After your children are grown, and if you’ve been lucky enough to hang onto and grow some of the money you’ve made, you can finally think beyond your immediately needs.
You can think about whom you may want to help, and how. Or maybe you’re looking ahead to the time when you’ll have this financial freedom. Either way, having a financial plan — a strategy for reaching your financial goals — is key, to building wealth and being prepared to put a plan into action at the end of your life.
Life insurance as a financial planning tool
One of the tools that you can use in financial planning is life insurance. In younger years, buying the cheapest life insurance possible is one way to ensure that your family can replace your income if you die. Younger people usually focus on less-expensive “term” life insurance, buying as much coverage as possible for a specific time — 15 years, say.
Once there’s additional money, your financial plan can also benefit from another type of insurance called permanent life insurance.
The basic types of permanent life insurance are:
- Whole life insurance. This type of permanent life insurance has higher premiums than term and has an investment feature called cash value. Your premiums stay the same for the life of the policy, the death benefit is a guaranteed amount and you get a guaranteed rate of return on the policy’s cash value.
- Variable life insurance. There’s increased risk with variable life insurance because an investment portfolio is tied to the value of the policy. The premiums are fixed, but the cash value and death benefit can fluctuate depending on the performance of the underlying investments.
- Universal life insurance. The most flexible form of permanent life insurance, the California Department of Insurance notes that universal life allows you to make variable premium payments or modify the death benefit more easily than other types of life insurance. The flexibility comes from three parts of the policy (premium, death benefit and cash value) separately. Although this form of permanent life insurance has several advantages, there is a possibility that you won’t build cash value under certain circumstances.
Deployed strategically in a financial plan, permanent life insurance can provide many benefits. The proceeds from a permanent life insurance policy could provide a legacy for people and causes you love so they can carry on when you’re gone. The death benefit could also be used to cover taxes on your estate so heirs will receive all you intended for them. Another financial planning strategy includes building additional wealth through a permanent life insurance policy after maxing out tax-deductible contributions to your 401(K), pension and IRA.
How does it work?
Unlike term insurance, with permanent types of life insurance, you receive a “death benefit” no matter when you die. Unless you’ve held a policy for a very long time, the death benefit your beneficiaries receive will be considerably more than the premiums you’ve paid into the policy.
“As an example, you might spend $100,000 for a $1 million worth of life insurance. What you’ve done is, you’ve really created an estate for dimes on the dollar,” says Michael Snowdon, president of Wealth Ridge, a registered investment adviser in Greenwood Village, Colo. He has taught personal finance planning and insurance management at the College for Financial Planning in Denver.
With permanent life insurance policies, insurers know they will have to pay your beneficiaries at some point. As a result, permanent life insurance polices have higher premiums than term life insurance. Marvin H. Feldman, president and CEO of the non-profit Life and Health Insurance Foundation for Education (LIFE), an industry-funded organization for consumer education, explains how it works:
- The cost of your death benefit is built into your monthly premiums
- The insurer sets aside a chunk of your monthly payments in a pool that grows with interest
- This accumulating pool of money provides, in addition to a death benefit, the cash value savings account. That’s why permanent life insurance is sometimes pitched as an investment. “Life insurance is not normally considered an investment, but the internal rate of return on permanent life insurance in today’s market is as good or better than most ‘safe’ rates of return available,” Feldman says.
You’ll need expert guidance to meet your particular needs. “Working with a knowledgeable professional is very important,” Feldman adds. “Many times it may be a combination of term and permanent that works best, it doesn’t have to be one or the other.”
While your cash value accrues on a permanent policy, earning interest, you can borrow against it if you need ready cash. Repay the loan (according to the terms of your policy) or subtract it from the value of your eventual death benefit.
If you decided that you do not want or need your permanent life insurance policy, you can give up the policy for the cash surrender value, or the accrued cash value. The longer you’ve paid into your policy, the larger your cash surrender payment will be. However, if you decide to give up the policy, there’ll be no death benefit for your heirs. Because of substantial surrender penalties, the California Department of Insurance warns that you shouldn’t buy a permanent life insurance if you plan to give up the policy shortly after purchasing it.
The financial planning role
If you’ve accumulated wealth — say, $1 million to $1.5 million or more in assets — you can use the policy’s death benefit to cover the cost of any taxes on your estate when you die. To leverage this strategy, you’ll need expert guidance. In addition to your insurance agent, enlist:
- A certified financial planner (CFP) who has expertise on insurance matters
- A certified public accountant
- An estate attorney who may create a trust for you.
These costs — in addition to the premiums — can run from a couple thousand dollars to $10,000 or $20,000, depending on your situation. But if you’ve got this kind of wealth, tax and planning expertise is typically well worth the money.
Through careful financial planning, life insurance can help you accomplish things in death that you could not accomplish in life. If you’ve been unable, for example, to be the philanthropist you wished, you can name an institution, a group or a school as a beneficiary of your insurance policy.
Although sometimes marketed as an investment vehicle, Snowdon says that life insurance is less powerful as an investment. Snowdon recommends evaluating permanent life insurance primarily on the basis of its death benefits. Products melding investments with insurance are hard to evaluate and can be more costly than comparable investments because the cost of insurance is included.
“However, if you do need the death benefit, life insurance can become a very useful tool that does double duty by providing a death benefit and providing a cash account that can be used in a variety of situations,” Snowdon says.