Too often the purchase of life insurance is made out of fear and confusion when it should be a point of consideration based on thoughtful analysis and understanding. In this article, find out everything you need to know about Term and Whole Life Insurance. First, let's dive into the advantages and disadvantage of life insurance.
Many people have a love-hate relationship with life insurance. What exactly is life insurance? According to Investopedia, life insurance is a contract between an insurer and a policyholder where the insurer guarantees a death benefit to the named beneficiaries when the insured dies. In exchange for premiums paid by the policyholder, the insurance company promises that payment of a death benefit. Let's look into some of the benefits and drawbacks of life insurance.
One of the main benefits of this life insurance is that it gives options to the survivors. (Depending on the type of life insurance you select, it can also give options to you while you are living too!)
Life insurance is also a tool that can be used for:
Now, it’s important to realize that access to cash values through borrowing or partial surrenders does have a few drawbacks.
Here are some of the drawbacks:
Now that you know some of the drawbacks and benefits life insurance can offer while you’re still living, you might be wondering: “What type of life insurance do you need?” Let's discuss what life insurance option may be best for you.
There are many insurance carriers that provide life insurance, with many similarities, but there are two main types of life insurance.
To help explain the difference, let’s talk about a hypothetical physician: Dr. Sarah and her husband Caleb.
Sarah is a brand new attending physician. Dr. Sarah and Caleb not only want to protect their income in the event of a temporary loss of earnings but also in the event of a permanent loss of earnings. Dr. Sarah and Caleb should consider getting a life insurance policy.
Why is life insurance planning a good option for Dr. Sarah and Caleb if they're young and healthy? The main reason they would want to consider life insurance at their age is to replace their income or to provide for their spouse and children in the case something happens. Here is a graph of the options life insurance gives survivors:
When you are in your 30’s and 40’s, you have a long career ahead of you. You might have children and debt, which creates the need to cover these costs in the event you die. Those needs definitely decrease as your assets grow, the needs don’t go to zero, but we see them trend back up as you start planning for estate taxes, legacy, charity, providing for grandchildren, that sort of thing as you grow older.
Your life insurance needs change over time, and there are two different ways to determine your life insurance needs: Human Life Value and Needs Analysis.
What’s the right insurance for you? The first thing you need to do is figure out how much you need.
Let’s take a look at the case above. Dr. Sarah and Caleb have a one-year-old son. She is making $225,000 a year. If she asks us “how much insurance do I need?” our first response is “I don’t know that she needs any, but it’s certainly prudent to consider it.” Let's dive in further discussing the two accepted methodologies to determine their life insurance needs.
The needs analysis calculation essentially looks at how much the family needs to accomplish their goals. These questions can help you determine those goals:
When we add all that up and discount it by inflation for what it is today, we are calculating what is the LEAST amount of money today that would cover all those expenses in the future if nothing changes. In the case study above, Dr. Sarah’s needs a total of $2,129,468.
By contrast, the human life value calculation looks at the situation very differently. If in fact, Dr. Sarah should die in an auto accident and the other driver was drunk or at fault or negligent, and Caleb went to an attorney to consider whether he should sue, the attorney would not walk him through an exercise to determine how little he should sue for. The attorney would walk him through an exercise to determine the economic value that Dr. Sarah brought to the family. How much would she have earned over the length of her career – based on her age, her retirement contributions, the social security she might have accrued, not to mention the punitive damages of pain and suffering. What was she worth to the household? That is a very different figure!
Typically, what we see is that a needs analysis calculation will be somewhere around 10 or 15 times your earnings, early in life, whereas a human life value calculation will be somewhere around 20 to 25 times your earnings depending on your age. For Dr. Sarah and Caleb that would translate to somewhere between $2 to $6 million dollars of insurance.
Now that you understand the two different ways you can determine how much life insurance you need, the next question is: what type of life insurance makes sense for you?
There are two basic categories of life insurance: term insurance (temporary insurance) and whole life insurance (permanent insurance).
Within cash value life insurance label there are specific product types including whole life, universal life, variable life, adjustable life insurance, indexed universal life insurance, ordinary life insurance.
Sometimes people refer to cash value life insurance as whole life, but whole life is just one of the types of insurance under the category of cash value life insurance. Understanding the difference between these types of life insurance is very useful. See the image below for a comparison of the two.
Term insurance is a lot like renting a house. After matching to your residency program, you may have to move to the city where your program is located. You may be there for a relatively short period of time: 3, 4, or 5 years. You could end up staying in the area or you may end up going into practice in another city or state.
In this scenario, many residents choose to rent a house. What are the benefits to renting a house while you are in Charlotte? It’s temporary. You’re only going to be here for a couple of years and it’s not worth it to buy a house because when you leave the city you may not be able to recoup all of the costs of buying a home.
Another benefit of renting is you don’t have any ownership. This may sound negative, but you may not want to be an owner at this point. You don’t want to be responsible for the property taxes, the repairs on the roof, the paint and all those sorts of things. Because it’s temporary, it’s flexible. You don’t like the place you rented in your residency program’s city, OK, after your lease is up you can move to a different place. As part of being a tenant and renting you recognize that you are not getting any tax benefits with your rent payment, there are no deductions available on your tax return, you are not getting any equity when you choose to move, but it is serving your primary need at this point – it is providing housing and it’s temporary.
