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Life Insurance Q & A

A steely-eyed killer wrote in with some life insurance questions recently.  The answers may be helpful to the crowd, so please read on.

Question(s)

“I’ve recently lost a couple of family members way too early and it got me thinking about it.  I have limited knowledge other than what you can get on the googlewebs.

Standard term vs permanent.  Is there an “optimal” time to get said insurance based on my planned advantageous exit at 70-73 years old (5 generations of data to support)?  What if I outlive that?  The term policy would obviously be sunk cost but…assuming I pay $80 a month I (my family) could presumably have an $800k egg if I nail the window.  How do the tax benefits compare to a traditional retirement account?  I believe the conventional wisdom is to first max those contributions before considering a life insurance policy (for the tax benefits)?”

Answer

Copy Shot and I’m sorry to hear about what your family has gone through.  When I brief the Life Insurance Motherhood, it often sounds about like this:

If adults have people who depend on them for income, then it’s best to have a little too much life insurance, starting a little soon, and kept for a little too long then any of the opposite cases.

Starting a little too soon… Any of us can wake up tomorrow with a medical issue that makes us uninsurable, so if there’s a mathematical or emotional need for insurance, it started yesterday.  It’s time to act before fate does.

The insurance underwriting process is pretty painless.  You’ll fill out some online forms, probably do a phone interview, then give blood and vitals.  Some companies will send a med tech to your home so you don’t even have to roll to an office.

It usually doesn’t make a lot of sense for a single 22-year-old Lieutenant to get an extra $500K of Term Life insurance.  When “I do” approaches, time for a “new picture” call. When the stork is inbound… “new picture” for sure.

A little too much…  There are several methods for calculating how much insurance one needs.  A baseline might look like: enough to cover a paid-off home; all remaining kids’ college expenses; and several years’ worth of spending needs during the survivor’s grieving and adaptation.

For military pilots, there are only three major insurance companies that will write policies that I know of—USAA, Navy Mutual and AAFMAA.  They limit how much they’ll offer based on your rank/income, so most folks I’ve talked to get the max available and update it as they promote, assuming there’s still a need for more.  Updating can look like layering on a new policy or substituting the smaller old policy for a larger new policy.

A million dollars of life insurance may sound absurd when you’re 30.  My dad made $30K a year the first time I remember asking him.  At the time that sounded like an absurd amount of money… #inflation.

For a little too long… Term insurance is “rental insurance.” We generally keep it while we have a need for it, then drop it when we don’t have a need for it.  Put another way, we keep it until we’re self-insured against the catastrophe of an untimely death.

If we’re trying to protect against the need to pay down a mortgage, pay for college, or provide income while grieving and adapting, then as those needs pass into history, the need for insurance does too.

The methodology for becoming self-insured usually looks like growing a nest egg, getting kids through college, and paying off (most of?) the house.

At that point, if the breadwinner passes away, the survivor likely inherits enough from the nest egg to cover the remainder of the mortgage and the grieving and adapting period.  If there is still life insurance it may be gravy, but that’s clearly dependent on the size of the nest egg and the remaining consumption needs.

After 10-20 years of inflation, the death benefit of a policy will have eroded, so it may not be a lot of gravy.  Inflation will have also reduced the impact of monthly premiums on cashflow, so continuing to pay for the policy won’t lighten one’s wallet much.  I often joke that the premiums your 55-year-old self pays on a policy you bought at age 40 are essentially budget dust.

Up to now, I’ve made the assumption we’re only talking about Term Life Insurance.  I pay about $110 ($1,320 per year) for $1.5M of 20-year level Term Life.

Nerd Wallet recently stated that in 2021, average rates for a 30 / 40 / 50-year-old male for $500K of Whole Life Insurance are $4,308 / $6,388 / $9,875 per year. At my age that’s about 7.5x for one third of the coverage.

Most of us have probably heard the adage “buy term, invest the rest.”  The assumption being that a few extra thousand dollars per year productively invested in tax-efficient, low-cost investments will grow larger than both the face value of the Term or Whole policies over the decades.

