Should you buy term insurance and invest the difference or buy a permanent insurance policy?
This question is amongst one of the most common in the financial services community.
Depending on whom you talk to, it’s likely that you will find passionate supporters on either side of the argument. Financial advisors with an investment bias often suggest that you buy term and invest the difference. Insurance agents often side with buying a permanent policy (not surprisingly, these biases tend to favor how each of these individuals is compensated, but that’s a discussion for another day).
Regardless of where professional allegiances lie, it’s important to evaluate the conversation from a numbers perspective to accurately determine which option may be best.
Historically, the conversion attempting to answer which option may be best has been complicated by the projected tax assumptions input by the illustrator. Insurance agents, using a combination of high future tax rates and tax-free income withdrawals were able to make permanent insurance policies look very attractive, as compared to the buy term and invest the difference alternative.
Unfortunately, varying user input (as it pertains to tax assumptions) made it nearly impossible to compare these two scenarios equivalently.
Fortunately, this has changed.
With the advent of the ROTH 401(k), we are now able to more fairly compare a permanent insurance policy solution to a buy term and invest the difference option. Specifically, we can do this by equalizing the tax implications on both the contributions and the withdrawal. Specifically, we see the following:
- Contributions – ROTH 401(k) and permanent insurance policy contributions will be funded with after-tax dollars.
- Distributions – ROTH 401(k) distributions and permanent insurance policy distributions (assuming they are taken correctly) will be tax-free.
(Previously, a ROTH IRA was available that could equally compare the two. However, limits on annual contributions, eligibility, and phase-outs for earned income made it burdensome and unattractive for those looking to contribute substantial annual contributions. The ROTH 401(k), assuming both a husband and wife are eligible and under age 50, can allow up to $36,000 of annual contributions).
An Example –
In an effort to illustrate the analysis, I will use myself as an example using the following assumptions:
- Annual dollars available to allocate – $18,000
- A 33-year-old male
- Non-smoker, super preferred underwriting (this is a best-case scenario as it pertains to pricing for a male. This means that any other situation could make the life insurance example less than what is illustrated below)
- A hypothetical 7% gross rate of return for both the investments and for the variable universal life policy
Illustrating a Permanent Insurance Policy
If the goal is to maximize income distributions in retirement, a specific life insurance design strategy should be considered. Specifically, the strategy will be to buy as little life insurance as possible. By keeping the amount of life insurance low, you will also lower the cost of insurance charges. This strategy may lead to a greater buildup of cash value inside the life insurance policy.
Implementing this strategy, we will purchase a VUL (variable universal life) policy with a $600,000 initial death benefit (rounded).
Insurance companies are then able to illustrate how this policy may perform (please keep in mind, insurance illustrations are projections. The policy may or may not perform as originally illustrated).
Looking at the illustration for the life insurance policy detailed above, we observe the following cash values
- In 10 years – $236,420
- In 20 years – $663,802
- In 31 years – $1,519,409
Eventually, the goal of this policy will be to generate income in retirement. If implemented correctly, it’s possible to “pull” tax-free income from this cash value.
Looking at the illustration, we see that the policy will pay out $114,000 per year for 20 years.
To summarize, the total amount of contribution to this policy will have been $558,000. The cash value will grow to $1,519,409, and it will produce $114,000 for 20 years, tax-free!
Seems like a great idea! Right?
The point of today’s blog is to compare the two options. Therefore, we can’t say quite yet if this is a great idea or not. In order to come to that conclusion, we need to compare these figures, as illustrated by a VUL, to a ROTH 401(k).
Buy Term and Invest the Difference In A ROTH 401(k)
In order keep the analysis fair, in the buy term and invest the difference scenario, we should buy a $600,000 life insurance policy (amount equal to the original VUL policy), and we should buy a 20-year term insurance policy.
The cost of a 20-year term insurance policy for a $600,000 death benefit for a 33-year-old male, super preferred, non-smoker is $279/year (offered by the same insurance company as mentioned above).
We then need to deduct the cost of the term insurance policy from the $18,000 of available dollars. By doing so, we learn that we can contribute $17,721 each year into a ROTH 401(k).