Since life insurance often comes into play when people die, it is usually a topic that is part of the discussion with estate planning attorney who draft wills and trust. To help explain life insurance further, I decided to ask an estate planning and tax attorney about what he sees with his clients. When asked about temporary life insurance, Todd Stewart, CPA, JD, and owner of Stewart Law, P.A., said, “Term– the only tool of its kind that enables clients to replace a future income stream by starting to pay modest annual or monthly premiums.”
The “renting” part of term life insurance is great, but there are some caveats. Stewart goes on to say, “We do find some clients, particularly those in their 50s and 60s who have come to take the peace of mind [temporary insurance] provides for granted only to find that at the end of the level-premium period, this tool becomes unaffordable.”
Why would life insurance become so expensive when you get older? I’ll share another example. Let’s say you signed a lease for your house or condo for one year, with the understanding that every year the price may go up. When the lease is up, you have the option to renew and when you do, the price may change.
The rent may go from $800 to $900 a month. Now let’s say you told the landlord you plan on being in town for a few years. You could propose something like this: ”I know I love this house and I want to stay for all three years, will you give me a three-year lease?” he may say “OK, I will rent it to you for three years for $850 and I won’t raise the rent for three years.” He may amortize the rent to a flat rate, but after the three years, you can rest assured he may notably raise the rent.
If you want to stay in the house once those three years are up, you will have to renegotiate your lease with your landlord. Term life insurance works in a very similar way.
You can buy term insurance that adjusts in rate every year. This can be a nice feature because at the age of 30, the cost is very low. Your mortality at age 30 is typically fairly low, and every year the cost goes up a smidge.
One might say, “I need temporary insurance for 10 or 20 years, my kids are young but when they’re done with school I won’t need this anymore.” In this case, the insurance company will give you a flat rate and guarantee it for 20 years. If you are asking the insurance carrier to hold the price constant for 20 years, the rate will be higher than it will be for the annually adjusting insurance. However, it’s not usually advised to own term insurance when you are getting close to your mortality. In your 60’s, 70’s, or 80’s, term insurance is extremely expensive, and premiums could cost tens of thousands of dollars every month.
When the length of time for your term insurance contract ends, you will need to be re-underwritten based on your health at that time, up if you want to continue having the insurance. You may opt to continue the premiums, or the company may opt-out of re-underwriting you based on your health at the time.
By contrast, whole life insurance is like owning a house. It has very different responsibilities and benefits than that of renting a house. When you decide on the city where you are going to practice medicine, you will be more likely to buy a home. The two reasons for owning a home: you will want a place where you can stay for an extended period of time and you don’t want to pay rent to someone else. Buying a house offers value to the homeowner, such as, tax benefits of making mortgage payments and being able to deduct the interest portion of those payments from your income taxes.
Wondering how secure these tax benefits are? Stewart says they’re even written into some states’ constitutions, such as North Carolina. When asked about Whole Life insurance, he expressed this value of these constitutional rights by saying, “In addition to providing liquid funds in an income tax-favored manner, the wealth generated in the policy is given substantial asset protection benefits.” Stewart continues, “Permanent policies are also a core asset in many long-term family trusts because they can be structured to be free of both income and estate and gift taxes.” Compared to other assets, Steward explained this means the whole life insurance policyholder can reap a tremendous after-tax investment returns.
As an owner, you will also be paying off your house and building equity. Because you own the house, you will be the one who benefits from any appreciation that occurs in the value of the home. If you choose to move or sell the house after 10, 20, or 30 years, the money that it’s worth will go to you because you owned the appreciation and you had the responsibility of keeping up with the mortgage all those years.
Owning a home is in many ways similar to cash value insurance. While there are many different types of cash value insurance, those types are essentially like the types of mortgages that you can buy. Similar to buying a house, you would select an insurance policy that would provide an amount of death benefit you would have throughout your lifetime and you would begin to make a monthly payment and you would know that that payment would typically never change.
Like mortgage options, you could select to buy a house with a thirty-year fixed mortgage, a ten-year fixed mortgage, or an adjustable-rate mortgage and similarly there are different types of payment options for cash value life insurance. The earlier you buy whole life insurance, the lower the monthly cost. If you choose to make payments for an insurance policy all of your life, the premiums will be much lower than in a policy where you decide to make premium payments for just ten or twenty years to fully pay for it.
Just like when making mortgage payments, the faster you pay your cash value premium payments, the faster the equity builds within it. At the end of paying off mortgage, you’d expect to own all of the equity. This is the same for paying off a cash value policy. After a period of time, all of the premiums you will be paying will be going into the equity portion, which is available to you – not just when you die – to withdraw from the policy just like any other account.
Term Life Insurance and Whole Life Insurance both have pros and cons of their own and can play a valuable role in your financial plan.
A financial planner is someone who can help you with your insurance strategy -- based on your career, your employment situation, your health – they can help you find the right company and the right combination of benefits to help protect your future earnings.
If you have any questions about disability income or other insurance planning, schedule a complimentary discovery call with John Dameron!
John Dameron has been a financial planner and partner with Spaugh Dameron Tenny since 2002. With the help of the SDT team, John created a lecture series called Physicians Financial Focus, authored a book entitled The Residents and Fellows Financial Survival Guide, and has coached hundreds of physicians from residency/fellowship into practice. His expertise has also been featured on KevinMD.
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