Term Vs. Permanent Life Insurance – The Right Choice for You
Choosing a life insurance policy starts with a simple decision: Do you want a term policy, or a permanent policy?
Neither policy is inherently superior to the other; making the right choice means evaluating each type of policy in relation to your actual needs and financial goals. We’ll look at some of the pros and cons of each policy type and explain why there is a clear choice for most people.
But first, let’s talk a little about life insurance in general.
A Brief History of Life Insurance
Sales of life insurance began in America in the 1760s, while the states were still colonies of the United Kingdom. A lot has changed since then (obviously) but the basic premise of life insurance remains the same: Pay a premium in order to secure financial relief for your family in case you pass away.
From the start, permanent life insurance policies were the default. That means that, once enrolled, your coverage (and your premium payments) would continue until you leave this earth.
Fast forward to 1981, when the Tax Equity and Fiscal Responsibility Act (TEFRA) was passed into law. This made many banks and insurance companies interest sensitive, which caused the general population to start questioning why they would invest their money into permanent life insurance policies when they could simply invest it in the market instead (and leave far more money for their families than they would receive from an insurance payout).
Because of this shift, term insurance policies (which only cover an individual during a set period of time) started becoming more popular. They started as supplemental protection to go along with someone’s market investments, but insurance agents quickly saw the opportunity and started focusing their sales efforts on term policies.
Term Life Insurance: The Popular Choice
Once market investments became a viable financial planning option for most people, thanks to TEFRA, term insurance policies became the norm for people seeking extra protection. Term insurance policies work by providing coverage only during the stated term of the policy.
For example, if you purchase a 20-year term policy, your premiums are guaranteed to stay the same for those 20 years, and if you die during this time, your insurance company will pay out your death benefit to your beneficiaries.
This makes term insurance more affordable than permanent insurance, which is part of what makes it more popular. It’s also generally a simple product, making it easier to shop for than permanent insurance policies. It’s also a competitive market, which favors the consumer and makes policies affordable.
Term insurance is a great fit for younger individuals and families who need protection against the loss of income for a primary earner over a certain period of time, such as waiting for other investments to vest.
Say you are set to collect a pension at age 65. When you’re 45, you enroll in a 20-year term policy that will protect your family financially in case you die before you’re able to cash in on your pension. Once you hit 65, your term insurance policy is gone, but your family is now protected by the security afforded from your pension payments.
The downside to term insurance is that, at the end of the term, the policy will have no value. That means there’s no payout if you outlive your coverage. Of course, this is heavily outweighed by the upside of still being alive when your term ends. You can also work around this by looking for term policies with conversion privileges that allow you to opt into a permanent insurance policy.
Permanent Life Insurance: When It’s Right, It’s Really Right
Permanent or whole life insurance policies are more complicated, more expensive and less common than term policies – but they’re potentially far more lucrative for your survivors.
The big benefit of permanent insurance is that it is guaranteed to pay out. You can’t outlive your permanent policy like you can with term insurance. This guarantees your death benefit is paid out to your beneficiaries. But it’s also one of the big reasons whole life insurance is more expensive than term.
They also offer tax incentives that can help in retirement planning. You won’t pay taxes on the gains in your policy each year. If structured properly, this provides a source of tax-free money to help supplement your retirement. However, it’s rarely as efficient as investing in a 401(k) or an IRA plan, so make sure you have those policies in place before looking to life insurance as another savings avenue.
Generally speaking, there are a lot of other financial goals you should check off before investing in a permanent life insurance policy. Pay off your debt, top-off your emergency reserves, fatten up your savings account and have your retirement savings plan in full swing before looking to add whole life insurance.
All of this makes permanent insurance a niche choice, best for individuals with more than $1 million in assets and/or substantial annual income ($250,000 a year or more). State tax codes and other factors may also make permanent insurance a better choice for some individuals.
What’s Right for You?
Most consumers will find all the protection they need from a term policy. Plus, they’re more affordable and far easier to understand. Even if you can financially afford a whole life policy, your money is often better spent purchasing term insurance and investing the difference.
Life insurance policies aren’t for everyone, but they can play an extremely important role in providing financial security for the people you care most about. If you think a life insurance policy is right for you, step one is planning time with a financial advisor to help determine exactly what makes the most sense for you.