If you were to ask someone who does estate planning and sells life insurance whether permanent or term life insurance is better for you, you’d likely be told that permanent insurance is the way to go. As a general rule of thumb, term life insurance — while it might offer a lower cost because it’s a temporary policy — is not ideal for things like creating a trust or providing for a large estate.
In some very specific cases, term life insurance could be an advisable option, but support is overwhelming for universal life or whole life policies over term policies. In fact, statistics show that about 59% of those who bought life insurance policies in 2019 bought permanent life insurance. Those numbers make sense because most people who use life insurance aren’t simply using it to provide for beneficiaries. They’re using it to provide a legacy, so whole life insurance is the better option.
How Whole Life Insurance Works and Who It’s For
Whole life insurance is called that because it covers you for your whole life, or as long as you continue to make premium payments. Universal life insurance is more flexible and can still cover you for your entire life since you can program the duration using a cost effective life expectancy approach that minimizes cost while providing coverage for your lifetime. Many permanent policies are structured to stay in force until you need them and often will accumulate a cash value over its lifetime. Whole life policies might pay dividends, allow you to borrow against a cash value, and offer tax-deferred growth. Universal life policies usually credit interest based on a predetermined rate or based on the performance of a major index such as the S&P 500. They also offer tax-deferred growth and the ability to borrow.
When we’re looking for estate tax shelters, one of the first funding sources we look to is permanent policies held in trusts. This allows the proceeds to be kept out of your estate when you pass away. That means the funding within the trust can be used to cover legacy projects, pay ongoing income to heirs, or create business continuity, depending on your estate planning goals.
This makes universal or whole life policies best for people who are concerned about providing long-term payments or have a significant amount of assets. If you’re anticipating exceeding the $11.7 million exemption for estate tax, universal or whole life policy is the better choice for you. That doesn’t mean that term life insurance is always a bad idea. While it’s not ideal for large estate planning, there are certain scenarios where term life insurance could be a better option.
How Term Life Insurance Works and Who It’s For
Term life insurance is called “term” because it covers you for a specific period — usually a span of 10, 20, or 30 years. You pay the premium for this set amount of time and the policy provides you with a set level of coverage. When the term ends, you may have the option to renew, but it’s likely your rates will go up. Term life insurance does not have cash accumulation and does not offer any living benefits. You can’t borrow against it because the purpose of the coverage is to pay out its face value.
Putting a term life insurance policy into a trust isn’t usually advisable because there is a chance that the policy could expire before the trust makes any payments at all. You don’t get anything back from the policy when it terminates, so you could pay in for years and never see a return. At the end of a term in term life insurance, your policy has no monetary value.
The main benefit of term life insurance lies in its cost. These policies usually cost a fraction of what a whole life policy costs because they’re limited. If you’re in a situation where you want to keep costs down, then it might be advisable to get a term life insurance policy.
For example, say your divorce decree requires that you keep a life insurance policy with your ex-spouse as the beneficiary. This isn’t as common now as it used to be, but it used to be one of the top reasons people bought term life insurance. Generally, those legal provisions are only required for a set number of years, meaning that coverage for life is unnecessary. Purchasing a term policy to fulfill that legal requirement gives the option to discontinue the policy later on once the requirement lapses.
Term life insurance might also be a good idea if you’re younger and just looking to replace your income in the event that something happens to you. In this case, you should consider something called term life with a conversion privilege.
A conversion privilege allows you to renew your policy into a universal or whole life policy. It doesn’t require an additional medical exam for proof of insurability and you could get a locked-in rate. This makes it ideal for you if you’re using the insurance initially for children, but would like to use it as an estate shelter vehicle as your assets grow. Either way, you’ll also need to be aware of the different tax implications of each of these policies so you will know how they’ll benefit your estate and your heirs.
Tax Implications to Consider in Universal and Whole Life Insurance versus Term Life Insurance
Despite the fact that the policies are pretty different, how they’re taxed is quite similar. In both cases, you can’t write off your premiums paid on your taxes, but your beneficiaries will receive the policy face value without having to pay income tax on it. On both universal and whole life policy, any interest earned may be taxable if withdrawn, unless it is taken as a loan and the policy is not a modified endowment contract.
In addition, all forms of life insurance can be estate tax free as well if properly structured in terms of ownership. That is precisely why regardless of the type of coverage, permanent or term, the proceeds will be considered part of your taxable estate if you’re the named owner. That’s why it’s best to hold policies in a trust if you’re concerned about estate taxes.
In either case, a trust can be used to buy and sell policies on your life to benefit someone else. When choosing between whole life insurance and term life insurance, it is advisable to talk with an expert. Call us at 800-DIE-RICH to connect with an advisor who can help you find the right policy to suit your needs.