Estate planning is a critical aspect of ensuring a smooth transfer of wealth and assets to your beneficiaries. While comparing permanent life insurance policies with investing in the stock market, it is essential to consider the unique features of each option and how they impact your overall estate planning strategy.
In this comprehensive article, we will examine the rate of return, tax implications, and other factors that differentiate permanent life insurance policies from stock market investments from an estate planning perspective.
Permanent Life Insurance
Permanent life insurance is a category of life insurance policies that provide coverage for the insured’s entire life and often include a cash value component that can be used as a long-term investment. Whole life and universal life insurance are examples of permanent life insurance policies. However, from a purely financial returns perspective, permanent life insurance is generally a poor investment choice, with some exceptions for those who are highly risk-averse.
- Rate of return: Permanent life insurance policies offer a stable but relatively low rate of return compared to other investment options. The cash value typically grows at a guaranteed minimum rate or is tied to the performance of the underlying investments. Although insurers may declare higher dividends or interest rates based on their investment performance, this is not guaranteed. As such, the modest returns of permanent life insurance policies are usually not sufficient to justify their high premiums and fees.
- Tax advantages: Permanent life insurance policies provide certain tax benefits, such as tax-deferred growth of the cash value and tax-free death benefits for beneficiaries. However, these tax advantages may not be significant enough to outweigh the lower returns and higher costs of permanent life insurance policies compared to other investment options. In addition, the tax treatment of the cash value is usually treated as ordinary income, which is a vastly inferior tax rate compared to long term capital gains or a Roth account.
- Liquidity: Permanent life insurance policies allow policyholders to borrow against the cash value, providing a source of liquidity in times of need. However, loans will accrue interest, and unpaid loans will reduce the death benefit. This relatively low liquidity of permanent life insurance policies may be a disadvantage for some investors, especially when considering the surrender charges that can apply if the policy is terminated early.
- Estate planning considerations: From an estate planning perspective, permanent life insurance policies can provide a guaranteed death benefit that can be used to cover estate taxes, support heirs, or fund charitable bequests. Additionally, policyholders can establish an irrevocable life insurance trust (ILIT) to help minimize estate taxes and leave the death benefit in further trust to ensure it is used according to their wishes. However, I would caution that the high costs and lower returns of permanent life insurance policies may not make them the most efficient choice for estate planning purposes. It is best to consult with an estate planning attorney familiar with financial planning and taxation in order to determine your best course of action.
Compared to Investing in the Stock Market
Investing in the stock market entails purchasing shares of individual companies, exchange-traded funds (ETFs), or mutual funds with the goal of capital appreciation and/or income generation.
- Rate of return: Historically, the stock market has generated higher average returns compared to permanent life insurance policies. For example, the S&P 500 has provided an average annual return of around 10% since its inception. However, these returns are not guaranteed and can be volatile, with periods of significant gains and losses. If you wish to capture these returns, invest in low-cost, diversified index investing as a more efficient way to achieve long-term growth compared to permanent life insurance policies.
- Tax implications: Capital gains and dividends from stock market investments are generally subject to taxes. However, investors can mitigate tax liability by utilizing tax-advantaged accounts, such as IRAs or 401(k) plans. In the context of estate planning the tax implications of stock market investments can impact the overall tax burden. However, proper planning and the use of Roth accounts can help minimize the tax burden for beneficiaries.
- Liquidity: Stock market investments are typically more liquid than permanent life insurance policies, as they can be bought and sold with relative ease. Contrast this with permanent insurance which requires a loan or a cash out in order to access the funds. Since life insurance death benefits are transferred in the form of cash and stocks receive a step up in basis or are easily liquidated within a tax advantaged account, neither has any benefits relative to the other with regards to estate planning.
- Estate planning considerations: Both vehicles offer some estate planning advantages and disadvantages. Stock market investments offer higher average returns over the long run compared to life insurance, but if you die before your time, life insurance is the better play. With regards to lifetime gifting, only stocks allow the grantor to easily do so. However, some people are extremely concerned about having a certain dollar amount to pay bills or buy out partners or any other reason. The ultimate choice relies upon a host of factors and is a highly individualized decision.
Incorporating Diversification and Life Insurance into Your Estate Plan
When it comes to estate planning, diversification is key. Many financial planners argue for a well-diversified investment portfolio that includes a mix of low-cost, broad-market index funds, bonds, and other assets. While permanent life insurance policies may not be the most efficient investment choice for many individuals, they can still have a place in a diversified portfolio for those who are highly risk-averse or have specific estate planning needs that can be met through life insurance.
- Utilize life insurance for specific estate planning needs: For individuals who require a guaranteed death benefit to cover estate taxes, provide financial support to heirs, or fund charitable bequests, permanent life insurance policies may be a suitable option. However, do consider the high costs and lower returns of these policies compared to other investment options before making a decision.
