What Kind Should You Buy?

Life insurance companies are brilliant at devising new kinds of policies. But try to remember that whatever the name on the policy -- universal life, variable life, Irresistible Life, Irreplaceable Life, The Champion, The Solution -- all are in fact variations on the two basic kinds of coverage: term insurance and whole-life insurance (also called cash value or permanent).

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The case for term insurance

The fundamental purpose of life insurance is to provide dependents with the financial support they would lose if you died. If you're straining to buy enough insurance to accomplish that goal, then term is what you should buy. Dollar for dollar, term gives you the most protection for your money. Period.

Beyond that important truth, the arguments for term are the arguments against whole life. True, the cash value in a whole-life policy could add to your financial resources as the years pass, you can't get your hands on the cash unless you surrender the policy(thereby terminating your coverage) or borrow some of it. Borrowing keeps the policy in force, but any unpaid loan balance will be deducted from the face amount if you die. To restore the full face amount of the policy, you'll have to repay the loan, plus interest.

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How expensive are these loans? Some companies charge variable rates so that the interest they collect reflects the current market. Others reduce dividends to reflect the amount of the cash value encumbered by the policyholder's loan, an approach called direct recognition. Under direct recognition, in effect, the more you borrow the less your policy earns. Either of these approaches can make policy loans more expensive than they appear. In any case, you can leave your options open by starting with a term policy that you can convert to whole-life coverage.

The case for whole life

One of the strongest arguments for whole life is that the cash value in the policy builds up tax free, which substantially boosts the compounding power of your earnings. If you have maxed out on 401(k) plans, individual retirement accounts, and other tax-sheltered savings and investment plans, then cash-value insurance provides another option. It's entirely possible that a $250,000 policy bought at age 35 could accumulate a cash surrender value of $100,000 by the time you reach age 65 -- a nice addition to your retirement nest egg if you decide you don't need the insurance anymore.

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Meanwhile, you can turn in your policy any time after the first several years and collect the cash value, no questions asked. The proceeds are tax free to the extent that the cash value doesn't exceed the premiums you've paid. Or you can borrow against the cash value and leave the policy in force, with no requirement that you pay the money back (although you will owe interest on the loan, and if you die with a loan outstanding, it will be deducted from the face amount paid to your beneficiaries). It's safe to say that cash-value life insurance has financed many a college education, even though there may have been better ways to do it.