Life insurance: a term that can really dampen the mood in a financial planning meeting. As time has progressed in the financial industry, it seems life insurance has lost its true value and purpose in a financial plan. So, why is that? In my opinion, it is because it is sold to people rather than it being purchased by them. This is due to the lack of industry knowledge or education by agents along with the high compensation and benefits that agents receive with life insurance. It’s then coupled with the incentives and pressure executives place on captive agents to sell more life insurance policies and generate more revenue for the firm. So, how do people know what type of life insurance is right for them in their exact situation, or if they even need it in the first place? The answer is: it depends, but let’s break down a few scenarios that we deal with on a daily basis.
Young Couples Just Starting Their Careers
Young people often hear others talking about life insurance, whether it be from a friend, a family member, or someone they know in the financial industry. While it’s never a bad idea to explore your options, too many young people purchase the wrong type of life insurance. To start, a young person should not purchase life insurance until they are married. If there is no debt or a fear of lost income due to a premature death of a spouse, then life insurance may not be necessary, or they may purchase at the minimum a small term policy. But if a young couple has a child, then life insurance becomes non-negotiable for the two spouses.
The right type of life insurance in this situation would likely be a term life insurance policy with a level term for 20 to 30 years depending on the couple’s assets, debt, and age. Factors when determining the right amount of coverage for an individual include income, net-worth, debt, mortgage, and future events such as a child’s college or wedding. Term life insurance not only defends a young couple from the unexpected but also allows them to be protected in a much more affordable way with insurance premiums.
Too many times, young couples are persuaded to purchase permanent life insurance due to the cash value component, but from an investment standpoint it is a very poor decision. Purchasing permanent life insurance comes with a steeper premium cost and a significantly lower death benefit. Permanent life insurance is not bad, but it is not the right solution for this scenario. Young couples who are starting their financial plans have more effective ways to accumulate wealth such as 401(k)s, 403(b)s, Roth IRAs, IRAs, and even other taxable accounts.
Life insurance agents often argue the idea of an individual’s risk tolerance, and they might promote the tax-free benefits of permanent life insurance from a wealth accumulation standpoint, but proper financial planning is about more than an investor’s risk tolerance. It should also be about their time horizon, investing knowledge, performance objectives, and tax scenarios.
High Income Earners
Permanent life insurance has its place for certain scenarios, and one of those is for high income earners. This can be effective for people who are older and have less than a 20-year time horizon, but it can be most effective for high income earners who have a timeline of more than 20 years. That is simply because the longer someone allows the policy to grow, the more their cash value will benefit from compounding interest—just like everything else with investing.
Before committing to a permanent life insurance policy for wealth accumulation, there are other investment options that need to be checked off before doing so. People need to participate in their employer’s retirement plan such as their 401(k) or 403(b) which allows individuals under 50 years old to contribute up to $23,000 in 2024, or up to $30,500 if they’re 50 and over. For those who do not have access to a 401(k) or 403(b), there may be other options available. For example, they may be able to leverage a Roth IRA or IRA. In 2024, those under 50 years old can contribute up to $7,000, or up to $8,000 if they’re 50 and above. Collectively, a married couple under 50 who has access to each of these can save up to $60,000, or up to $77,000 if they are 50 or older.
On top of IRAs and employer-sponsored accounts, people can consider taxable accounts such as individual or joint brokerage accounts that can be used for long-term goals. These are taxed at capital gains rates which can be effective for those in high tax brackets for their ordinary income. Additionally, if someone is utilizing 401(k)s, 403(b)s, Roth IRAs, IRAs, and other investment vehicles to their full capabilities and still wants to find other tax-free solutions, they can look into an indexed universal life (IUL) policy to accumulate wealth. An IUL is a type of permanent life insurance policy that utilizes indexes such as the S&P 500 to accumulate cash value. Unlike the stock market, however, one of the main perks of an IUL is principal protection, meaning that the policy cannot perform worse than 0% in any given year. The trade off with that is the IUL policy may have limited upside potential or capped gains, which can vary by company and policies, so individuals want to make sure they know exactly how the insurance policy is structured, as well as the policy’s track record and rating. You may also want to consider the cost of the policy and the insurance company’s reputation and financial strength.
