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Benefits and Drawbacks of Life Insurance

Are you looking into a life insurance policy but aren’t certain about signing up for it yet? That’s understandable. Life insurance is a complex and varied industry that boasts a wide range of products. If you are ready to do the research, you’ll find that there are many benefits and potential drawbacks of buying a life insurance policy. But first, let’s take a quick look at the many options you have available.

Different Types of Life Insurance

Three basic types of life insurance are available for the consumer market, including term life, whole life, and universal life. You’ll see many subcategories of insurance, but they all are built on the framework of these three kinds of insurance. Here’s a quick look at the main features and drawbacks of the most commonly available kinds of insurance policies.

Insurance TypeMain FeaturesDrawbacks
Term Life Insurance– Monthly premium payments
– Larger death benefits
– Lower premium payments
– No cash-value
– Term limits
Whole Life Insurance– Permanent life insurance
– Build cash-value
– Can get loans/payments
– Potential dividend earnings
– Higher premium payments
– No investment flexibility
– Lower death benefits
– Outdated product with inflexibilities
Guaranteed Universal Life– Permanent life insurance
– Guaranteed death benefits
– More affordable premiums
– No cash-value growth
– Policy can lapse for non-payment
Indexed Universal Life– Cash-value growth tied to the indexes like S&P 500
– Control over participation amount
– Higher cash-value growth
– Optimized investment risk (tied to the whole market performance)
– Can’t choose how cash value is invested
Variable Universal Life– Flexible premium payments
– Minimum death benefit
– Choose how cash-value is invested
– Increased investment risk
– Additional fees from investment products
– If investment doesn’t go well, premiums need to increase to avoid causing the policy to lapse

Benefits of Life Insurance

Life insurance offers many potential benefits beyond serving as a way to set aside money for your afterlife expenses. Here are a few of the benefits available with your insurance policy.

Provide for Your Family

Life insurance policies are also used as a way of providing financial protection for your loved ones. Policyholders can obtain enough insurance to pay off the house, pay bills, pay debts, or provide for the children’s college in the event of death.

Tax-Free Death Benefits

The federal government doesn’t charge taxes on death benefits paid to your beneficiary. This allows you to leave a nice lump sum to loved ones without having to worry about it being diminished by large taxes. There are a few exceptions, such as having a large estate or if you sell the insurance policy to an investor in a transfer-for-value sale.

Tax-Free Withdrawal and Possible No-Interest Loans

If you get a whole or indexed or variable universal life insurance policy you’ll also be able to take loans or withdrawals on the cash-value without paying any income tax. Policyholders have a nice line of credit or retirement annuity waiting for them with the right life insurance policy. If you have indexed or variable universal life insurance and the amount you need to withdraw being less than total premiums that you have paid, you don’t need to pay any interests. This is called “the basis” of the policy.

However, if you need to withdraw more than the total premiums you have paid, the amount above the total premiums is considered a loan you take against the cash value account, insurance companies will charge some interest rate, usually from 3-5%. In the case of whole life policy, insurance companies always charge some interest rate on the amount you withdraw from the cash value account. Interest rate charged in the whole life policy is usually higher than that in universal life policy. However, in both whole and universal life policies, interests are deducted from the policy’s cash value account itself. You don’t need to pay interests out of your pocket.

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

Tax-Free Investment Growth

The cash value in your life insurance policies can also grow without being charged taxes on the interest earned. This allows the cash-value to accrue faster and potentially leaves you with a larger amount to draw from for future annuity payments or loans. As mentioned, when you withdraw or take out a loan from cash value account, you don’t have to pay any income tax. This is the main reason why life insurance has become a popular tool for retirement planning. Learn more how to use life insurance in retirement planning through a case study.

Receiving Dividends

Many life insurance companies also offer dividend reimbursements to their policyholders. Dividends are paid out based on how well the insurance company did during the year. Policyholders can:

  • Opt to get the dividend payment as cash
  • Invest it in their cash-value
  • Use it to buy more insurance 
  • Put it towards their premium payments

>>MORE: What is Dividend Paying Whole Life Insurance?

>>MORE: Understanding How Dividend Paying Whole Life Insurance Works

Collateral Asset

Permanent life insurance policies that build up cash value account over time can be used an a collateral asset. You can take out a loan using such a collateral asset when you need to. Learn more about collateral assignment life insurance policies here.

Drawbacks of Life Insurance

Just like any product you purchase, life insurance does come with some potential drawbacks. Here’s what you want to keep an eye out for when you are shopping for life insurance policies.

Medical Exams

Medically underwritten life insurance policies, such as whole life insurance, usually require a medical exam with blood and urine tests. If you don’t get this medical exam, you won’t be approved for the policy. However, there are alternatives, such as no medical exam life insurance, and many kinds of term life insurance.

Term Limits

If you opt to get term life insurance your coverage will only last for a specified length of time, such as 10, 20, or 30 years. This term limit means that your policy will end once you reach a certain age. Most insurance companies offer the option to extend your policy for five years at a time, or the option to convert your existing term life policy into a permanent life insurance policy.

Low Interest Earnings

In general, life insurance is not intended as an investment vehicle so the cash-value in your policy usually grows at a low interest rate. If you want a policy that grows more quickly, there are alternatives. A variable universal life insurance will allow you to place all or part of the cash-value into an investment fund of your choice. These investment accounts, like mutual funds, have a higher interest rate. However, you may not see any cash-value growth if the market does poorly.

>>MORE: The Differences Between Variable Life Insurance (VLI) and Variable Universal Life Insurance

High Premiums

Some policyholders could be stuck with high monthly premiums when buying life insurance for a number of reasons. Most premiums are determined by the applicant’s age, general health, and the type of insurance obtained. Whole life insurance policies are meant to provide a permanent life insurance for policyholders, so the premium is much higher compared to term life insurance.

Quaranteed and Permanent

Yes. Guaranteed Universal Life Insurance (GUL) provides the same guaranteed and permanent coverage for less than half the cost of Whole Life Insurance premiums.

Final Thoughts

The potential benefits of life insurance outweigh the drawbacks for those who are looking to add a little extra protection for their families. It also serves as a potential low-risk investment for retirement or to have a line of credit for low-or-zero-interest loans. Plus, there are a wide variety of life insurance policies on the market. It’s possible to find a perfect fit for your situation no matter where you are in life.

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