- For those who choose to incorporate permanent life insurance into their estate plan, an irrevocable life insurance trust can help minimize estate taxes and provide more control over how the death benefit is used.
- Diversify your investment portfolio: creating a well-diversified investment portfolio that includes stock market investments, bonds, and other assets will provide a balance of growth, income, and stability. For risk-averse investors who choose to include permanent life insurance policies in their portfolio, proper diversification can help ensure that their estate is well-prepared for market fluctuations and future needs.
- Create trusts for stock market investments: Transferring stock market investments to trusts can provide more control over the management and distribution of the assets. Trusts can also provide tax advantages and protect the assets from creditors and legal claims.
- Utilize the annual gift tax exclusion: Gifting stock market investments to beneficiaries during your lifetime can help minimize estate taxes and provide financial support to loved ones. The annual gift tax exclusion allows individuals to gift a certain amount each year without incurring gift taxes, making it an effective way to transfer wealth.
Understanding How Life Insurance Works
Life insurance can play a pivotal role in providing financial security for your loved ones upon your passing. In exchange for the premiums you pay, the insurance company guarantees a certain death benefit to your beneficiaries. But how does the insurer afford to pay this benefit? They invest your premiums – typically a diversified mix of bonds, equities, and other investments.
This investment portfolio is used to pay out the death benefits owed by the company within any given year. The excess goes toward the insurance company’s operational expenses and profit margins. All these expenses are embedded within your insurance premiums.
Beating the Insurance Company
The fundamental design of life insurance is based on actuarial principles and the law of large numbers. The reason insurers don’t go bankrupt from paying out death benefits to a bunch of people who pass before their time is the law of large numbers. By insuring tens of thousands of people, they are able to spread the risk out amongst all the subscribers to the policy. In addition, they rate customers according to risk.
This enables insurance companies to calculate average lifespans and the appropriate premiums to charge for the provision of a death benefit. Given the overwhelming volume of data and actuarial acumen it is virtually impossible to “beat the insurance company”. When it is possible, “outsmarting” the insurance company would mean dying prematurely.
Direct Investment: An Alternative Path
What then is the alternative? Instead of paying premiums to an insurance company, consider investing the same premium amounts directly in the the stock market or a diversified portfolio of bonds and stocks. This would cut out the middleman, allowing you to avoid the costs an insurance company would otherwise deduct for operational expenses and profits.
By investing the premiums yourself, you’re guaranteed to see higher returns because of the reduced costs, so long as you live close to or longer than a normal lifespan. It’s important to note, though, that investments can fluctuate in value and there are no guaranteed returns, unlike the death benefit of a life insurance policy. In addition, if you pass away before your actuarial lifespan, you may not come out ahead even after accounting for costs.
Guarantee of Cash Value vs. Potential Higher Returns
A key point of contrast between direct investment and life insurance lies in the concept of guarantees. A permanent life insurance policy’s cash value component comes with a guarantee that it won’t lose value, providing a measure of security and certainty. This guarantee is the insurance company’s commitment to provide a minimum rate of return or keep the cash value at a certain level.
However, nothing in life is free and the cost of this guarantee is the lower overall returns compared to what you might earn through direct investment. While the guarantee of not losing value provides peace of mind for more risk-averse individuals, it’s crucial to account for the opportunity costs associated with the lower returns.
The choice between purchasing permanent life insurance or investing directly in the stock market should hinge on an in-depth analysis of your financial objectives, risk tolerance, and estate planning needs. With careful deliberation, you can make a decision that best aligns with your long-term goals, whether that’s the guaranteed death benefit or the potential for higher returns.
Estate planning is a critical aspect of ensuring a successful and efficient transfer of wealth to your loved ones. I hope this article has provided valuable insights into the advantages and disadvantages of permanent life insurance policies compared to stock market investments in the context of estate planning.
While permanent life insurance policies offer guaranteed death benefits and certain tax advantages, their high costs and relatively low returns may not make them the most efficient choice for many investors. Many financial planning authorities suggest that stock market investments, particularly low-cost, diversified index funds, can provide better growth potential and flexibility in estate planning for most individuals.
However, for those who are highly risk-averse or have specific estate planning needs that can be met through life insurance, permanent life insurance policies may still have a place in a diversified portfolio. Proper diversification, the use of trusts, and tax-advantaged accounts can help ensure a well-rounded estate plan that addresses the unique financial goals and needs of each individual.
Ultimately, consulting with an estate planning attorney who is familiar with low cost financial planning techniques can provide valuable guidance and help tailor your estate plan to your specific needs and objectives. Remember, estate planning is not a one-size-fits-all endeavor. It’s an ongoing process that evolves with your life circumstances, financial goals, and market conditions. By staying informed and making deliberate, well-informed decisions, you can create an estate plan that ensures a smooth and efficient transfer of your wealth to the next generation.