If you have children or other loved ones who depend on your financially, you need life insurance – no question about it. And you’ll need an amount that can enable your family members to continue their lifestyle if you aren’t around. But there may be less certainty about what type of insurance you should purchase: term or permanent. And the issue can cause even more confusion if you’ve heard the phrase: “Buy term and invest the difference.” What does this mean? And is it good advice?
First, let’s review the chief differences between term and permanent insurance. As its name suggest, term insurance lasts for a set period, such as 10 or 20 years, while permanent insurance can last your entire life. Term insurance only pays a death benefit – there’s no opportunity to build cash value. But permanent insurance, such as universal life, also contains an investment element. Consequently, permanent insurance premiums are generally considerably higher than those of term insurance.
Given this difference in premiums, you may have heard that it’s a good move to buy term insurance and use the “savings” – that is, the money you would have spent on a costlier permanent insurance policy – to invest in stocks or mutual funds, rather than rely on the investments contained in permanent insurance. But in reality, it’s not that simple. Here are a few reasons why “buy term, invest the difference” may not always be the best strategy:
- People don’t consistently invest the difference. Although people may have the best intentions when it comes to investing the savings achieved by purchasing term insurance, life often gets in the way and they find other ways to spend the money. Or they may invest sporadically or make poor investment decisions. By way of contrast, the premiums that go into permanent insurance are invested systematically and managed by professionals.
- Term premiums won’t always be cheap. Term insurance is quite affordable when you’re young. But when the term expires after, say, 15 or 20 years, the premiums can become much more expensive. Consequently, there will likely be much less of a gap between the costs of term and permanent insurance.
- Permanent insurance investments can grow tax-deferred. If you followed the “buy term, invest the difference” approach, and you purchased stocks or mutual funds, you might incur taxes on capital gains and dividends. But the investments within a permanent insurance policy are tax deferred, so you won’t pay taxes on interest, dividends or capital gains until you withdraw the proceeds, similar to the tax benefits you get with your IRA and 401(k) accounts.
Even though you should consider the above issues, you don’t necessarily have to dismiss the “buy term, invest the difference” strategy. Everyone’s situation is different, so you’ll want to explore your options carefully. At different times of your life, different insurance and investment solutions may be appropriate. But however you choose to do it, you’ll want to maintain sufficient life insurance and invest for your long-term goals – two actions that can pay off for you and your loved ones.
Jennifer Barrett (AAMS) is a local Edward Jones Financial Advisor.
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Edward Jones, its employees and financial advisors are not estate planners and cannot provide tax or legal advice. You should consult your estate-planning attorney or qualified tax advisor regarding your situation.