Many insurance companies pitch cash value life insurance as an investment vehicle. "It's a tax-advantageous way to save for retirement or other long-term needs," agents say.
Although enticing, it's important to understand the many downsides to this option. Life insurance is best used for its intended purpose. That is, to provide for your loved ones in case you pass away unexpectedly.
Let's take a closer at look at cash value life insurance (and why term life is a better fit for physicians.)
Also known as permanent life, cash value life insurance lasts as long as you pay the necessary premiums. As the name suggests, it builds an account value you can access as cash. Meanwhile, term life insurance only lasts for a defined term of years (typically 10, 20, or 30). It only offers a death benefit.
There are two basic types of cash value life insurance:
- Whole life insurance.
- Universal life insurance.
Both are far more expensive than term life insurance.
With a universal life policy, your premium payments support the amount of coverage you elect to own. This is the face amount. Each premium payment enters the policy’s account value. This is where the insurance company deducts fees and charges for providing coverage. Whatever is left over after those charges are deducted is the policy’s cash value. This earns interest over time.
The universal life premium you pay and the death benefit you receive may vary monthly and annually. It depends on how much interest is credited to the policy.
Whole life insurance provides a lifetime death benefit to the policyholder. The premium and death benefit typically remain the same for the life of the insurance contract.
Because coverage is lifelong, whole life is a far more expensive than term life. This option only pays a benefit if the insured passes away within the policy’s term period.
Like other types of life insurance, whole life premiums are based on:
- The amount of the policy’s death benefit.
- Underwriting factors, such as age, gender and health.
When you buy whole life insurance, the insurer set a premium for the life of the policy. In doing so, you will pay more of the overall cost upfront. This allows the insurer to recover as much of its expenses as possible before:
- You pass away, or...
- You surrender the policy.
(Just like how you pay a larger portion of mortgage interest in the early years of homeownership.)
Because the insurer does not require all of your premium dollars at the beginning of the contract, it sets a portion of it aside for later. This becomes the policy’s cash value, which earns a set rate of interest each year. Your cash value will pay the higher mortality costs later in the policy.
However, the policy’s owner can access the cash value:
- By withdrawing the cash value, or...
- By surrendering the policy and taking the total accumulated cash value.
The main argument against whole life insurance is its price. Whole life is considerably more expensive than a similar term policy. Because of its cost, many people surrender their whole life policies after a time. But this leaves them with little to nothing in return. (Similar to paying a mortgage and having it foreclosed on.)
Another reason to avoid whole life is the commitment. If you end up not needing coverage for your entire life, you’ll still be stuck paying the higher premium anyway. As doctors reach retirement age, most have already paid off their mortgages and no longer have dependents.
Furthermore, whole life isn't a great option for high-incomer earners who can afford to save more.
You should accumulate more than enough to pass on to loved ones after your death without the need for life insurance if:
- You maintain a thriving medical practice.
- Save a portion of your income for decades.
- Invest it well.
For example, imagine at age 35, you begin setting aside $20,000 a year. You do that each year for 30 years until you retire at age 65. If you averaged a conservative 5 percent annual return, you would save roughly $1.5 million by retirement.
Whatever you do not use in retirement can then be left to your surviving spouse or other dependents. In this scenario, the only life insurance coverage you would need is a term policy. This would protect your loved ones if you die unexpectedly before building long-term savings.
Another red flag attached to whole life policies is how they are sold. Given the cash value component, agents frame whole life policies as tax-free investment vehicles. But when you crunch the numbers, it's clear life insurance should only be purchased for protection against the loss of life. Buying a term policy and investing the difference between it and a whole life policy in mutual funds (or another traditional investment) would generate a far bigger return.Any money you remove from a whole life policy also reduces your death benefit.
Cash value life insurance also has more fees and charges than other types of investments, including:
- Sales charges that include the selling agent’s commissions.
- Administration fees for maintaining the policy, including accounting and record-keeping.
- Mortality and expense risk charges. Upon issuance, the insurance company assumes the insured person will live to a certain age. This charge compensates the insurance company in the case the insured person doesn’t live as long as it assumes.
- Cost of insurance. This is the actual price of your coverage. It is based on your age, gender, health and benefit amount.
While cash value may seem convenient, your policy will not accumulate it for several years after you buy it. From an investment standpoint, this can make the overall rate of return much lower than a traditional account.
For example, say you make an initial premium payment of $10,000 for a cash value insurance policy. This does not mean you now have $10,000 in cash value. That’s because most of the money you contribute early on is used to pay for the cost of the coverage. Depending on how much you contribute, you may actually have negative cash value early on.
Meanwhile, investing $10,000 in stocks, bonds or mutual funds is worth that amount until it grows or falls in value.
Traditional savings accounts also offer more flexibility. A 401(k) or IRA enables you to start and stop contributions anytime. Regardless, whatever you have contributed will still continue to earn interest.
With life insurance, that perk is off the table. To keep the policy intact, you must continue paying the necessary premium. Otherwise, it may lapse causing you to lose coverage.
It's also possible to lapse your policy if you withdraw too much of the cash value. If this happens, iyou may need to pay taxes on the overdrawn amount.
401(k)s and IRAs also allow you to deduct your contributions from your tax obligations. Life insurance does not.
Life insurance is intended to protect your loved ones. When buying life insurance, it's important to understand:
- The two main types of cash value life insurance.
- How insurance agents may try to deceive you into buying.
- Why most should avoid it at all costs (especially doctors!)
With this in mind, you should be able to move forward with a term life policy that's right for you.
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Joel Palmer is a writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.