Assuming a hypothetical 7% gross rate of return, we can calculate the following future values.
- In 10 years – $224,841
- In 20 years – $726,481
- In 31 years – $1,808,836
We then need to calculate the tax-free withdrawals in retirement.
If we assume the same $114,000 of tax-free distributions for 20 years, we can calculate a “left-over” value at the end of Year 20 of $2,326,138.
The Big Question – Comparing the Two
In summary, we can compare these two options by asking two simple questions.
Would you rather have $1.5 million that is subject to insurance company strings?
Or would you rather have $1.8 million that is totally liquid and available? And an additional $2.3 million 20 years later.
Continuing the Conversation – A full comparison
To me, the ROTH 401(k) seems like the overall clear winner.
However, with that said, a balanced argument will include a discussion of when the insurance policy may be the better choice.
In our analysis, the permanent insurance policy would be the better choice for your heirs if and when, you, the insured, dies before or early in retirement.
In this scenario, the beneficiaries of the deceased may receive more money via the insurance plan then they do via the ROTH 401(k).
The Details at Death
The beneficiaries of a permanent insurance policy (as we have designed it for this blog post) will receive the death benefit only (not the total of the death benefit plus the cash value).
With the permanent policy, the death benefit grows as the cash value grows. Using our hypothetical example, in Year 10, the death benefit is $876,610, in Year 20 the death benefit is $1,764,732, in Year 31, the death benefit is $2,905,687, and in Year 51, the death benefit is $450,366.
|Permanent||Cash Value||Death Benefit||Total|
|End of year 51||$260,752||$450,366||$450,366|
Assuming someone buys term and invests the difference, the beneficiaries will receive the value of the investment account AND the death benefit. In our scenario, in 10 years, the beneficiaries will receive $844,841, in 20 years $1,326,480, in 31 years $1,808,836, and in 51 years $2,326,138.
|Buy Term/Invest||Cash Value||Death Benefit||Total|
|End of year 51||$2,326,138||$0.00||$2,326,138|
The longer you live, the more and more likely it becomes that the ROTH 401(k) is a better choice.
What About Whole Life Insurance?
Because a VUL isn’t right for everyone, I took the liberty of completing the same analysis for a whole life policy. For the whole life policy, we have used a current dividend scale (this means that the numbers are projected, not guaranteed).
In short, the whole life policy doesn’t even come close to the other examples above.
Specifically, for the same $18,000 and the same time frame, the whole life policy will produce $96,000 of income for 20 years. $96,000 is approximately 15% less income than the $114,000 detailed above.
|Whole Life||Cash Value||Death Benefit||Total|
|End of year 51||$166,929||$621,231||$621,231|
In my continued effort to be fair, in this case, a whole life policy (while not my favorite, I fully disclose) will produce the highest guaranteed cash value of these 3 hypothetical options.
What Can We Learn From This?
When comparing buying term insurance and investing the difference to buying a permanent insurance policy, the numbers suggest that buying term and investing can mathematically lead to better long-term outcomes.
In addition, buying term and investing the difference may have other added benefits, such as tax deferral (assuming our ROTH 401(k) example) for the beneficiaries and more liquidity/access to the money.
The ROTH 401(k) option also eliminates the concern that tax-free withdrawals from life insurance could lead to a potential large taxable event if you don’t withdrawal correctly or withdrawal too much.
However, for those who are seeking additional options beyond what is allowed due to ROTH 401(k) limits and for those who are seeking alternatives to the traditional investment models, permanent insurance may be a wise choice. If you find this to be true, then it should be designed appropriately to maximize cash value.
However, the analysis suggests the argument for a permanent life insurance policy as a first financial planning decision may be misguided. Furthermore, those choosing to buy term and invest the difference into a ROTH 401(k) may win in the long term.
The above figures and examples are hypothetical and are for illustrative purposes only and do not attempt to predict actual results of any particular investment.
Tax services are not offered through, nor supervised by Lincoln Investment or Capital Analysts. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.