The Hard Truth about “Buy Term, Invest the Difference”

Penn Mutual

By Penn Mutual | September 4, 2018

If you turn on the TV, you’ll hear many popular financial gurus say term life insurance is really all you need—because life insurance is only needed when you have children or a mortgage. According to them, you should purchase a term policy to cover those 20 or 30 years, and invest what you would have saved by not purchasing “expensive” permanent life insurance. The idea is that when you invest the difference, your returns would outpace those of a whole life policy.

However, in the decades since the idea of “buy term and invest the difference” first gained popularity, we’ve learned that this approach doesn’t work so well in real life.

Here is the hard truth about buying term and investing the rest:

You Probably Won’t Invest the Difference

One of the myths is that you will actually invest the difference. Studies have shown that few people follow through on their intention to save and invest, at least to the level at which the proponents of “buy term and invest the difference” would have you believe. People don’t invest the rest because there’s no forced savings element involved in the strategy. Purchasing a permanent policy, such as a whole life policy, can provide the discipline many people need to invest a set amount on a regular basis.

Investing in the Stock Market is Risky

The long-term trend of the stock market over the last 90 years has been upward, with an average annualized total return of 9.8 percent for the S&P 500 index over that period. But, as they say, past performance is no predictor of future results. There is no guarantee you will see similar returns when investing.

The stock market can swing widely over the short term, which can make it difficult to time withdrawals. If you need money when the stock market is down, you lock in your losses and forego any gains you might achieve when the market recovers.

Some permanent life insurance products offer a guaranteed return, and have cash value available to you no matter how the market is performing.

Plans Change, and You Might Be Uninsurable If You Need Insurance Later

Term insurance is temporary, providing coverage for a specified period of time—10, 20 or maybe 30 years. This helps keep the cost low, as your chances of dying at a younger age are relatively low. Once you reach the end of those 10, 20 or 30 years, the premiums will likely skyrocket. This is cause for concern because if you’re still planning for more kids or you just bought a new home, you’ll still need that life insurance.

On top of that, it’s possible that your health might have changed during that time in a way that makes you uninsurable. If you buy a permanent life insurance policy while you are young and healthy, you lock in your insurability.

You Miss Out on the Tax Benefits of Life Insurance

“Investing the difference” in a non-qualified account might require you to pay capital gains tax on any appreciation in value when you sell. Dividends are taxed as income in the year they are paid. Likewise, investing through a qualified 401(k) retirement plan only defers the taxes—and any withdrawals you make will be subject to regular income tax, and a penalty if you are under age 59 ½.

Life insurance, on the other hand, offers powerful tax advantages. As with term policies, the death benefits are income-tax free, and it’s possible to set up a policy so that the benefits are estate-tax free as well. But permanent life insurance can also be a great source of tax-free income while you are alive. The cash value of a permanent policy can be accessed through withdrawal of premiums, which the IRS treats as “just getting your money back,” so it’s not taxable. Another approach is to take the money as a loan. As long as you keep the policy intact, the money isn’t taxable.

With these tax advantages, life insurance can actually outperform investments without taking as many risks. Your financial professional can show you how. The tax advantages of life insurance should be part of comparing against the “buy term and invest the rest” strategy.

You Can’t Take Advantage of the Living Benefits of Life Insurance

Term insurance only offers a death benefit-nothing else. Permanent life insurance, on the other hand, offers “living benefits” that you can take advantage of during your lifetime. Your policy’s cash value is available to you at any time, for any reason—no questions asked. Typically it can be accessed income-tax-free, plus there are no penalties on distributions prior to 59 ½ or forced required minimum distributions (RMDs) when you turn age 70½. This money can be used to pay for college, start a business, provide income in retirement, or pay for long-term medical care.

Another little known benefit: If you become chronically ill, many permanent insurance policies allow you to access a portion of your death benefit for use while you’re alive.

