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.