When it comes to insurance, the phrase ‘buy term and invest the difference’ comes up often in the popular press. What does that exactly mean anyway? And it is really…well…true?
The basic concept is this: Take the difference in cost between a term policy (which is just pure insurance protection) and a permanent policy of equal death benefit. Invest that difference.
If you die in the early years, the death benefit from the policy provides for your beneficiaries because the side fund doesn’t have a lot accumulated yet. Plus, early on, you haven’t paid a lot in premiums anyway.
Later on, the side fund grows to the point where it has enough money for what you want to leave to your loved ones and you can drop the insurance.
Sounds great. What’s the catch?
Well, for one, taxes. As that side fund grows, you pay tax on those earnings – interest and/or dividends. So it really doesn’t grow to as much as you think.
And don’t forget opportunity costs. Taxes that you would pay could instead be used to earn a return for you.
Even if the side fund is used in an IRA / 401(k) structure where annual earnings would be tax deferred, when beneficiaries take out that money, they pay income taxes.
So with this, you swapped an income tax free death benefit for something that is taxable to your heirs. Uncle Sam thanks you.
Another catch is estate considerations. The side fund could be subject to probate, which can be both costly and time consuming. Also, assets going through probate are used to pay off debts of the deceased first before being distributed to their heirs. So that big account might shrink if die with debt. Your credit card companies thank you.
A third catch is being able to ‘use’ the money. Well, it’s in an account so you can use it for whatever you want. True, but that tax issue comes up again.
On the other hand, if your side fund is in an IRA, you might pay income taxes and possibly even a penalty if don’t meet one of the qualifying exceptions.
So you need to take money out for some sort of emergency – like a big auto repair, once again, Uncle Sam thanks you.
These are just some of the things that dispel the myth of ‘buy term and invest the difference’. Next time you see some ‘expert’ on TV talking about this, think a bit deeper to see if it’s really right for you.
Answer to last week’s trivia question: B – 36th.
This week’s trivia question: As reported in the media, the Tax Foundation estimates what percentage of US households will NOT owe any tax in 2009. Is it?
A – 5%
B – 24%
C – 35%
D – 47%