Don’t get me wrong. Term life insurance has its place. It’s great for temporary coverage, when you need a certain amount of death benefit for a short period of time, or because you’re just starting out and can’t afford as much permanent coverage as you need. It is good “starter life insurance,” where you can lock in your insurability now to get the death benefit you need and then, over time, convert to permanent insurance as your income rises.

But be careful not to fall for the myth of “buy term and invest the rest.” Permanent life insurance offers unique benefits, and it can form the foundation of a solid financial plan.

All guarantees are based on the claims paying ability of the issuer. Life insurance policies are subject to eligibility requirements and restrictions, and may not be right for everyone. Accessing cash value will reduce the death benefit and policy values, and may be taxable. Some of the life insurance benefits described may require additional riders and may be subject to additional costs.

9 Comments

  • Avatar Paul Martin says:

    Great article Andrew, really sums it up!

  • Avatar Robin Howard says:

    Great article! I have seen some companies offer living benefits (at least a terminal illness rider) through their term policies, though.

  • Avatar Chris Hamilton says:

    My insurance policies allowed me to significantly fund my children’s college years , leaving them without DEBT. That was a Tremendous advantage for them. As I got to be about 60, my supplementary term policies helped cover my life in the earning years. As I turned 60 I found a permanent life policy with one company that I pay monthly under 100 dollars and then have coverage of 50,000 covered by cash value and dividends for the rest of my life and for my wife, no more premiums. NO term policy allows that to be possible. You are correct.

  • Avatar Stanley Brown says:

    Too bad you don’t cover that most whole life policy loans charge between 6-10% interest that goes straight into the companies hands and that the average rate of return of a whole life policy is (according to consumer reports) between 1.5-2.2%, which is less than inflation was in 2018.

    • Andrew Martin Andrew Martin says:

      Thank you for your comment. You are correct that whole life policies do charge loan interest if you borrow from your policy. Our loan rate today is 5 percent, which supports providing a dividend to the policyholder on their outstanding loans. I am not sure what consumer reports you are referring to, but a typical whole life policy will have a higher rate of return than you stated, over the life of the policy. I would suggest reaching out to a financial professional to discuss if a whole life policy is right for your particular situation.

  • Avatar Gary T Vick says:

    Hi Andrew,
    I really appreciate your article. One point that is often omitted in the “buy term and invest the difference” discussion is, as a for instance, in the 20 year term example, even if you did invest the difference, and the investment outperformed the cash value of the permanent policy, in year 21 your term insurance is gone. At some point, the death benefit of the permanent policy will pour into the insured’s estate. Obviously, if that death benefit was paid out in year 21, it would blow away the “invested difference”. The later the insured dies, the less significant that difference is – assuming the investment is performing well.

  • Avatar charles ward says:

    If I die at year 20, why doesn’t my family get both the face value of my whole life policy and the cash value?
    I get them both with my term policy and IRA investment.
    How come the cash values of whole life policies are never shown adjusted for average annual inflation?
    Does an agent get paid more for selling a whole life policy or a term policy?

    • Penn Mutual Penn Mutual says:

      Thank you for your questions. We’ve itemized the answers below and recommend consulting a licensed financial professional to help determine the best options for your personal situation.

      Face Value/Cash Value: The cash value of a whole life policy grows with accumulated premiums and interest over time. This design allows the insurance company the ability to offer a premium that is guaranteed not to increase during the life of the policy and reduce the net amount at risk to the insurance company as the insured grows older and the cost of providing coverage increases. When the insured passes away, the insurance company will then pay the death benefit to beneficiary and keep the cash value.

      Cash Value + Inflation: Regulations on policy illustrations prohibit the use of a projected inflation factor for displaying future values.

      Compensation: Financial Professional compensation is calculated as a percentage of premium paid. Because whole life policies protect the insured until death or the policy matures and term policies only provide insurance coverage for a temporary, and defined, period of time (10-30 years), the whole life premium will be higher than a term policy premium. The compensation for the agent would generally be higher on a whole life policy relative to a term policy.

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