I recently met with a prospect who was looking for a second opinion. He was being offered a whole life insurance product from a well-known financial firm. Of course, he had received the standard pitch – higher returns, better tax treatment, ultimate flexibility, etc.
The truth is, whole life insurance is a product with a specific purpose, and it can be a valuable tool for a small fraction of ultra-high net worth individuals. The tax treatment of life insurance makes it an effective vehicle for leaving a large inheritance.
Unfortunately, huge financial incentives cause insurance companies and their sales reps to peddle permanent insurance to anyone willing to buy, regardless of their goals or financial situation.
For the vast majority of individuals who are looking to fund their retirement and who hope to spend or give away most of their money while they are living, whole life insurance rarely makes sense.
Whether you have a vast estate or are just looking to start investing, here are 10 places that you should consider putting your money, before purchasing a whole life policy:
1. 401k Match
If your employer matches 401k contributions up to a certain %, this is likely the first place you should invest. You won’t find a better return anywhere than a dollar for dollar match. Be aware of your plan’s policy on vesting of employer contributions. If they don’t vest (which just means you get to keep the money if you leave the company) for several years, and you don’t plan on staying with the company that long, then this may not be the best place to start. But for the majority of employees, this will be the highest return on your money.
2. Emergency Fund
If you don’t have money set aside for a rainy day, then make funding your emergency fund a priority. A typical rule of thumb is 3-6 months of expenses, but you’ll want to adjust this number based on your life situation (job security, consistency of income, working spouse, etc.). Start with at least a month of expenses before moving on, but you can continue to build your emergency fund over time to a comfortable level.
3. Credit Cards
Paying off debt with a 20% interest rate is equivalent to investing at a guaranteed 20% return. And trust me, you’re not going to find that anywhere – certainly not in a life insurance product.
I have been absolutely appalled to meet people who are swimming in debt who have been sold a whole life policy. Most of them end up lapsing on the policy and never see a dime of their investment back. If you have high-interest debt, don’t even think about buying a whole life policy until it’s paid off.
4. Health Savings Account
If you have a high-deductible health plan, you are eligible to contribute to an HSA. Some employers match contributions, but even if they don’t you can open an account online.
Like your 401k, HSA contributions are made with pre-tax dollars, which means anything you contribute to your HSA helps lower your tax bill. What makes HSA’s even more appealing is that withdrawals are also tax-free if used for medical expenses! It’s the only vehicle I know that gives you a tax break when you contribute and when you withdraw.
If you can afford to, pay your current medical expenses out of pocket and keep your HSA invested until retirement so you can maximize the tax-free growth.
5. Max Out Your 401k
Pre-tax savings is something your 401k can give you, that your life insurance can’t. If you’re in a 25% tax bracket, your $1,000 401k contribution goes in pre-tax. In other words, you invest the full $1,000. If you want to invest that in whole life insurance, you would pay $250 in taxes and be left with $750 to add to your whole life policy.
You can contribute up to $18,500 ($24,500 if you are over 50) to your 401k each year. Work with your HR department to make sure you max it out as contributions can only be made through payroll deductions.
6. IRA or Roth IRA (or Backdoor Roth IRA)
You can contribute up to $5,500 ($6,500 if over 50) per year to an IRA or Roth IRA. IRA’s receive the same tax treatment as 401k’s, i.e. they are pre-tax. Roth IRA’s are after-tax, so you don’t get a tax break this year, but they are tax-free on withdrawal.
The way the math works out, it makes more sense to contribute to a Traditional IRA if you are currently in a higher tax bracket now than you will be in retirement. If you are in a low tax bracket now and think you’ll be in a higher bracket in retirement, then a Roth is a way to go.
Since you won’t know for sure, it’s nice to have some money in both types of accounts.
*Note – if your income is too high and you have a retirement plan at work, you lose the ability to deduct IRA contributions or to contribute to a Roth IRA. If you find yourself in this situation, you can look at doing a “backdoor” Roth, described here.
7. Student Loans
After taking advantage of retirement accounts, it’s time to revisit debt. Student loans or other debt with interest rates in the 5-10% range are good candidates to consider paying off. You are very unlikely to achieve higher returns than that in a whole life policy.
8. 529 Plan Account
A 529 is a great tool for saving for kids’ college. Growth in the accounts is tax-free if used for qualified educational expenses. And some states even offer state tax breaks when you contribute.
9. Taxable Brokerage Account
If you’ve exhausted all of the above tax-preferred savings vehicles and you’d still like to invest more, a taxable brokerage account can be a good option. In this type of account, you pay taxes each year on dividends, interest, and capital gains.
However, a good financial advisor can help you structure the account to minimize taxable interest and defer capital gains. Done right, this type of account can actually be more tax friendly than a whole life policy because you pay lower capital gains rates, compared to ordinary income taxes on gains in a life policy.
In addition, you don’t have to worry about surrender charges or lock-up periods common in whole life policies.
10. Spend It or Give It Away!
A few of you may find yourselves with more assets and income then you will ever need to fund retirement, college, and any other consumption needs. You may be wondering what to do with the rest of your money. First of all, congratulations! Financial independence is a great achievement.
Now you are faced with the task of deciding what to do with your wealth. And I don’t know anyone who wants to see Uncle Sam take it all away. You may know people who are using life insurance as a way to avoid estate taxes or you may have even been pitched this strategy yourself. And while life insurance may provide a way to avoid some estate taxes, it’s certainly not the only way.
Spending your money or giving it away as you earn it is another option worth considering. You can use the annual gift tax exclusion to give money to your kids or grandkids. You can set up an endowment or donor-advised fund and see your charitable donations in action while you live.
In short, there are many ways to shrink your estate that for many will be more attractive than life insurance. Consider what you want your legacy to be and the best way to achieve that, before tying your money up in a whole life policy.
Don’t Get Sold
As you can see, there are many alternatives to whole life insurance. Most of them have better tax treatment and likely will have better long-term returns.
Your financial plan should be designed to maximize your assets, so you can achieve your goals – not maximize the size of your agent’s commission.
If you’d like an objective opinion on your financial situation, you can schedule a complimentary, no-obligation introduction. Just click here.