Permanent Life Insurance: When Does It Make Sense?

Life insurance can be incredibly valuable when it solves the right problem. It can also be expensive, complicated, and unnecessary when it is sold to someone who doesn't really need it.

For most families, the purpose of life insurance is fairly simple. If you die prematurely, you want to make sure your family is financially okay. You may want enough money to replace your income, pay off the mortgage, help with kids’ college, or simply give your family some financial breathing room.

If that's the goal, term life insurance is usually the best place to start.

Permanent life insurance can make sense, too. But I think those situations are much more specific.

Term Insurance vs. Permanent Insurance

Term life insurance provides a death benefit for a set period, commonly 10, 20, or 30 years. You pay a relatively inexpensive premium, and if you die during that period, your beneficiaries receive the death benefit.

There's usually no cash value or investment component. It's simply insurance.

That's also one of the biggest advantages. Term insurance is relatively inexpensive. A healthy person may be able to purchase $1 million or more of coverage for a reasonable monthly premium.

This works well when you're trying to protect against a temporary risk. Maybe you have young children, a large mortgage, or a spouse who depends on your income. Twenty or thirty years from now, the kids may be grown, the mortgage may be paid off, and hopefully you've accumulated enough assets that you don't need as much life insurance anymore.

The downside is that term insurance eventually expires. If you still need life insurance at age 70 or 80, buying a new policy may be very expensive or, depending on your health, may not be an option.

Permanent insurance is different. It is designed to remain in force for your entire life. Depending on the type of policy, it may also build cash value.

The downside is that it can be expensive, and the policies tend to be much more complicated.

When Does Permanent Insurance Make Sense?

There are situations where I think permanent life insurance can be a very useful planning tool.

One example is a family with a special needs child who will need financial support throughout his or her lifetime. In that case, the need for insurance doesn't necessarily go away once the parents retire or the mortgage is paid off. Using a permanent death benefit to fund a special needs trust can help provide money for that child's care after the parents are gone.

Another situation is someone who wants to leave a specific amount of money to their children or other heirs. If you know that you want $500,000 or $1 million to go to your family regardless of whether you die at 65 or 95, permanent insurance can provide some certainty around that goal.

Permanent insurance can also be useful for families with significant wealth, especially when much of that wealth is tied up in assets such as a farm, family business, or real estate.

For an individual in Illinois with a net worth approaching or exceeding $4 million, or $8 million for couples, Illinois estate taxes should at least be part of the conversation. This becomes even more important if most of the estate isn't sitting in stocks, bonds, or cash. Life insurance can potentially provide liquidity, so the family isn't forced to sell a business, farm, or other asset simply to come up with cash for taxes and other expenses.

Outside of situations like these, term insurance tends to be the right solution for many families.

The Different Types of Permanent Life Insurance

Permanent life insurance isn't one specific product. There are several different versions, and they work differently. Here are the most common examples, along with a few pros and cons.

There isn't necessarily a "best" type of permanent policy. It depends on what you're trying to accomplish.

How Cash Value Works

Cash value is one of the biggest selling points you'll hear with permanent life insurance.

Part of the premium goes toward insurance and other policy expenses. Another portion may go toward building cash value. How that money grows depends on the type of policy you have. It could receive guaranteed growth, interest credits, dividends, or investment returns under the policy.

As the cash value builds, you may eventually be able to access some of that money through withdrawals or loans.

This is also where I think some of the sales pitches need additional context.

You may hear permanent insurance described as a way to create "tax-free retirement income" or to "receive tax-free loans by borrowing from yourself." There is some truth behind that idea, but it's important to understand how it actually works.

If the money you take from the cash value is less than the premiums you have paid, it is considered a withdrawal. These withdrawals are generally tax-free because you're taking out money that you've already contributed with after-tax dollars.

If you take out more than you've put into the policy, you may be able to access additional cash value through a policy loan. Loans from a properly structured life insurance policy generally aren't treated as taxable income as long as the policy remains in force. But it's still a loan. You're generally paying interest on the money you borrow, which reduces the available cash value.

Once you have a significant loan against the policy, keeping the policy in force also becomes important. If a policy with a large outstanding loan lapses, it can create an unexpected tax bill.

So yes, you may be able to borrow against a life insurance policy without paying taxes immediately, but that doesn't mean there aren't costs or other considerations involved.

Our Experience with Permanent Life Insurance

When Linnea and I were 22 years old, just out of college and newly married, we were referred to a "financial advisor" who worked with a large insurance company.

We were at that stage of life where we were trying to become responsible adults and make good decisions about our financial future, so we decided to meet with him. He came to our house and told us he was there to help us understand our financial goals and develop a plan for achieving them.

At the time, we had a negative net worth. We had gotten married and returned from our honeymoon, which we financed ourselves, and we also had significant student loan debt from our undergraduate degrees, which would continue to grow as we both completed graduate degrees.

We were in the early stages of figuring out how to pay off those loans, which were at the top of our priority list, while also learning to manage the cash flow from our new careers.

Rather than spending much time helping us with those things, this advisor's primary recommendation centered on his company's permanent life insurance.

There's really no other way to describe it. It was a high-pressure sales meeting, and we felt like he wasn't leaving our house until we bought something. We each purchased a $1 million term policy for around $40 per month. He also recommended that we each purchase a $100,000 permanent life insurance policy for around $150 per month.

His strategy was for us to convert another $100,000 of our term insurance into permanent insurance every year until eventually the entire $1 million of coverage was permanent.

So, at 22 years old, we were paying around $380 per month for life insurance while also trying to pay down student loans with interest rates between 4% and 8%.

His idea was that someday we would have a large pool of cash inside these policies that we could borrow against to help pay for our kids' college, supplement retirement, or use for other needs.

But what we didn't fully appreciate at the time was how long it would take for the cash value to catch up with the money we were putting into the policies and how much interest we would continue paying on our student loans in the meantime.

Based on the policy projections we received, after paying approximately $36,000 of combined premiums into the permanent policies over ten years, the cash value would finally be around the amount of premiums we had paid.

Meanwhile, there was no investment plan or student loan repayment strategy, and there was little discussion of budgeting or building an emergency fund. The primary financial recommendation we walked away with was life insurance.

We ultimately decided to close the permanent policies shortly after opening them.

That experience has stayed with me and influenced how I think about financial products and financial planning today.

Every Product Should Solve a Problem

Even after all that, I don't think permanent life insurance is a bad product. Whole life, universal life, guaranteed universal life, and variable universal life all have legitimate purposes, and I've seen situations where permanent insurance absolutely makes sense.

The important part is starting with the problem you're trying to solve rather than the product someone wants to sell you.

Do you have a special needs child who will need financial support after you're gone? Do you want to guarantee a certain inheritance for your children? Does your estate need liquidity because much of your wealth is tied up in a business, farm, or real estate? Those are all situations where permanent life insurance may be worth considering.

On the other hand, if you're simply trying to protect your spouse and children during your working years while you pay down debt and accumulate investments, term insurance will usually accomplish that goal for a fraction of the cost.

Ultimately, the question isn't whether permanent life insurance is a good or bad product. It's whether it makes sense for what you're trying to accomplish.