On Wednesday, I mentioned that you can gain a meaningful benefit by buying life insurance when you’re young.  I want to take a little more time and highlight why you should buy one type of insurance over another.

I’m a firm believer in buying term life insurance.  The other option is to purchase a permanent policy.

You should definitely know the difference between the two, and the reasons why term insurance is likely better for you than permanent.

The difference between the two

Term policies cover you for a specific period of time – usually 10, 20, or 30 years. In return, you pay a level premium (the amount you pay the insurance company for the policy) and get a fixed death benefit (the amount the insurance company pays your beneficiaries if you die while the policy is in place).  I like to think of it in terms of winning a bet. If you die during that specified time frame, your beneficiaries win because they receive the insurance proceeds. If you don’t die, the life insurance company wins and gets to keep the money you paid in premiums.

Permanent insurance also provides a death benefit but includes a cash value component that increases in value over time. That cash comes from the amount that you pay in premiums that exceeds the cost of the insurance protection. You can invest that excess cash for faster tax-deferred or even tax-free growth. (If you die while the insurance protection is in place your beneficiaries receive the death benefit tax free.) You can also take loans and withdrawals from this cash value. Permanent policies come in a variety of forms such as whole life, universal life, or variable life policies.

Arguments for permanent policies

Some believe that permanent insurance will benefit people in the following circumstances:

• Those who need to create liquidity to pay federal estate tax.
• Those concerned about asset protection (many state laws provide that cash value and insurance proceeds are not subject to claims from creditors)
• Those who need forced savings.

While these arguments seem plausible, they don’t stand up to much scrutiny. With the estate tax exemption at $5.25 million, very few people need liquidity to pay estate taxes (an estimated 1.4 out of every 1000 estates paid estate tax in 2013). In addition, retirement account assets can also be protected from creditors, even in a bankruptcy proceeding. Investing in retirement accounts will likely benefit you much more than investing in life insurance.  Lastly, there are many cheaper and more beneficial ways to obtain forced savings, such as buying a home or automatic withdrawal for a company sponsored retirement plan.

Why Term Wins

The main argument for why term wins stems mostly from cost. If you need insurance to replace 10 to 15 times your annual salary if something happens to you, the monthly premium on a permanent policy may prohibit you from purchasing it in the first place.

A healthy 40-year-old man could get a 20-year level term policy with a $500,000 death benefit for about $30 per month. That same 40-year-old would have to pay $250 per month for a $500,000 death benefit on a permanent policy. In short, you pay over $2600 more a year for the same death benefit.

Some argue that you benefit by building cash value in the permanent policy, which is technically true. Unfortunately, the first 12 or so years of those excess payments go towards your insurance agent’s commissions and administrative costs. And even if you held the permanent policy over 20 years, the investment options you could obtain outside of the policy will likely be cheaper and more diverse.  This division of investment and insurance is what people refer to when they say, “buy term and invest the rest.”

Lastly, term policies are just easier to understand. You don’t have to worry about whether to choose a whole life, universal life, or variable life policy. You don’t need to track how much of your premium goes to pure insurance coverage and how much goes to your cash value. And it’s easier to compare the prices of different policies. Many of the fees and administrative costs of permanent policies are hidden.

Overall, my policy is to use insurance for insurance, and investment vehicles for investments. No need to merge the two. That’s why I recommend investing in term policies.