Life Insurance Refresher – Part II

In last week’s column I reviewed a few basics regarding life insurance.  I suggested level term life insurance as the best choice for the family bread winner with the emphasis on being sure that you have plenty of life insurance while keeping your monthly premiums low.  Most people underestimate just how much life insurance is needed to replace the income of a family member and therefore are often underinsured.  A simplistic way to think about it is to decide for how many years you will need how much income and then do some simple math.  For example, you decide that if you died suddenly, you’d need to replace $50,000 of income for the next twenty years.  $50,000 times twenty years equals $1,000,000.  Ok, I understand that we could discount the amount of insurance we will need by what we expect to earn on the proceeds, but let’s keep it simple.  Consider the earnings portion as part of emergency reserves or to help offset future inflation.  And let’s remember that in many cases this is just the bare minimum of insurance you’ll need.  You may need a larger policy to cover future college costs or money to fund continuing income if your homemaker-spouse does not intend to return to work after raising your children.  At age thirty, a $1 million twenty-year level term policy costs less than $500 per year for a male in excellent health (females are much less).  If you chose to purchase a cash value policy, your premiums would likely be at least four times that much.  As you can see, trying to solve a big insurance problem with cash value insurance can be very taxing on your personal finances.

So when is buying a cash value policy a good idea?  Not too long ago we saw lots of situations where permanent (cash value) life insurance was needed to pay estate taxes for many middle income Americans.  However, the most recent changes to the death tax laws provides that there are no death taxes if your estate is less than $5,430,000 (double that for married couples) so this does not come into play for the vast majority of people today.  The other reason for buying a cash value policy is for the savings or investment feature.  It is true that life insurance policy cash values grow tax deferred and escape income taxation if the policy pays out as a death benefit but the cash value returns tend to be negative in the early years and very modest over the long term.  I’m not against using cash value life insurance as a savings vehicle but would strongly prefer investing first through your company 401k plan, an IRA, a Roth IRA or in stocks or low-cost no-load stock mutual funds.  You’re going to need the higher long-term returns of the stock market in order to build enough wealth for retirement.

Term insurance conversion trap

The big advantage to term insurance over cash value insurance is low cost.  But what happens if at the end of the term period (twenty years in my example above), you decide you still need the insurance but you are now uninsurable?  Most term policies allow you to ‘convert’ your term policy to a cash value policy with your same insurance company and you don’t have to prove you’re still in good health.  You simply sign a conversion form and you now own a ‘permanent’ cash value policy.  While this sounds simple enough, there are two problems of which you need to be aware:

  1. Conversion to lousy policy. If you’re converting your term policy, the insurance company is guessing that you may be in poor health and therefore a higher risk.  To discourage you, many companies don’t allow you to convert to their best policy…in fact they write a special policy that is very expensive and a lousy deal compared to their other policies.
  2. Conversion option expires before the end of the term insurance period. Most companies allow you to convert for the entire time you own the policy (20 years on a twenty-year term policy, for example).  However, some companies drop the conversion privilege two to three years before the policy ends.  Why?  I can only surmise they hope you’ll ‘forget’ and when you need to convert at the end of the policy, it’ll be too late.

Protect yourself in both of these cases by asking your agent to confirm that you can convert to a competitive policy and that the conversion right extends for the full term of the policy.