It is possible to take tax free distributions from a life insurance policy in excess of your contributions (basis) via a loan against the cash value. However, if policy loans exceed a certain point and the policy lapses, its possible the policy owner could have a big tax liability on their hands.

      ROTH doesn’t have this concern. You can pull 100% of the money from the ROTH (contributions and earnings) and it will be tax free (assuming they are qualified).

      As for the brokerage account, it’s a great thought. And further analysis should include this conversation. I will suggest the final version will be slightly less desirable than the ROTH. Brokerage accounts, even tax efficient brokerage accounts, may spit off dividends and interest (as you mentioned) that will be taxable in the year of distribution. So while you can control capital gains, you may not be able to control all investment income (unless, of course, you avoid investments that pay dividends).

      Once you exceed the ROTH limits, a fair comparison would likely be a brokerage account (with various tax assumptions) vs. various permanent policies for those with excess dollars to contribute to a plan of some sort.

      • Jim March 31, 2016 at 8:41 pm #

        Okay good, so I wasn’t missing something.

        Good point about the loan, but I would hesitate to consider that an actual distribution, since the insurance company is technically charging you interest to borrow money from yourself… (insert exclamation points as warranted).

        I was thinking about this after I sent the first comment: If your cash distributions are tax-free to the extent of your principal, um, didn’t you pay taxes on that money in the first place…before you put it into the policy? So, while the money may grow tax deferred, I’m stymied as to how permanent insurance is really “tax-free” at any point in the process (disregarding, of course, any death benefit paid to a beneficiary and your loan example, which still isn’t free).

        Don’t get me wrong, permanent life insurance, is a powerful financial planning tool, but I’d wager that 99% of permanent life policies are sold because of the fat commision rather than because it’s the best solution for a mark, er, I mean client.

        • Daniel Zajac, CFP®, AIF®, CLU® March 31, 2016 at 9:32 pm #

          Yes, withdrawals will simply be a return of your own money that as already taxed. Withdrawals of your basis do come out first though (which is different than some other tax deferred vehicles).

        • David April 1, 2016 at 7:29 am #

          This should not be news to Daniel, but life insurance policy loans are usually either a wash or very low-cost.

          And, if a person really wanted an income from it, the income options on most of these things makes lapsing it almost a non-issue.

          I don’t see anything here that suggest permanent insurance is good or bad. It just is.

          People complain about the commissions on permanent insurance, but they’re usually less than a lifetime of money management fees for mutual funds.

          Now if a person really wanted lower risk/volatility and pay lower or no fees, they would concentrate some of their savings in a few very well-managed companies and purchase the stock directly.

          That worked out well for people who did it 30-40 yrs ago and their yield on cost is pretty amazing – better than indexed returns and lower volatility.

          If they wanted to insure their savings, they would use a bank account, timed deposit, or insurance.

          If they wanted to capture the entire market, index funds would be their best bet. If they wanted exposure to the oil industry…

          The point is, these all serve totally different purposes. And none of them is mutually exclusive.

  3. Cameron Millstone December 2, 2016 at 4:39 pm #

    Hi Daniel,

    Just wondering how you could only purchase $250,000 of life insurance in your example without the policy being classified as a MEC?

    Once it is classified as a MEC, you lost the tax-advantaged status (FIFO) and the policy becomes LIFO.

    Thanks,
    Cameron

  4. Jerry February 5, 2017 at 3:14 am #

    Daniel

    I appreciate the effort and understand it’s a tough task to try to simplify a complex case study into a short article but I’m relatively well versed on the “whole life” side of things, I can say many of the benefits of a par WL was not discussed. Also I would have preferred if you used IUL for the first example .. cause that seems to be the most discussed comparison .. and the more popular life product… VUL’s are not commonly sold nowadays partly due to the low interest rates on the fixed account.

    – assuming a 7% return during the withdrawal period is unreallistic as we know porfolios tend to be more conservative because of market risks during retirement. The WL product would not have that issue. As you noted dividend rates maybe lower or higher, but the cash value won’t go down during the distribution period..
    – This examples assumes a 20 year withdrawal period. Most retirees want to make sure they have income for a lifetime so a longer withdrawal period is more realistic. With that being the case , both the VUL and the Roth example would be subject to a more conservative withdrawal rate. Since Market exposure is non-existent with WL .. the withdrawal rate could be much higher than the recommended 4% rule. Based on the 4% rule, the withdrawal income for the Roth would be less thank 50k a year, while the WL depending on the product use you’d be able to withdraw 5% or more. and that’s based on the current low dividend rate while the Roth is assuming 7%.
    – I ran your numbers with what I considered a great Par-WL company at Standard (not a fan of quoting preferred for comparisons) and I had better cash value .. not by a whole lot so I’d say your product or design is probably not as bad as some other advisors make it seem.
    – The client’s risk profile has to be taken into consideration here. Let’s say 2008 happens on year 31.. the WL would look a lot better, while if if 2008 happens on the tail end of retirement, the Roth would fare better.
    – Another advantage of WL is that it won’t count against your SS income tax calculations.

    • Daniel Zajac, CFP®, AIF®, CLU® February 6, 2017 at 11:14 am #

      Hi Jerry – agreed. A complex topic that is difficult to fully address in one article. I do attempt to be fair and balanced with the info. Even crediting WL for the highest guaranteed cash values of the 3 options.

      As for some of the other thoughts.

      1 – I used a 20 year period that is consistent for both illustrations. To your point, we can certainly adjust the distribution periods to be shorter and longer, but the fact that they are equal periods was my attempt to balance the discussion. If we illustrate 30 years, I would suggest the spread will be similar, but the annual distribution will be lower.

      2 – I quoted preferred in an attempt to be fair to insurance. If I quote standard (all else being equal) the CV will likely be lower and thus the distributions will be lower. But to your point, individual insurability matters. And will likely impact the numbers. One could argue as insurability worsens, the more attractive BTITD becomes.

      3 – Risk tolerance is so important. And to your point is likely different at different life stages. Equally important is the sequence of returns. Or as you mentioned, what happens if we have another 2008.

      4 – The question of IUL vs VUL is a big one. I know IUL is popular right now, but I wonder if it will outperform VUL in the long run (this comes down to many factors including fees, caps, participation rates, market rates of return, risk tolerance, etc, etc). This article was not an attempt to compare the two.

      5 – Its likely ROTH income wont count against SS either.

      For me, the illustration is an attempt to be balanced in the conversation. At the end of the day, the actual CV performance of the VUL (IUL), WL, and investment account will all dictate what will actually occur.

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