The types of life insurance to avoid in this scenario are whole life insurance policies, which pay a dividend from the insurance company rather offering growth based on market-based indexes. Whole life is presented as a wealth accumulation strategy, but the cost of insurance to keep the policy in force drives the cash value opportunity downward. Another option that is like an IUL but is not as beneficial is a variable universal life insurance (VUL) policy. A VUL is like an IUL with the potential of market gains. The difference with a VUL is that it does not provide downside protection for the policy, as the funds are actually invested in the market. A VUL also comes with high fees and expenses to own and operate the policy. Additional riders can also be added such as downside protection that can make the life insurance policy more expensive, making it even more imperative to familiarize yourself with the policy you’re purchasing.
One of the most important things a person can do when determining the value of a life insurance policy is calculating its internal rate of return (IRR). This calculation will show the ultimate return on the cash invested over a certain period. To calculate the IRR before purchasing any type of permanent life insurance, look at the policy illustration. Prospects for permanent life insurance need to avoid listening to the annual dividend the insurance company issues or the index’s projected performance because the IRR and the stated dividend or index average can be significantly different, especially to start.
Those looking for a permanent life insurance policy need to be extremely cautious when purchasing their policy. Your investing options within the policy are often limited, and you grant a certain level of control to the insurance company that you may instead want to retain. Permanent life insurance is a long-term commitment, so it is important to make sure you partner with a reputable insurance company and an independent financial planner who has access to multiple investment solutions and insurance carriers.
Individuals with a Large Estate
One way those with large estates help their heirs cover estate taxes and keep their assets intact is through life insurance. For 2024, the federal estate tax exemption is $13.61 million per individual. Some states may enforce an estate tax law, so it is important to consult an estate attorney on which estate tax laws affect you. It’s also important to note that at the end of 2025, the sunset provision can potentially go back to the previous federal estate tax exemption of about $7 million per individual. An estate attorney, tax advisor, and independent financial advisor can help you develop a strategy to make sure you are adequately prepared for any estate tax liability.
For estate tax purposes, there are multiple options to consider for permanent life insurance. The main policies individuals use for estate tax purposes are universal life policies and “second-to-die” policies. The universal life insurance policy allows for one person to be insured for a set number of years, which can vary on a person-to-person and policy-to-policy basis. Some policies can even last from age 100 to 120. Universal life policies can provide guarantees from the insurance company like premium cost, death benefit amount, and length of policy. These benefits, along with a death benefit rather than cash accumulation, can make universal life insurance cost effective for those looking for permanent life insurance. Each insurance company and universal life policy is different, so it is very important to see multiple options.
Second-to-die policies are for people such as a husband and wife who want to combine two people into one life insurance policy. The death benefit in a second-to-die policy does not pay out until after the death of the second insured. Second-to-die policies can potentially be more cost effective than buying two individual permanent life insurance policies. Furthermore, if one spouse has a lower rating and the other spouse has a higher rating, it can help the lower rated person get a better rating and premium cost for the entire life insurance policy.
Other life insurance policies such as whole life, index universal life, and variable life can be used for covering estate tax liability purposes, but there are more appropriate and cost-effective solutions to execute the estate tax objective. One key thing to understand when dealing with estate tax liability is that life insurance is not the only solution to navigate this complex situation. If someone has charitable intent, there are strategies that can be used to lower estate tax liability. The fact that there are so many options makes it crucial for individuals to sit down with an estate attorney, tax advisor, and an independent financial advisor who is knowledgeable in this type of planning to showcase different solutions that may fulfill their estate planning needs.
The three scenarios above are just a few ways life insurance is used appropriately. Other scenarios can include key person policies for those with high level roles within a company or organization and buy-sell agreements with business partners who want to plan for unexpected events within the business. More often than not, life insurance needs to be purchased for the insurance component, not as an investment. In the right situation it can be a helpful tool for wealth accumulation and estate protection, but it is important to sit down with a knowledgeable estate attorney, a tax advisor, and an independent, fiduciary financial planner who understands your goals and can offer multiple solutions rather than just insurance products.