Gone are the days when a life insurance plan was solely about paying benefits to beneficiaries upon the insured’s death.
The presence of a cash value component in permanent life insurance policies has opened a new vista – using insurance policies as a savings or investment tool. A part of the premium is accumulated in an investment account, and the insured can withdraw from this or borrow against it at very low rates. That’s an enticing option, especially in a high interest rate environment.
Whole life insurance (a type of permanent life insurance policy) has even become a part of retirement planning as people look to increase their income in retirement while ensuring that their loved ones get guaranteed death benefits when they pass away. It’s like killing two birds with one stone.
But it’s not for everyone. People looking to secure their children’s future often consider a 529 college savings plan instead of life insurance. This can be a fantastic option as well.
Investment vehicles are nuanced and complex, so I will break it all down for you in easy to understand terms. By the end, you’ll have a great sense of which investment vehicle is right for your circumstances.
What makes whole life insurance a good savings or investment tool?
There are at least six features of a whole life insurance policy that make it appropriate as a savings or investment account:
- Tax-free growth: The cash value component grows tax-free.
- Guaranteed rate of return: If you have a low-risk capacity or tolerance, then the guaranteed rate of return provided by whole life insurance policies will be attractive.
- Tax-free and guaranteed death benefits: In addition to the cash value, beneficiaries will get a guaranteed and tax-free death benefit upon death.
- Tax-free loans: Loans taken against the cash value component are tax-free as long as the policy remains active during the lifetime of the loan and the loan amount is not higher than the cost basis (the total premiums paid; net dividends received).
- Tax-free withdrawals up to cost basis: Similarly, withdrawals are tax-free if the total withdrawal amount does not exceed the cost basis.
When withdrawals exceed the cost basis, they become taxable. However, this still makes sense if you expect to fall into a lower tax bracket once you start making taxable withdrawals. By deferring tax to the time of withdrawal, you can minimize your tax liability.
- Dividend payment: If you opt for a participating policy, you can participate in the profits of the insurer through dividends.
What downsides should you consider when looking at a whole life plan?
Nevertheless, there are certain cons to using whole life insurance as a savings or investment tool:
- Low growth rate: If you have more risk tolerance, the low but guaranteed rate of return on whole life insurance may not appeal to you.
- Surrender Charges: Many whole life insurance policies may assess a surrender fee on withdrawals from the policy either partially or entirely. While surrender fees vary from one insurance company to another, it is important to carefully review both the length of the surrender period and the surrender fees.
- Expensive premiums: Whole life insurance premiums are usually expensive compared to term life insurance, for example. Interestingly, if you subtract the premium of the term life insurance from that of the whole life insurance and invest the rest in an independent investment vehicle (one that buys stocks, mutual funds, ETFs, etc.), you are likely to have a bigger investment account than the cash value component of a whole life insurance.
- Cash value does not start growing immediately: In the early years of the policy, the greater part of the premiums will go towards administration costs, fees, and other commissions. The cash value part may not start growing significantly until the tenth year or further.
How whole life insurance compares to a 529 plan for savings
To better understand the pros and cons of whole life insurance, let’s compare it with another savings plan – the 529 plan.
There are four key differences between them:
- Control: The owner can select the investment options available within the specific 529 plan while the insurer oversees those decisions in whole life insurance.
- Usage: While tax-free withdrawals can be made from a whole life insurance for any purpose, only qualified withdrawals (for college tuition, K-12 education, student loan repayments, and apprenticeships) are tax-free under a 529 plan. Non-qualified withdrawals are taxed and penalized (10% of earnings).
- Tax benefits: Qualified withdrawals from a 529 plan are tax-free. Withdrawals from a whole life insurance are tax-free, provided they do not exceed the cost basis.
Also, additional tax benefits, such as deductions or credits on contributions, may be available with a 529 plan (depending on the state).
- Risk/return profile: A 529 plan can provide more returns since there is freedom to invest in mutual funds; age-based portfolios, and ETFs of your choice. However, with a potential higher return comes higher risk.
On the other hand, whole life insurance’s lower returns are compensated for with a guaranteed rate of return.
Here is a quick chart to help you more easily spot the differences:
| Factor | Whole Life Insurance | 529 Plan |
|---|---|---|
| Control of Investments | Insurer manages investments; policy owner has no say. | Account owner selects from the plan’s menus of mutual funds or age-based portfolios. |
| Use of Withdrawals | Tax-free withdrawals (up to basis) can be used for anything; loans are also tax-free if managed properly. | Tax-free only for qualified education expenses (tuition, K-12, student-loan repayment, apprenticeships). Non-qualified withdrawals incur income tax and a 10 % penalty on earnings. |
| Tax Breaks on Contributions | None at the federal level. | Many states offer deductions or credits for contributions. |
| Risk/Return Profile | Lower guaranteed returns; minimal volatility. | Potential for higher returns (and higher risk) via stock and bond funds. |
Given the differences we have outlined, the following are useful guidelines if you need to choose between whole life insurance and a 529 plan:
Control
A 529 plan may be more appropriate if you value more control, choice, and flexibility with investment options.
Risk tolerance
Whole life insurance is a better option if your risk tolerance and capacity are low.
However, a 529 plan may be more appropriate for individuals with a higher risk tolerance.
Investment Options
For a portfolio heavily skewed towards high-risk assets, whole life insurance can help reduce risk, while a portfolio skewed towards low-risk assets can benefit from the higher-return assets available through a 529 plan.
Purpose
If you want to use your withdrawals for a wide range of purposes, a whole life insurance policy may be appropriate as long as you have not exceeded your cost basis.
Though you can make non-qualified withdrawals from a 529 plan, the tax and penalty implications may make such withdrawals imprudent. The only exception is if the extra returns you generate on the plan (compared to a whole life insurance policy) exceed the tax and penalty you will pay for non-qualified withdrawals.
Making An Individual Choice
In the end, choosing whether to use either of these two options (or none of them) is a personal decision. Consult with a financial advisor (CFP® professional) for more personalized advice. And keep in mind that you’re already ahead of the game by even considering these savings vehicles – nice work!
