Sunday, May 3, 2020

Whole Life - Swiss Knife of Life Insurance

The 5 Best Swiss Army Knives
The stock market may be jittery right now, but the whole life cash value continues to chug along. In my 20 years of providing financial advice, The whole life insurance to be one of the most important, yet overlooked financial planning tools on the market.

There are many benefits to owning some whole life. From the guaranteed cash value, to income tax-free loans, to long-term death benefit protection for the family, whole life insurance has many different uses. It is often refer to it as the "Swiss Army Knife" of financial planning. But before we get into the benefits of whole life, let's first review some background on how it works.


Insurance for your 'whole life' - As its name may suggest, whole life insurance is life insurance intended to stay with you your whole life. Whereas term life insurance is only intended to cover a specific amount of years, say 20 or 30 years, then it goes away. Whole life insurance has a fixed level premium that does not increase in cost. It is a higher outlay than term life insurance, but with whole life there is a savings component. Part of your annual whole life premium pays for the cost of insurance, and the balance is invested in a pool of conservative fixed income investments managed by the insurance company. This part invested is referred to as the "cash value."
In-life benefits - The cash value inside the whole life policy has two parts. There is a guaranteed value, which basically is a return of your premium over time. There is also a non-guaranteed value, which is the guaranteed value plus dividends (more about dividends later). The cash value is your money, and you can access it via a loan at any age for any reason. If the loan is not repaid, it is netted against the death benefit when and if you pass. For example, let's say I withdraw $50K from my cash value. The withdrawal is an income-tax free loan. Should I never pay the loan back, the death benefit when I pass is reduced by the unpaid loan. For example, a $250K death benefit is reduced by the unpaid $50K loan plus the loan interest accrued. (The loan interest on withdrawals is variable but usually is similar to the interest rates on other secured loans like home equity loans.)

It's all about the dividends - Assuming you buy a whole life policy, the insurance carrier can credit your policy a dividend at the end of the year. Dividends are nothing more than a return of your premium. For example, if the insurance company does a good job of managing expenses, at the end of the year they may refund some of your premium as a dividend. Dividends get reinvested in the cash value. Dividends are not guaranteed and can fluctuate year-to-year.

As the dividends accrue, they may become large enough to pay for the policy's future premium. When this happens will ultimately depend on the dividends' performance. If the dividends underperform then you may have to pay longer. That is why whole life is not a short-term product. You really have to be patient and find a premium you can stick with for many years. 

For those who fund their whole life policy year after year, there are many benefits, here are five:

1. Forced Savings Account - most people don't do a good enough job of saving. It is hard to consistently save money over time. Things happen. Unlike saving in an IRA, which is completely voluntary, a whole life insurance premium has to get paid. If you choose to not pay the premium, a few things can happen. First the policy will go into a 60-day grace period. If the premium is still not paid after 60 days, the policy can borrow from the cash value to pay the premium. If there is not enough cash value to pay the premium, the policy may default. For this reason, it is essential -- especially in the early years when the cash value is still low -- to fund the policy. That's why I refer to whole life as a "forced savings account." Getting that bill every month forces me to pay the premium, part of which is allocated to the cash value. 

2. Long-term protection - You may need or want life insurance for longer than your term insurance lasts. If for example, you still carry a mortgage in your 60s, you may be grateful to have whole life even when your term insurance expired. If you do self-insure -- say pay-off the mortgage and don't need the insurance protection -- the death benefit can be left to the kids, grandkids or a charity. Keep in mind too, all life insurance death benefits are income tax-free to the beneficiary -- unlike IRAs and 401(k)s -- making it an extremely tax-friendly way to leave money to the next generation.

3. The cash value inside a whole life policy is a part of your asset allocation - Whole life cash value is invested in a large pool of Treasuries, corporate bonds and guaranteed investment contracts. For this reason, I look at whole life as a part of my overall asset allocation. If I want to be 80% equities and 20% fixed income, the cash value in the whole life policy should count toward that 20%. Moreover, the cash value in a whole life policy may perform differently than other bonds I own elsewhere, providing another layer of diversification. 

4. Retirement Income Planning
- Whole life shares two tax advantages with the Roth IRA. In both cases the earnings or dividends are not taxable. As for taking money out, qualified withdrawals from a Roth are income-tax free. Withdrawals from a whole life policy are considered loans and are income tax-free as well. Whole life loans are subject to repayment. If a whole life loan is left unpaid, as explained earlier, it is taken off the death benefit when you pass.

How does this help in retirement planning? The more different accounts you can access in retirement without paying income taxes the better the chance you have of paying less tax on your Social Security income, pensions and IRA/401(K) required minimum distributions. Benefit 

5. It's all about the riders - Whole life insurance policies usually offer two optional riders. One is the "disability waiver of premium." With this rider, if the insured becomes totally disabled -- the definition of total disability varies, but usually it's a severe disability -- the insurance company will allow the whole life policy to continue functioning as normal. This means the premium is waived, dividends continue to accrue, and the death benefit can grow without creating a loan. Usually there is an age limit for this rider, such as premiums are waived till age 65. 

The second rider is the "long-term care rider." This rider allows the insured to borrow against the cash value a certain amount of money each month to pay for home health care or an assisted living facility without creating a loan. A doctor will have to certify you qualify for care. This may mean not being able to bathe or walk on your own.

I like the long-term care rider because it usually doesn't add much to the cost. Although, I'm not sure if I would buy a whole life policy solely for long-term care benefits. A stand-alone long-term care policy may be better, or there may be other options to pay for care depending on your situation. However, if I am committed to buying whole life for the life insurance protection first, then adding on the long-term care rider may make sense. Benefit 

The arguments against whole life - Some say you should buy lower-priced term life insurance and invest the difference in premium of what a whole life policy costs in the stock market for greater growth. This sounds like a reasonable argument on the surface, but there are two concerns:

Many don't save the difference, they spend it - The risk/return of whole life and investing in the stock market is completely different. Whole life behaves like fixed income. The stock market is riskier and, rightfully, should be more rewarding. A fairer comparison is comparing the whole life cash value to a muni-bond return, since that is a fixed income product and provides a tax-free return. It's best to run your own comparison or have a qualified agent help. Insurance is based on your health and age, so the expected returns on whole life will vary.

'Too Expensive' - Some say whole life is "is too expensive." True, whole life costs more than term life insurance. But they are different products. If you buy term insurance you can invest the difference in cost on your own. If you buy whole life, the insurance company invests it for you. Those are two different approaches. But to say whole life "is too expensive" negates all the benefits described above. Some may value whole life's long-term death benefit protection, diversification benefits and the disciplined savings.

Term insurance can provide a lot of death benefit protection for substantially less money than whole life. For young people or those who can't afford whole life, term may be the only option. However, most people who want or need life insurance can and should consider some whole life as part of their overall financial planning for the five reasons listed above. It's not an all-or-nothing decision.
Finding a balance - give whole life a chance. Too many pundits and want-to-be financial writers scoff at whole life, given the higher outlay than term life. But it's naive to make blanket statements. Term life insurance may be the best option for some, and others may value having some whole life as part of their insurance portfolio. No one knows for sure what the future may hold, but whole life creates options for your future self. The more options you have, the better prepared you are for whatever life may throw at you.

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