For example, if a 40-year-old could pay $1,320 per year for a $1.5M 20-Year Term policy or pay $6,388 for a $500K Whole Life policy, and chose the Term policy while investing the difference of $5,068 every year for 20 years at 10%, the investment account would be $324,365.  Over the 20 years, it’s the difference between shelling out $26,400 and $101,360.

Now $324K isn’t $1.5K, so it’s crucial that the family funds retirement savings too, preferably not starting at age 40!

To find out what the Whole Life policy’s cash value would be, you’d have to get a quote from an agent, but I’m confident it wouldn’t be anywhere near $324K… and the buyer would still have several decades before paying it off.

I’ll skip the discussion of trying to use life insurance to either borrow from in retirement or for investing.  Every time I do the math, Whole Life is expensive to buy and maintain.  The only people I’ve ever met that are excited about it, sell it.  There’s good reason.  Commissions on Whole Life are anywhere from 50% to 100% of the first year’s premium.

What’s more, because the premiums on a policy with a meaningful face value in one’s 70’s and beyond are costly, Whole Life policies lapse at rates over 70% after 30 years.  That implies renting a really expensive, under-performing policy, for a really long time, while losing the ability to “invest the rest.”

I will say that there are some corner cases for Whole Life Insurance, but they’re rare and usually apply to those who can’t qualify for (enough) Term, or that own estate-taxable assets but lack the liquidity to pay the taxes.

While I think I targeted most of your questions let’s pull lead pursuit to be sure:

What if I outlive my life insurance?  The best case is that you expect to do so because you invested adequately over the years to be self-insured with elephantiasis of the nest egg.  Your survivor/heirs will use a tiny slice of that to pay for funeral and final costs, then live on the generous remainder.

Some people like to keep a tiny insurance policy around to pay for final costs, even if their assets dwarf their survivor’s needs.  I don’t see harm in that, even if it is mental accounting.  It’s just important to remember that $10K today may cover a funeral.  It likely won’t in 50 years, so it’s best to invest in a way that outpaces inflation.

Are there tax benefits to Life Insurance?  For Term, generally no.  An employer can offer $50K of group Term Life as a de minimis fringe benefit.  The employer can also cost-share a policy with you and that makes a portion of the premium tax-free.

The downside of paying for insurance with pre-tax dollars is that at least part of the benefit is taxable.  The Survivor Benefit Plan has this downside too.

Whole Life policies appear to have tax benefits the same way that the latest diet pill claims to melt fat in just 7 days.  If the cash value in a Whole Life policy grows after sloughing off a generous commission and fees to the company, any growth is not taxed until it’s paid out.  What’s more, the growth would have to exceed the value of the premiums.  The premiums must still be paid with after-tax dollars, so there’s no benefit most of the time.

Most people will let the Whole Life policy lapse, taking the meager cash value and wondering where their taxable premiums went.  If the insured dies, the beneficiaries receive the face value.  Unless expensive riders were added to the policy, the cash value goes to the insurance company.

Should I fund my tax-advantaged retirement accounts first, or life insurance first?  If the budget only has room for one, and the criteria for having life insurance exists (survivors count on your income), then life insurance is probably the more critical budget line item for most families.

Putting that in context however, maxing out IRAs for a couple means saving $12K per year and Term Life insurance would probably give that at worst a $1K to $2K haircut.  Thus, both are a key part of financial security and some level of both should likely be funded.

As income grows over the years, what I tend to see is that family’s can both afford to max-out IRAs and at least one TSP/401(k), but often add some extra Term Life because it’s affordable.  If 30-year-old you took out an extra $500K (on top of SGLI), and 45-year-old you would like to pad the numbers up to age 65, there’s probably plenty of room in the budget.

If I had to make a hard call in a lean year, I would choose the minimum amount of Term Life that my family needs and pause retirement investing temporarily.  I can always get back to retirement investing.  I can’t always be young enough and healthy enough to qualify for inexpensive Term Life.

Cleared to Rejoin

Life insurance isn’t sexy and it’s not an investment.  We don’t gild the lily when we buy Auto or Home insurance.  We buy enough to cover the need.  When the need goes away, we put our money to more productive uses.  Thus, Term Life until self-insured it almost always the best way to cover the need for survivor income.

A little too much, starting a little too soon, kept for a little too long… until self-insured…

Fight’s On!

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