Life Insurance. Completely necessary for most people, and (in many cases), completely confusing. Why? Because there are just so many products out there, with more created every day. The good news? Whole life, term life, variable life, universal life, and the dozens of variations of each – can be whittled down to just two basic types: Term and Permanent.
In this article (Part I), we are going to discuss the difference between term and permanent life insurance. In Part II, we will discuss where each is most appropriate.
Term Life Insurance – What Is It?
If you have ever had trouble sleeping and turned on the television late at night, you may have seen an infomercial where an actor pretending to be a father of four discusses the benefits of term life insurance. These commercials are made for term life insurance, as this is by far the easiest insurance type to understand.
But before we get there, we need to explain the basics to understand the basics – the components of life insurance. A life insurance policy, at its most rudimentary level, has five main components – the owner, the insured, the beneficiary, the death benefit and the premium.
- Owner: The individual who is purchasing the policy.
- Insured: The individual whose life is being insured (i.e., the individual who must die before the policy pays out) NOTE: the owner/insured are in many cases the same person.
- Beneficiary: The individual(s) who receives the monetary payout if the Insured
- Death Benefit: The sum of money that is paid out if and when the Insured
- Premium: The money paid by the owner to the life insurance company to keep the policy in force – typically an annual amount.
Now that we have the basics down, we can discuss how term life insurance works. The chief characteristic of this type of life insurance is right in its name — the term length of the policy. This length represents the amount of time the policy will provide the stated life insurance death benefit protection to the beneficiary. There are a variety of term lengths – from staying in effect to a specific age of the insured (e.g. pay to age 70) to a specific number of years (typically 10, 15, 20, and 30 years).
Note that term life insurance is a one-sided contract. In other words, you can drop the policy by simply not paying the premium whenever you desire – thus you are not “locked in” to the policy for the entire length of the term. However, if you do decide to drop the policy, you lose the coverage.
Most term life products are also known as “level,” meaning that the premium will stay the same each year for the length of the term. After the term ends, the policy typically becomes what is known as “annual renewable term,” which means that the policy will become renewable every year thereafter at a new, higher premium. In most cases, this higher premium can be substantially higher than the original level premium (and will continue to get higher as the insured ages).
In most cases, given the dramatically higher premium when the term ends, most people will simply drop the insurance (unless the insured is very sick, i.e. terminal, in which case you may want to pay the higher premium). If you drop the policy, in most cases there is not a return of premium – meaning not only will your beneficiary not receive the death benefit, you will not receive a dime of the premiums you have paid in over the years. In this regard, you are essentially “renting” insurance, no different than your car or house insurance. However, since you are only purchasing protection for a certain time period (the term length), this is the cheaper alternative when compared against permanent insurance.
Permanent Life Insurance – What Is It?
Discussing permanent life insurance opens a Pandora’s Box, one which we should avoid in this article (otherwise this may end up being a novel instead!). Thus, we are going to discuss the two main types on a very high level and jump into the details at another time.
From a very basic level, permanent insurance is, well permanent. Its main goal is to provide a beneficiary a death benefit, which they know will be there in the future, with the hope that so long as you pay the premium, the insurance will be there (which, unfortunately, is not always the case with all policies).
A main difference between permanent life insurance and term is the ability for permanent insurance to accumulate what is known as “cash value” over the life of the policy. When you pay the premium on a permanent life insurance product, a part of the premium goes to the “cost of insurance” – this pays for the life insurance component. The remaining portion of the premium goes to the cash value. As you continue to pay the premium, your cash value will grow over the life of the policy.
This is where the differences come in between the different types of permanent products. For instance, on a whole life permanent policy, the growth of cash value is guaranteed, based on the life insurance company’s predetermined growth rate. Universal/Variable permanent policies grow based on outside forces – current interest rates, the market, etc.
What can you do with this cash value? First, if you were to surrender the policy, you receive the cash value, less any surrender charges – or the “penalty” for stopping the policy before a certain period of time, known as the surrender period. If you surrender the policy and take the cash value, your heirs will receive nothing – you do not get both. If you surrender your policy, there could potentially be a gain on the policy, which could lead to Uncle Sam knocking. The gain on the surrender of a cash value policy is generally the difference between the gross cash value paid out and your basis in the policy – the total premiums paid (less a few other components, including tax-free withdrawals, which we will discuss now).
Secondly, you could also (potentially) withdraw a limited amount of cash from the policy as well. When you decide to withdraw money from a policy’s cash value, it is considered a partial surrender of the cash value – there is no putting the toothpaste back in the tube. This withdrawal will result in a reduction of the policy’s death benefit that would be paid out as well. Whether you will owe any taxes or not will depend: Any amounts up to your basis withdrawn will be non-taxable; any withdrawals that exceed your basis, meaning you are dipping into gains, will be taxed at your ordinary income rate. It is also important to note that your death benefit will be reduced based on the amount you withdraw.
Thirdly, instead of withdrawing cash from the policy, you could simply borrow against the cash value. Each policy is different – some policies have an interest rate that is static, while others have a variable rate that may change over time. The difference when you borrow against your policy versus making a withdrawal is that you are not necessarily reducing the cash value in the policy. Instead, your policy’s cash value will instead be held as collateral for the loan, subject to you paying the money back. If you do not pay the cash value back to the policy prior to the insured’s death, the death benefit will be reduced by the outstanding loan, just as it would be had you made a withdrawal (did you get all of that? It is a mouthful).
We hope that the above was helpful in providing the differences from a high level between term and permanent insurance. In Part II, we will discuss the situations where it makes the most sense to use each type of product. Please do reach out to us if you have any questions!
Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors.
Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors.
Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. You may want to consult a legal or tax advisor regarding any legal or tax information as it relates to your personal circumstances.
*Licensed but not practicing on behalf of Lincoln Financial Advisors.