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The raging debate over term vs. whole life

Few people who have bought insurance -- or even window-shopped for it -- have escaped the debate over "term vs. permanent insurance."

And the wrong kind of permanent or term life insurance can do more damage to your financial plans than just about any other financial product today. This basic conflict --which type is best -- is important because it revolves around the first and most important decision you must make when buying life insurance: term, permanent, or a combination of both?

Term life policies offer death benefits only, so if you die you win (so to speak). If you live, you (or more specifically, your family) get no money back.

"Permanent" life policies offer death benefits and a "savings account" (also called "cash value" or sometimes "account value") so that if you live, you usually get at least some of, and often much more than, the amount you spent on your premium. You get this money back either by cashing in the policy or by borrowing against it.

Permanent life insurance: more expensive

As you might expect, permanent life insurance premiums are more expensive than term ones because some of the money is put into a savings program. The longer the policy has been in force usually equates to a higher cash value since more money has been paid in and the cash value has earned interest, dividends or both.

The debate

If you haven't figured it out by now, the debate is all about cash value. If you buy a policy today, that first annual premium is usually much higher for a permanent life policy than for term.

However, the premiums for permanent life usually stay the same over the years, while the premium for term life increases. That extra premium paid in the early years of the permanent policy gets invested and grows, although your agent probably gets a chunk of that as a sales commission. The good news is that the increase is tax-deferred if the policy is cashed in during your life. (If you die, the proceeds are usually tax-free to your beneficiary.)

First years are critical

The saying you always hear is, "buy term and invest the difference." The fact is, it depends on how long you keep your policy. If you keep the permanent life policy long enough, that's the best deal. But "long enough" varies depending on your age, health, insurance company, the types of policies chosen, interest and dividend rates, and more. The reality is that there is not a simple answer because life insurance is not a simple product.

Guidelines to live by when buying

Even with all these variables, there are some guidelines you can follow. The key is how long you plan to keep the policy. If the answer is less than 10 years, term is clearly the answer.

If it is more than 20 years, permanent life is probably the way to go. The big gray area is in between. Here is where you need an expert to run the term vs. permanent analysis for you. Of course, this assumes you keep the policy in force. Most people drop their policies within the first 10 years, but if you do your homework now that shouldn't be the case for you.

How to choose

If you need $60,000 for college and your youngest child will graduate in three years, you need $60,000 of term insurance as a short-term hedge against your death, thus "insuring" that your child can finish his or her education. Meanwhile, if your estate will owe $200,000 in taxes at your death, you probably need permanent insurance because you may not die for another 25 years (you hope). You also may want to re-evaluate your estate plan, but that's a different issue.

Once you figure out your term or permanent needs (or combination thereof) you are faced with the happy task of choosing which type of policy makes most sense for you.

Term insurance

Term insurance is relatively easy. You can buy term insurance that stops after 10 or 20 years, or that can be continued until age 70 or later. You can choose for your premium to increase each year (annual renewal term) or to be the same amount for a fixed number of years.

Most term policies offer both a "current payment schedule" and a "maximum" rate for each year. With some policies, the company is reserving its right to increase premiums if company costs increase. With others, the issue is your health. At certain "re-entry" ages you may have to prove your good health in order to keep the lower premium. Most term policies are convertible to permanent ones without evidence of good health.

Types of permanent life

The real wild card in terms of price is permanent insurance because most policies have guaranteed and non-guaranteed portions. There are three main types of permanent insurance, and the one with the most guarantees is traditional whole life coverage.

The annual premium is guaranteed, and there are at least minimum guaranteed cash values and death benefits. Most whole life policies these days are "participating," meaning that they earn dividends which can be used to increase the cash value and/or death benefits, decrease the premiums or be refunded in cash.

Traditional whole life insurance

If you are a conservative investor and also have trouble saving, traditional whole life makes sense. If you need premium flexibility especially in the early years of the policy, universal life is for you. And if you consider yourself a knowledgeable and risk-accepting investor, check out variable life. It may be that you cannot afford all the permanent insurance you have decided you need, so consider a combination term-plus-permanent policy.

Avoid all the fancy riders except perhaps the waiver of premium, which suspends your premium payments and keeps the policy in place if you become disabled.

Keep those issues in mind as you consider the types of permanent life insurance offered:

Universal life

Universal life insurance was developed in the 1970s, when insurance industry regulations changed so that companies could be more competitive with other financial services industries. It is more flexible than traditional whole life because the premiums can vary from year to year and sometimes the premiums can even be skipped.

Universal life has maximum guaranteed premiums and at least minimum guaranteed cash values and death benefits. Instead of dividends, universal life policies earn interest at the "credited interest rate" determined each year.

Variable life

Variable life insurance has the fewest number of guarantees and therefore offers the greatest potential for cash value increases. There are required guaranteed annual premiums and a guaranteed minimum death benefit.

However, there is no guaranteed cash value and you have to select the investments for your policy. Buyers typically are offered a variety of mutual fund accounts ranging from money market to aggressive growth funds.

Not an investment tool

Life insurance should never be purchased solely as an investment. After all, some of your premiums are being used to buy the death-benefit coverage and to cover other expenses (including sometimes-large commissions). Life insurance should not be purchased on children as a way to save for college, and make sure you (and your spouse) have all the coverage you need on yourselves before you buy any on a child.