What investments in my life should I keep insured?

Why purchase temporary term life insurance that you’ll likely never use? Isn’t that like throwing money away? With permanent life insurance, part of your premiums are invested and some of it can be borrowed tax-free for retirement, or your children’s college education, or anything else you’d like and your heirs will get a nice death benefit when you pass away.

But is it really always as great as it sounds? As with many controversies, the truth is somewhere in the middle. Whether it makes sense in your particular situation depends on several factors:

How much life insurance do I actually need?

This is important for a couple of reasons. First, you want to make sure you purchase as much as you need. If a more expensive permanent policy means you can only afford to buy less, it’s probably not a good idea. After all, the whole point of insurance is to make sure your family has enough to be taken care of financially if something were to happen to you.

Likewise, you don’t want to be buying insurance that you don’t need either. That’s because on average, you’re likely to spend more on it than you or your family will ever receive. Think about it for a moment. The insurance company has to collect enough in premiums not only to pay out benefits but also to cover their expenses (including that nice big fat commission check your adviser could get for selling it to you) and make a profit. In fancy business lingo, your expected return on those premium dollars is negative.

How long will you need the insurance?

One of the main reasons that permanent insurance is so much more expensive is that it’s meant to cover you for your entire life (hence “permanent” insurance) while cheaper term policies tend to cover you when you’re younger and least likely to use it. Most people don’t need much or even any life insurance once they retire. Either they don’t have any dependents (hopefully the kids will have moved out of the basement by that point) or their dependent (usually a spouse) will have enough income to live on from Social Security, their assets (included those they inherited from the person who passed away) and any survivor benefits they’ll receive.

So who needs life insurance in retirement? They generally fall into three categories. The first is someone who doesn’t have enough assets to cover their final expenses (like funeral costs) and wants a small policy to cover these expenses so they don’t burden their family.

The second is someone who has a dependent that won’t have enough income to live on after they pass away. For example, some people decide to choose a higher “life only” payout on their pension, which leaves nothing to their spouse after they pass away, and then use the extra pension income to pay for a life insurance policy instead. This is called “pension maximization” and can be beneficial if the person is in really good health and can get a low cost policy.

The final scenario is someone who has a taxable estate (currently one worth over $5 million) and wants to use a life insurance policy to pay the estate tax. This is particularly useful if they don’t want their heirs to have to make taxable retirement account withdrawals or sell a business or a piece of real estate in order to make those tax payments. Needless to say, this is a very small percentage of the population.

If none of these scenarios sound like you, you probably don’t need life insurance for your entire life and a low cost term policy would likely suit you just fine.

Do the tax benefits outweigh the costs?

When you purchase permanent life insurance, part of your premium goes into a cash value account that can grow based on policy dividends, interest, and/or earnings from mutual fund-like sub-accounts. Each policy is different so make sure you understand the particulars of how it works before you buy it (like any investment). The main advantage is that you can borrow from this cash value for things like retirement or education expenses without paying taxes on it.

Some of these sub-account investments involve risk and you may be required to add additional dollars to keep the policy going if the investments don’t do well. There’s a good chance that will be during tough economic times when extra money might be scarce. There are also fees and expenses that could eat quite a bit into your returns-make sure you know what all those costs are.

To figure out whether it’s a good deal for you, compare it to purchasing a lower-cost term policy and investing the premium difference somewhere else like your 401(k) or an IRA.

As you can see, the benefits of using permanent life insurance as an investment can be significantly outweighed by the costs. It’s always a good idea to run the numbers for yourself though because each person’s situation is different. For example, if you’re in a very high tax bracket and you’ve maxed out all your retirement plan contributions, the tax benefits of a permanent life insurance policy would be more valuable to you.

It’s also important to note that your adviser is not trying to “scam” you if they recommend a policy that ends up not being worth it. This is the difficulty of being a financial adviser on a commission. Your adviser may just be doing their job in the best way they know how. It just means that you may also want to get a second opinion from an unbiased source.