(LifeWire) - By investing in life insurance, almost anyone can transfer the financial risks of dying early, guaranteeing a payout for family members who might otherwise be left in economic turmoil. Today's life insurance policies, however, often come with features borrowed from the investment world, blending traditional insurance with attributes of a mutual fund account.
Vehicles for Investing in Life Insurance
Those who haven't purchased a policy may be familiar only with "term" life insurance, which covers the owner for a set period of time, say, until their child graduates from college. If the owner lives past that date, the plan expires and is worthless.
But some life insurance policies are "cash value," which means the fees, or premium, initially are greater at the start of the policy than they would be in a term policy. The excess premium is then invested in a "separate account," either by the insurer or in an account controlled by the policy holder, building up cash value. Any investment gains can be used in a few ways: to increase the death benefit, to borrow against for any use or to keep the policy in effect if you stop paying monthly premiums. Policies that offer this investment feature come with significantly more complex terms, and are offered by salespeople who may earn a significant commission off your initial premium.
In variable life insurance policies, the cash value and benefits may actually decrease or go away completely depending upon the performance of your investments. The National Association of Insurance Commissioners website offers a downloadable consumer guide to life insurance policies that urges prospective buyers of variable life policies to obtain a prospectus from the company and to read it carefully.
Tax Benefits of Investing in Life Insurance
Tax benefits are chief among the advantages of a variable universal life insurance policy. Each year's earnings on the investment portion of the policy are not taxed, and the taxable gains on policies that are later cashed out can be reduced by the amount of insurance protection the plan provided. And if the policy holder dies, the gains are not usually taxed.
Similar tax benefits are also offered through pure investment accounts, such as 401k plans, IRAs and Roth IRAs; some financial advisers recommend that these choices be funded to the maximum amount before an investment-oriented insurance policy is considered.
In addition, insurance policies may offer a wide variety of investment options, including stocks, bonds, balanced mutual funds, international mutual funds and money market accounts. Investments may also be tied to a major stock market index, like the Standard & Poor's 500. These are often similar to what might be found in a retirement investment account.
Flexibility of Investing in Life Insurance
The death benefit on a variable universal plan may be increased with a lump-sum payment, or borrowed against in the event of a pressing financial need like a medical emergency. The ability to skip payments is also considered an advantage. In addition, the investment account may be shifted to more conservative or aggressive options.
Fees and Complexity of Life Insurance
Critics of variable universal life insurance plans say that the tax benefits are outweighed by a variety of fees that eat away at returns. These fees may be misunderstood by the policy holder, disclosed in long prospectus documents but glossed over in sales pitches. These policies may charge a fee, often 4% to 6%, on each deposit; annual contract fees; administrative charges on the account, and expenses on the investment options themselves. Many of these plans come with "surrender" charges of $10,000 or more in the event the policy is cashed out before a certain number of years. While other investment accounts come with a variety of fees, critics of life insurance policies say the true cost of the plans are difficult for many buyers to comprehend.
Tips for Investing in Life Insurance
If you decide that a variable universal life insurance policy offers appropriate benefits, you might consider purchasing a plan directly from the insurer and skipping the salesperson. These include Ameritas, USAA life and TIAA-CREF. Though you won't be enriching a salesperson, there are still sales costs that should be explained by the company's agent. Here are some other tips:
- Consider funding your other tax-advantaged retirement accounts before opening a variable universal life insurance policy. Term life insurance, however, continues to provide a unique benefit.
- Holding a cash value insurance plan until death or retirement increases the likelihood that the plan will be an appropriate investment.
- Dodge big fees, commissions, and surrender charges by investigating "low-load" insurers.
- Read the prospectus, which explains the benefits and risks in relatively plain language, without the spin of a sales pitch.