Introduction

What are the different types of life insurance policies out there and which one is right for you? I’m Garrett Ray, financial planner here at The Wealth Guardians and the Ray Financial Group. And I’m Brice Payne, and you’ve entered the vault, the Wealth Guardians video series on all things pertaining to retirement planning.

In this episode, we’re going to talk about life insurance. The four main types: term life insurance, whole life insurance, universal, and variable.

Introducing Term Life Insurance

Let’s start off with the simplest and most basic kind: term life insurance. This one has to do with your own passing and what happens with the various types of life insurance out there. It’s the most basic kind, the one most often used, and sometimes people will call it pure life insurance.

Term Life Insurance

How Term Life Insurance Works

This life insurance policy is going to cover you for a very specific period of time. That could be a set number of years. It could be a 20-year policy. So, if you’re 42 and you buy a 20-year policy, it’s going to cover you until age 62. You can also design them to basically expire by a certain age. Let’s say it will cover you up until age 72. So, if you had an unfortunate early passing, you pass away before age 72, then your beneficiaries would inherit the death benefit associated with that policy.

Designing a Term Policy Around Life Events

A lot of times it’s maybe not an age, but an event that happens. A mortgage gets paid off or the kids have graduated college, your income, should you cease to exist and your income ceased to exist, now that need for that income has dissipated or left altogether. We’ve seen clients if they’re young professionals, let’s say they’re in their mid-30s and they have young children, they may design a term life insurance policy that covers up until the youngest child is age 25.

At that point, most young adults are out on their own getting established, and there’s no need for if the parents were to suddenly pass away, a source of funds or a source of income for that likely minor child.

Cash Value and Premiums in Term Life

No cash value to term life insurance. The one thing I will end the term life insurance discussion on is that the death benefit the beneficiary receives is, in almost all cases, a tax-free benefit. And normally, in a term life insurance policy, the premium that you pay is fixed. Whether that’s a monthly payment, a quarterly payment, a semiannual payment, an annual payment, that’s going to remain the same for the term of the policy, and the death benefit is fixed.

So, if you set it at say $100,000 death benefit, it will always remain $100,000 for the term of the policy. And most people might be familiar with term insurance through their employer group term. That’s a common way for you to have access to term insurance at a lesser rate. Credit unions are another way that you could have access to one.

Whole Life Insurance

Coverage for Your Entire Life

Whole life insurance is similar to term life in that it’s going to pay a fixed and known death benefit. Let’s say in this case it’s a $500,000 policy, half a million dollars. But it pays out regardless of the age you pass away. Previously we had an example of, say, 20 years, or age 72, or maybe when the youngest child turns 25. That’s off the table. This is going to cover you for the entirety of your life.

The Trade-Off Between Premium and Coverage

Whether you pass away at age 48 or 88, it’s going to cover you. Because it’s designed to cover the person for the entirety of their life, the premium that you pay is going to be higher than the same amount of death benefit or the same amount of coverage you would get under a term life insurance policy. You can imagine that the insurance company is now taking a bigger risk. It’s almost inevitable that they are going to pay out a death benefit in a whole life policy, whereas the insurance company was calculating they probably weren’t going to pay out a death benefit in a term, so they can charge you a lesser premium there.

So, in this example, the premium is fixed but it might be, let’s say, $70 a month for a term policy, and higher, let’s say $150 a month, for a whole life insurance policy with the same amount of coverage. The other thing you get inside a whole life insurance policy is a certain percentage of the premium you pay each and every month is going to go into another account. It’s called the cash value associated with the policy.

How Cash Value Accrues

That’s going to start at zero, but it accrues with each premium payment that you make. In a pure whole life insurance policy, that cash value is going to grow at a fixed interest rate, let’s say 3 to 4% annually over the course of your life. Once that cash value accrues to a certain amount of money, you’re then allowed to either take a withdrawal of that cash, which is typically a taxable event, or you can borrow against or take a loan against the cash value. If it’s a loan or you’re borrowing against it, that’s typically a tax-free transaction there.

Whole Life as an Estate Planning Tool

These policies tend to be popular for people who, like any other investor, have brokerage accounts, a 401k, and IRAs, but whose goal is that what they leave behind to the next generation, whether that’s their kids or their grandkids, comes mostly from the life insurance policy, that death benefit associated with it, because it’s covering them for the entirety of their lives. What does that do for the investor? It frees them up to use their own IRAs and their own 401ks on their own expenses while they’re still living.

They’re basically building it into their estate plan: “Hey kids, hey grandkids, when I pass away, don’t look for too much in the 401k or the IRA, because I would have spent most of that down. Your inheritance is going to come through the whole life insurance policy, which is often a more efficient way to handle things if your goal is a certain legacy for your kids.” That’s often a more efficient approach than setting aside, say, a million dollars for each kid and never touching it.

