Previous Post: Buying Life Insurance
Why We Switched to Term Life Insurance
In a previous post, I mentioned that my wife and I had recently cashed in our variable adjustable life (VAL) policies and replaced them with term life insurance policies . I’d like to take you through my thought process for deciding to take this step.
Term or Universal/Variable/Whole?
When I first started my journey to learning about personal finances, most of the books and advice I read suggested purchasing term life insurance policies and not to combine your investing and life insurance. The main reason were the onerous costs and fees typically associated with the universal policies that tend to eat into your investment results (can I just refer to universal/variable/whole/etc as "universal?" – it’s a real pain to write them all out). I also have a friend who is a financial planner and he told me that he has never recommended a universal policy for one of his clients.
The fees really are pretty crazy on these policies. For instance, during the first year almost 100% of your premiums go toward…well, I don’t know where it goes but I do know that it does not go into your investing account. After putting around $5000 into the account during the first year, I remember having a few hundred dollars in cash value! During the last few months that I owned the policy, I reduced the premium amount to $50 and that sounds like a pretty good deal. But after riders and fees, less than half of that actually made it into the investing portion of my policy. You might say, not too bad – only $30 per month for insurance? Well, sorta, this did not actually cover the cost of the coverage – each month they would take money from the cash value to fund the difference. And these policies are terribly complicated: it took me more than a few phone calls to figure out where all the money was going. At one point, the agent did not even know what some of the fees were – he had to check with the home office and call me back.
Do universal policies ever make sense?
To be fair, In limited situations and for specific purposes, it might make sense to use a universal policy. The situation of which I am speaking applies to high-income earners who have maxed out their tax-advantaged investment options and still have more money to invest. Universal policies are typically tax-deferred and present another opportunity for avoiding the tax bite. Also, your universal policy usually affords some liability protection compared to a standard taxable investing account. If this applies to you, it might work for you to over-fund a universal policy to take advantage of liability protection and tax-advantaged growth. I certainly would not recommend doing what we did though – putting less into 401k accounts and Roth IRAs so we could fund an expensive life insurance policy.
Our experience with VAL
In 2001, my wife and I both purchased VAL policies on the advice of our financial planner at the time. We owned these policies until 2007. Of course, the investments started out rough during the early 2000’s but for the past few years, a pretty good bull market had been raging. My wife paid the minimum amount in premiums while I overpaid to build up extra investing equity.
So the result when we investigated how much they worth if we cashed them in? Well, let’s look at the bright side – at least I wouldn’t have to pay any taxes on the money. That’s right, the cash value amount after six years of funding the policies, even through a bull market, was less than I had paid in premiums. So, that pretty much sealed the deal for us. Unfortunately, that left me with the nagging feeling that if we had purchased much less expensive term policies and invested the difference in a Roth IRA we would be a lot better off now (my wife has repeatedly urged me not to dwell on this).
So we decided to investigate term policies
Previously, I discussed the process that we used to investigate and purchase term life insurance policies . Well, we followed that process and ended up with much more insurance with guaranteed premiums for 20 years at a much lower cost (basically I now pay yearly for 2x the coverage what I used to pay for 2 months).
Do something constructive with the extra money
If you replace a universal policy, you may have a chunk of cash when you cancel your policy and you will probably have a monthly savings as a result of paying lower premiums. Don’t just squander this money. Even if the fees are high on the universal policy, it does act as forced savings. You would have been better off keeping the universal policy than just blowing the premium savings each month.
Personally, we used the cash value of our old policies to pay down some of our student loans. Then we used the monthly savings to accelerate the remaining loan. These two factors were actually a big part of us finally getting out of debt except for the mortgage .
Do not cancel your current policy before the replacement is in effect
That’s the most important item to remember when replacing life insurance. In my next post I will expound on the topics that should be considered when deciding whether or not to replace a life insurance policy – please check back. This one is so important, however, that I have to point it out here and now. Let me repeat: even if your policy is super expensive, do not cancel it until your new policy is fully in effect.
Parting questions…
Has anyone else switched from universal to term? Were you able to be good about using the monthly savings constructively? Has anyone gone the other way? I would be very interested to hear the reasons for that switch.
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