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What is Term Life Insurance and is it the Right Choice?

Should You, "Buy Term and Invest the Difference"?

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Term insurance has always been the least expensive form of life insurance a person could buy. Furthermore, many people are tantalized by the promise of extremely high face amounts—sometimes hundreds of thousands of dollars for less than $100 per month, depending on a person’s age, health underwriting, and desired riders. Term is inexpensive because you pay only the cost of insurance plus an annual policy maintenance fee, but it is not the best product in every situation.

It’s important to realize that term insurance is exactly what it sounds like—insurance with a time limitation on it. The company is betting that you won't die within the time period, so even though the entire face value is at risk (at least for the first few years), the entire premium will ultimately be profit for them. They also know that while you could convert the policy later in life, doing so will be very expensive, and you probably won’t do so. Instead you will buy a smaller amount of insurance on a new policy or will simply do without, assuming your heirs will use your retirement for any final expenses.  While the policy is indeed inexpensive, it is nearly always pure profit for the company as people rarely die during the initial term.

What’s wrong with Term Life Insurance?
Actually, there’s nothing wrong with purchasing Term Life, as long as it’s a product that meets your needs. If you need insurance for a limited time period and are not interested in the advantages of building cash value and being able to borrow against the policy in an emergency, a term policy may indeed be right for you. Most young families cannot afford the higher premiums of a whole life or universal that would be sufficient to provide for the family if the primary wage earner should die; thus, if what you need is 250,000 to 500,000 or more, term is probably what you should purchase. What you should always do, however, is purchase it from a company that will allow you to gradually convert the term to either whole life or universal. That way you won’t find your self at the edge of retirement and without life insurance that you can afford.  

The original premise of term life?
Term Life was originally sold by banks as a way to protect a person with a high mortgage and insure that the bank would be paid if the mortgagee died. When it initially became available as publicly offered life insurance, companies sold it with the motto, “Buy term, invest the difference.” A few companies are still touting that logic, and it actually would make sense—at least to a certain extent—if the policy owner really did invest the difference between term and whole life. Unfortunately, most people purchase a less expensive product because they need the “difference” for other expenses, not because they intend to put it into a savings account of some sort.  

There is another, more critical error in the philosophy of “investing the difference.” Where would an individual put that money? The logical place to put it is into some sort of retirement account such as a Roth or an IRA. However, there are government limitations on the amount of money per year that can be put into such accounts, and if a person has a pension or 401K plan with an employer, it may be impossible to put money—pre-tax—into a privately managed account. If the savings is put into a taxable savings account, CD, or mutual fund, the gain will have to be reported as tax each year. Initially, the amount reported on a 1099 form will seem minimal, but due to the power of compounding, the tax liability as time goes on could increase a person’s income tax rate and effectively reduce the interest gained on the savings. The savings would have been much more fully realized (and untaxed) if the same individual had invested in a universal policy in the first place.

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