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Friday, July 12, 2013

4 things no one tells you about 'Buy term and invest the difference'

Avoid potential estate taxes by excluding life insurance from it
Life insurance death benefits are not taxable
By Jenni Wiltz

If you’ve ever tried to research life insurance online, you’ve probably seen YouTube clips of Suze Orman advising her show’s callers to “buy term and invest the difference.” 

She’s not the only one. Plenty of famous financial pundits second her opinion. "Permanent life insurance is too expensive," they say. "Don’t waste the money on high monthly premiums." Instead, they suggest you buy the cheaper policy and invest the difference.

But there are a few things they’re not telling you, a few things they ignore, and a few things they’re taking for granted when they give you this advice.

Things they’re not telling you

There’s a big tax implication you need to consider when choosing between permanent life insurance and investing more money in your Roth IRA or 401(k). It involves your beneficiaries (life insurance lingo for the person or people who will receive the policy’s death benefit after you pass away). The life insurance death benefit is not taxable, which is a huge bonus for the people you leave behind. If you buy a whole life insurance policy and keep it in force by making the payments, your beneficiaries will receive that payout absolutely tax-free.

Depending on the way you structure your policy, it is also possible to keep it from being included as part of your estate, reducing the amount of estate tax your heirs may have to pay. Investopedia has a brief and clear explanation for how this works.

On the other hand, if you invest the difference in an IRA or other retirement account, any money left in the account that you leave to your heirs will be taxed, and it will also count toward the estate tax. There is no way you can structure your personal retirement account to keep it out of your estate total. Your only option here would be to parcel it out among your heirs year by year, using the IRS’s stated maximum allowable amount for non-taxable gifts.

Things they ignore

There’s also a big implication as far as inflation goes. If you buy a term life policy that covers you for 30 years, chances are your death benefit will be level. In other words, it won’t go up or down—if you buy a $250,000 policy, it will remain set at $250,000 for the entire term. But if we experience the usual 3% to 5% inflation per year, that policy is worth much less 20 or 30 years later. For example, let’s say someone bought a hefty $250,000 30-year term policy in 1965. $250,000 went a lot further in 1965. If that policy paid out 30 years later in 1995, according to the Bureau of Labor Statistics’ Inflation Calculator, the recipient would need a death benefit of $1,209,524 to equal the original policy’s purchasing power.

With permanent life insurance, you have an option to use dividends from your policy’s cash value to purchase more coverage. Without spending a penny more out of your pocket, you can increase the death benefit to provide an inflation-adjusted amount for your heirs. This is called a “dividend-paying whole life policy.”

Things they’re taking for granted

When financial advisors like Suze Orman tell you to invest the money you saved, they’re expecting that you’ll experience a positive return. The scenarios they give you are usually best-case, with unrealistic returns in the neighborhood of 8% or even 12% per year. There are two big problems with that assumption, though.  

The first problem: it’s unlikely that any market these days will experience continual 8% growth year after year (it wasn’t called the “Great Recession” for nothing). The second problem: just because a particular stock index experiences an 8% rate of return doesn’t mean you will.

According to CBS News Moneywatch, the 2012 DALBAR Quantitative Analysis of Investor Behavior compared the rate of return for a specific market (the S&P 500) and then for individual mutual fund investors. From 1991 through 2010, the S&P 500 had a 9.1% rate of return. Nifty, right? Not when you look at what the average investor made. They’re down to an average of 3.8% per year. (Bonds performed even worse, if you’re curious.)

What does this mean? It means investors are human. They aren’t going to buy and sell at the exactly the right times to catch the market’s upswings and miss the downturns. Whether you pay a broker to manage your investments or you do it yourself, you’re statistically unlikely to match a particular index’s rate of growth.

Things you need to decide for yourself

If you’re planning on retiring early or think that you might need access to your retirement funds before the age of 59.5, you have a decision to make. The IRS imposes an additional 10% tax penalty on early withdrawals from retirement plans, as well as traditional IRAs and Roth IRAs.  This is to discourage people from pulling money out of their retirement funds. On the one hand, this makes sense—you might regret it later if you raided your retirement account to make a down payment on a car, for example. On the other hand, it’s your money. If you need it, why should you have to pay extra to have access to it?

Permanent life insurance solves this problem. There are no tax penalties for pulling money out of your cash value or for taking a policy loan. You are entitled to take out as much as you need up to the total amount of your premium payments, completely tax-free. If you decide to retire at age 55, for example, your life insurance carrier won’t penalize you the way the IRS will.

Term life insurance is a fantastic product that provides many families with peace of mind. If you need to make sure your family is protected through a specific financial obligation (such as paying off a mortgage or until the breadwinner retires), it does the job. But if you want a stable, secure way to grow your money over time, permanent life insurance offers some high-quality features and options that are worth looking into.

About the author: Jenni Wiltz is a blogger and social media specialist for Trusted Quote, a life insurance brokerage based in Roseville, California. She covers life insurance, annuities, and estate planning.

* Image licenses:  1. 401(k) 2012; CC BY-SA 2.0.  2. Morgue File; Royalty and attribution free.  2. Woodsy; RGBStock license