By Amie Agamata
We’ve all heard the saying “buy term and invest the difference.” There is a long debate in the financial services industry on the value of whole life insurance.
Why are some people either for or against whole life insurance? It’s not a religion. It’s not something you believe in or don’t. It’s an insurance product and its important clients understand all their options despite the advisor’s personal opinion. There are significant differences between term and whole life insurance and, as financial planners, we have a responsibility to share what those are so the client may ultimately decide what is in their best interest.
“Buy term and invest the difference” is an easy concept to grasp. It means buy term insurance and invest the difference of what permanent life insurance would have cost for the same amount of face value (death benefit) in something with a better and potentially higher rate of return. The saying essentially implies that whole life insurance is not a good investment because you can get a higher rate of return investing in something else.
Apples And Oranges
Well, life insurance is not an investment. It is, however, a valuable family asset and a tool that tends to shift over time depending upon what stage of life your clients are in. While whole life insurance has the cash value element, it still is an insurance product. It is unfair to compare whole life insurance to the stock market as that would be like comparing apples to oranges.
As financial planners, we understand diversification is essential in a comprehensive financial plan. Diversification goes beyond asset classes. Some may argue tax diversification is more important. One of the Big Four accounting firms, Ernst and Young, recently released an analysis on how permanent life insurance and deferred income annuities increases income potential in retirement and outperform investment-only approaches.
The study shows integrated retirement planning approaches tend to increase legacy assets and, more importantly, give clients better peace of mind and more confidence in their financial plan. Advisors must have an open mind around planning and investing strategies so we can better serve our clients and communities.
Here are 3 Reasons to Rethink the “Buy Term and Invest the Difference” Strategy:
Whole life insurance provides a tax-advantaged solution. How, where, and why someone saves their money should really depend on their short, mid, and long-term financial goals. For long-term goals such as retirement, individuals have limited options when it comes to saving their income each year.
The most an individual can contribute to their 401(k) or Roth 401(k) plan is $20,500 ($27,000 if over age 50). Or, if the individual’s employer doesn’t currently have a 401(k) plan set up, then that person is further limited to $6,000 ($7,000 if over age 50) in a traditional or Roth IRA.
Unless the person has access to a non-qualified deferred compensation plan there are only a handful of other places to save beyond qualified and Roth accounts: concentrated assets (real estate, company stock, crypto), deferred annuities, non-qualified, and permanent life insurance.
Often individuals opt to accumulate savings in non-qualified accounts because it takes savings to invest in concentrated assets like real estate and many don’t like the surrender charges that come with deferred annuities. While building assets is always a good thing, many don’t consider how taxes impact the long-term growth potential. Individuals are subject to dividend and capital gains income tax in their non-qualified accounts every year.
Whole life insurance offers a tax-advantaged savings solution through the cash value component. Cash value is guaranteed against loss and accumulates over time depending on the insurance company’s general account performance, expenses, and mortality experiences.
Unlike deferred annuities, individuals, depending on the contract provisions and as long as the life insurance policy is not a modified endowment contract (MEC), may be able to access the cash value in a permanent insurance policy without surrender charges and on a tax-free basis by taking a policy loan or surrendering additions. Your client may be able to collateralize the policy for banking purposes.
Cash value may complement bond positions. Interest rates have declined over the past 40 years and, although interest rates have started to rise over the past year, we’re still at historically low levels. The current 10-year treasury yield is 1.78% as of this morning.
Some investors turn to high yield bonds for more income potential; however, high yield bonds are junk bonds that tend to behave like stocks. Advisors must understand the actual risk in clients’ portfolios and ensure it is in alignment with the individual’s risk tolerance. For portfolio stability, whole life insurance may complement bond positions especially in a low interest rate environment because of the cash value performance.
According to research conducted by Dr. Michael Finke and Ross Junge, “growth in the cash value of whole life insurance has historically exceeded other lower-risk bond investments like tax-advantaged municipal bonds or taxable bonds after adjusting for ordinary income taxes.”
Whole life insurance gives individuals more planning opportunities in retirement. While the tax-free death benefit cannot be discounted, individuals with whole life insurance and significant cash value built up are positioned with more planning opportunities than those who only have term insurance.
Whole life insurance owners who may not have a need for the death benefit later in life can consider using the cash value to pay for long-term care insurance premiums on a tax-free basis or convert the policy to an income annuity for guaranteed income to help supplement social security.
Long-term care insurance may be tax deductible for individuals who itemize their deductions, however, only the amount of total medical expenses that exceed 7.5% of the individual’s adjusted gross income may be deducted. While some may be able to deduct part of their long-term care premiums, many may not qualify for the deduction. Policyowners with cash value and a gain in the policy may be able to complete a 1035 exchange to pay the long-term care premium on a tax-free basis.
Whole life policyowners also have the option to use the cash value to purchase a deferred or immediate income annuity. These annuities are designed to provide guaranteed income starting now or at a later date and last the rest of the individual’s life with or without a period certain depending on what’s in the annuitant’s best interest.
There’s no argument that individuals can potentially earn higher rates of return by investing in the stock market rather than by purchasing a whole life insurance policy. However, advisors and investors must understand these are two different strategies that should not be compared to the other. One strategy is not better than the other.
Diversification is key, including tax diversification. It’s important for financial planners to keep an open mind and consider how whole life insurance may be integrated into the client’s financial plan to provide better peace of mind.
And, as the Ernst & Young study indicates, an integrated retirement planning approach may result in more assets under management for your client, leading to greater peace of mind. A side effect of more assets under management is a more valuable investment practice.
Amie Agamata is a CERTIFIED FINANCIAL PLANNER™ in San Diego, CA with clients across the U.S. Her team’s business mission is “Working together to achieve financial success through understanding, education, and action©.” Amie is the NexGen President-Elect for the Financial Planning Association (FPA) nationally, member of the FPA Retirement Income Planning Advisory Council, and serves on The American College Alumni Council.
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