Saturday, April 28, 2007

Myths about cash value life insurance

Here are some of the things I hear when an agent is trying to sell whole life, universal life, or variable life insurance. If you want the real truth about your life insurance, read the policy. The facts may surprise you.

Myth 1: "In a few years, your life insurance will be paid up."
Fact: Unless you choose a payment option where it says in your life policy will be paid up on this certain time, your life insurance is never paid up. There is nothing free in this world. If your life insurance will be paid up in 10 or 20 years, that means you paying lots of premiums now to increase the growth of the cash value. That way in 10 to 20 years, there will be enough cash value to pay the standard premiums for the rest of your life without affecting the face amount of the policy. You want to be careful when someone is trying to sell you a limited pay life policy such as 20-pay whole life or Life Paid Up at age 60. They may say that you only need to pay for a limited time and it builds a large savings. Life insurance is to protect your family's income when you die, not as a way to build savings for your retirement.

In most cases, you are paying the premiums until age 98 or 100 because most people can't afford the limited pay option. If for some reason you can't pay your premiums in the future, the cash value will be used to pay it. The death benefit will be reduced each time you missed your premiums and each time you take a loan out of your policy.

To find out when your life insurance is paid up, check your policy. Usually on the first page it will state when its paid up. Don't believe what your insurance agent say since his/her primary goal is to make you buy it by making the life insurance look really good.

Myth 2: "Your life policy will pay dividends."
Fact: Dividends are not guaranteed. If the life insurance company pays you a dividend, that is because you have overpaid your premiums. So they refund the excess amount back to you as a dividend.

Myth 3: "Life insurance is a great way to build tax-deferred savings" or "It is a great investment."
Fact: Life insurance is the worst way to build tax-deferred savings because you may lose it all when you die. Unless it says in the policy your family will get both, the insurance company will keep all the cash value upon your death. In any case, whether your beneficiary gets cash value or not when you die, they are still the worst way to build tax-deferred savings. In the United States, there are various ways to build tax-deferred savings such as 401(k), 403(b), annuities, and all types of IRAs and all these plans can achieve a higher rate of return than investments in a life insurance policy.

Why is it good to keep investments or savings separate from life insurance? One advantage is that you don't pay surrender charges when you close your account. Second advantage is that you pay lower operating expenses. Mutual funds and life insurance have their own individual operating expenses. If you put them together, you are paying bunch of expenses that eats away the returns on your savings. Third advantage is that you own the money and have complete control on your savings. In life insurance, if you want to take money out, you have to borrow it and you have no control on where you want to save your money.

Myth 4: "You can use the cash value to pay for your kid's education."
Fact: You have to take a loan out of the cash value to pay for anything you want. By borrowing the cash value, you will lower the death benefit and the cash value until you pay it back. If there is a loan interest, this too will lower the death benefit and the cash value. In many retirement plans, especially IRAs, you can use the money to pay for higher education and never have to pay it back.

If you surrender the policy and didn't pay the loan back, the IRS will recognize that you have earned income and you will pay income taxes on the loan. If you paid the loan off or did not take any loans out of the cash value, you will not owe any income taxes. Unless the amount of cash value in the policy is greater than the total premiums you paid in, then you will pay income taxes on the gains. For example, if you paid a total of $50,000 in premiums and the cash value (after surrender charges) is $60,000, you will owe income tax on the $10,000.

Myth 5: "You own the cash value."
Fact: If you truly own it, then why the policy says that you can borrow it versus withdrawing it anytime? Why are there surrender charges? Why can't you only pay for the insurance and not the cash value? If you had a savings account, is there surrender fees? Do you have to put the money back when you take it out?

So the cash value doesn't belong to you. It belongs to the insurance company until you surrender the policy. Its like you giving $10,000 to the insurance company, they hold on to it and give you 4% interest on it. If you ever want to use it, you can borrow it and pay them a 8% loan interest on it. Oh, if you want to cancel the policy, they will charge you couple thousand dollars on the cash value for leaving them.

Friday, April 13, 2007

Money markets

Before I go on, there is two types of money markets you should know. One is called money markets accounts and the other is called money market fund.

What is a money market account? A money market account is a type of savings account offered by banks and credit unions. Usually, money markets have higher interest than regular savings accounts and may also have higher minimum balance requirement. Money market accounts only allow 3-6 withdrawals per month and only up to 3 check writings. All money market accounts are FDIC insured, meaning if anything shall happen to your bank, the government will insure your account up to $100,000.

Like many other bank accounts, your bank may charge you fees such as minimum balance requirement and excess withdrawals fee. There may also be a service charge. You should look around to find a bank that has the lowest fees and the best interest rate.

What is a money market fund? Money market funds are mutual funds that invest in short-term securities such as US Treasury Bills, short-term commercial papers, and CD's. They are offered by financial institutions and investment companies, and some banks. Anytime you see the word "invest" or "investment," you should know that there is no guarantee that your investments will earn money. But money market funds are very low risk mutual funds. The money manager will try to keep the price per share at $1/share. Even though its very rare that you may lose money in money market funds, you should know that the price per share may fall below $1/share. Because they are safe investments, money market funds may not be able to keep up with inflation.

The plus side of having a money market fund is that it pays you dividends almost every month. Dividends are earnings that a mutual fund makes and the mutual fund shares this earning to its shareholders in a form of a dividend. Your money market fund may also earn a higher return than a money market account because money market funds has risks (higher risks = higher rewards), while money market accounts has no risks. Money market funds are not FDIC insured because they are investments.

Similar to money market accounts, money market funds are easily liquidable, meaning you can withdraw money from it and you will get the proceeds in a few days (at most 7 days). Before investing into money market funds, you should obtain the fund's prospectus to find out its fees and expenses. A fund with high annual expenses are never good because it takes away your annual returns.

To sum this up, here is the difference between a money market account (MMA) and a money market fund (MMF):
1) MMA are FDIC insured, while MMF are not.
2) MMA may have bank fees, while MMF have annual operating expenses.
3) MMA pay monthly interest, but MMF may pay monthly dividends.
4) MMA are fixed rate accounts, but can be changed at anytime by the bank. MMF are variable rate accounts because they are base on how the market is doing.

Which one should you pick? Its really up to you, if you want guarantees and want no risks, then pick money market accounts. If you want higher returns and willing to accept some risks, then choose a money market fund.

Sunday, April 01, 2007

Theory of Decreasing Responsibility

This theory further reinforces my point that term insurance and investing the difference makes more sense than having any type of cash value life policy.

  • You may have kids
  • Have a mortgage to pay off
  • You probably have lots of debt (credit cards, student loans, car loans, etc) you need lots of income protection, but you don't have much money saved.

  • Your kids grow up and probably move out of the house
  • Your mortgage should be paid off
  • You shouldn't have too much debt to pay (hopefully all your loans are paid off and you have taken control of your credit card spending) you probably don't need much income protection or any life insurance, but you better have money!

When you are young, you may have young children to support, a new mortgage payment, and many other obligations. But you haven't had the time to accumulate much money to retire on. This is the time when the death of the breadwinner could be devastating and when you need coverage the most.

When you are older, you usually have fewer dependents and fewer financial responsibilities. Your kids grow up, the mortgage is paid up or almost paid off, and many routine payments such as loans have disappeared. As a retiree, you no longer need to protect your income for future obligations. Plus, you've had years to accumulate wealth through savings and investments. At this point, your need for life insurance has reduced dramatically and you have cash to see you through your retirement years.

What it all comes down to is that most people want to accumulate money for a secure retirement and life insurance is simply a way to protect your family until then. Of course, individual circumstances may dictate special needs.