That’s because the death benefit is tax-free, whereas if you had a traditional IRA worth a million dollars when you passed away, it becomes an inherited IRA and is subject to RMDs and everything else that comes with that. So it’s a much more tax-efficient legacy and estate planning tool than, say, your 401k or traditional IRA. Now, whole life insurance policies are very similar to the next one we’re going to discuss, universal life insurance policies, but with some key differences.

Universal Life Insurance

Flexibility Compared to Whole Life

Universal life is very similar to whole life. It’s still going to cover you for the entirety of your life. You just have more flexibility within the policy. In whole life, you had a defined death benefit, and the premium you were paying each and every month was fixed. You knew what it was going to be, and in some cases it could even grow on you. In universal life insurance, you have flexibility. The key difference here is that you can adjust the death benefit and adjust the premiums you pay each month as financial circumstances change.

Adjusting Coverage as Circumstances Change

Let’s say you started a universal life policy when you were in your mid-40s with young children. They’re not even adults yet, and you’re paying more during those years. Well, as you get older, say you find yourself in your early 80s with adult children who are out on their own and very successful, you can drop some of the death benefit, which then lowers the premium you have to pay per month. You’re still passing something down, but you’ve realized financial circumstances have changed. Your kids are mostly on their own two feet.

They’re not going to need too much help when you’re gone. So, this allows you to lower the premium you’re paying in your later years, freeing up money that you otherwise would be putting into the life insurance policy for other things: your own medical expenses, perhaps an assisted living facility, or other spending priorities you’d rather put money toward than the policy.

Deciding Whether to Keep Paying Into a Policy

One question that comes up when someone sits down with us is they hand us their most recent statement for some kind of insurance policy they’ve had for a while and ask, “Should I keep making the premium payments on this?” That’s one question to answer, but it’s not always a simple yes or no. It might also be a question of whether we should alter how much we’re paying in.

Often the answer is, “We don’t want to keep paying this much, but let’s pay a lesser amount until X happens,” like the mortgage getting paid off. If someone has a universal life insurance policy with a half million dollar death benefit, we might ask, “Do you believe your children still need that $500,000 if you were to pass, or deserve it?” That happens too. “If you were to pass next week, does that still fit the bill?” For some it may, for others it may not, and that helps answer the question of whether to keep paying into it.

Variable Life Insurance

Introducing Variable Life Insurance

Now we’re going to get to the last one. The first three, term, whole, and universal, all had one thing in common: the benefits were all defined. There was no ambiguity in what you were going to get if you passed away, or what the face value or cash value would be. Then there’s variable life insurance. Whenever we have the word “variable” in any kind of investment, that means something is going to change and it’s not fixed in advance.

How the Cash Value Is Tied to the Market

In most variable life insurance policies, the death benefit is actually fixed. It can change, but for the most part you’re going to know what that death benefit is. The difference is that the amount of accrual in the cash value associated with the policy is tied to investments inside the market, typically mutual funds. It looks a lot like a 401k plan, where you’ve got a list of maybe 10 to 15 mutual funds you can invest in.

Same thing here: the insurance company gives you a select list of mutual funds you can invest in, and those investments are what determine the cash value inside the policy.

Limitations and Fees

There are additional limitations inside a variable life insurance policy. You may be required to keep a minimum balance inside the account, and you’ll likely be charged fees for managing the mutual funds, including the expense ratio. Those fees get deducted from the cash value inside the account.

Growth Potential Versus Market Risk

The issue with variable life insurance is that the cash value generally has greater growth potential than, say, a whole life insurance policy sitting at a fixed interest rate of 3 to 4%, which is nothing spectacular. There’s a lot more growth potential inside variable life insurance on that cash value. The trade-off, of course, is that it’s tied to the market. So if you happen to pass away when the markets are down, that cash value could be down, or you could even have a loss inside that account.

Many variable policies allow the beneficiary to inherit not only the death benefit but also the cash value associated with the policy. If part of your legacy or estate planning involves investments tied up in a variable life insurance policy, and you pass away during a market downturn, the amount you leave behind could be a lot less than you were anticipating.

That’s one of the trade-offs with variable life insurance: greater growth potential, but market risk along with it. That’s what the word “variable” means in the insurance world: potential for more growth, but also some added risk, whereas with term, whole, and universal, you’re taking on no market risk.

Closing

Hopefully in the past 10 minutes or so, we’ve given you a working understanding of the four main types of life insurance out there. There are variations on all of these, but this should give you a solid foundation to start from.