An Insurance 101 Series
Welcome to Life Insurance 101. We’re here to make things simple for you. Today, we’ve got David A. Jacobs, J.D., Principal at Acumen Insurance Solutions on camera to discuss the difference between term life insurance and permanent life insurance in a way you can understand.
Let’s dive in.
What is Life Insurance?
Life insurance is a contract between a policy owner and a life insurance company. In this contract, the life insurance company promises to pay a designated beneficiary a death benefit upon the passing of the insured.
Most of the time, that death benefit is paid income tax-free to the beneficiary.
Term Life Insurance vs. Permanent Life Insurance
Interestingly enough, life insurance comes in a couple of different flavors. There are two main categories of life insurance: the first is called “term” life insurance, and the second is known as “permanent” life insurance.
The main difference between permanent and term insurance is that permanent insurance is designed to last for the insured’s lifetime and permanent insurance has a tax-advantaged cash value component.
But more on this later! Let’s discuss each individually.
Term Life Insurance
Term life insurance is exactly what it sounds like. It is life insurance that’s for a period of years; typically 10, 15, 20, or 30 years.
When it comes to term life insurance, there are only two components:
- The premium that’s due either every year, quarter, or month, and
- The death benefit, which is paid when the insurer dies within that term
Generally, premiums are level and the death benefit is guaranteed for that period. At the end of the term, the insurance policy stops, and the benefit is gone.
Lastly, some term life insurance policies have a special benefit that allows you to “convert” the term insurance to a permanent insurance policy without medical underwriting.
This can be a tremendously beneficial feature if the insured experiences a health issue that would prevent them from being able to qualify for new insurance after the term policy ends. These convertible term policies tend to cost more and require more effort to find than traditional term policies, but can be worth it depending on your unique circumstances and desires.
Permanent Life Insurance
The second type of insurance category is permanent insurance. The terms “permanent” and “whole life” insurance are sometimes used interchangeably.
Just as the name implies, permanent life insurance is designed to last for the insured’s lifetime, not just for a period of years. Since it’s designed to last longer, permanent life insurance is more expensive than term.
Permanent life insurance, however, has the benefit of a) lasting longer and b) having a cash value component. The cash value can be accessed for a variety of reasons and grows without tax.*
A Permanent Life Insurance Policy’s Cash Value Component
Let’s discuss more about the cash value component that is unique to permanent life insurance.
The cash value component of a permanent life insurance policy is available to the policy owner while the insured is alive, and grows tax-deferred. This cash value component can be accessed tax-free using either policy loans or a withdrawal of the principal.
This cash value component allows the policy to last as long as the policyholder wants it to. Permanent insurance is similar to a car; the more gas you put in, the longer it will drive. The same thing goes for permanent life insurance: the more premium you put into the policy, the longer the policy will last and the more cash value it will build.
Now, let’s briefly discuss the different types of permanent life insurance.
Types of Permanent Life Insurance
There are a couple of different types of permanent life insurance contracts to note, including:
- Universal life
- Index life
- Whole life
- Variable universal life
The difference between them all is how the cash value (the living benefit account) grows. For example:
- Does it grow based on a dividend? That’s a whole life policy.
- Does it grow based on an interest rate calculation or declaration? That would be a universal life policy.
- Does it follow an index, for example, the S&P 500, but with a “floor” and a “cap” mechanism? That would be an index policy.
- Or, does it involve the market (i.e. mutual fund-like accounts)? That would be a variable universal life policy.
Regardless, all of these policies have the same feature; as long as you continue to pay premiums and cash value remains in the policy, it will last until the death of the insured.
In the meantime, however, the policy owner can reach in and use the cash value for a variety of purposes. For example, it can be used to help pay premiums in certain years, fund education needs, supplement retirement, and/or support healthcare costs, all without triggering tax.
These are all things that the policy owner can use the cash value for while the insured is still alive.
Read on to learn more about the specific permanent life insurance policies available to you.
A Recap on Term Life Insurance vs. Permanent Life Insurance
To review, the differences between term and permanent are:
- Term life insurance lasts for a period of years and has two components: a premium and a death benefit.
- Permanent life insurance lasts as long as you want it to (typically a lifetime) and has three components: a premium, a death benefit, and a cash value.
No matter what type of life insurance you own, however, it is an asset. Moreover, it is an asset class that needs to be reviewed, monitored, and serviced regularly. Why? To make sure that the policy is keeping up with your goals as well as to make sure that the industry and the policy are still performing as anticipated.
Read on to learn about the question, “Can I Change My Life Insurance?”
Important Notes: Please refer to 26 U.S. Code §101(a) regarding tax-fee death benefit and 26 U.S. Code § 7702 (a) (g) regarding tax treatment of cash value. Policy performance is based on current rates as charges, and some values are not guaranteed. Medical and financial underwriting is required. Withdrawals and loans from life insurance policies classified as Modified Endowment Contracts (MEC) may be subject to income tax and a federal tax penalty, if taken prior to age 59½. Excessive policy withdrawals and loans may cause the policy to lapse, which will result in the loss of death benefit and adverse tax consequences. Life insurance is backed by the claims-paying ability of the carrier and is not FDIC insured. See policy illustration for details. Acumen Insurance Solutions, LLC does not provide tax, legal, or investment advice, and is not FINRA registered.