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The Problem with Whole Life Insurance

Choose the correct path, take the free dinner, leave the whole life policy.

Choose the correct path, take the free dinner, leave the whole life policy.

A common theme seems to run through most doctors lives as they progress through residency, and that’s being pitched by insurance salespeople.  The “cream of the crop” insurance product that they are all pitching is whole life insurance as it not only provides life insurance for you but also gives you a way to invest and comes with tax advantages.  This is the dream product for insurance salespeople because it sounds good to those who haven’t spent much time learning about investments or life insurance and the policies are generally very expensive. That means that the agent’s payout will be quite high as they take a commission on the sales they make, so why not try to sell the most expensive product they can?  This post will look at why you should avoid buying a whole life insurance plan from the completely biased view of someone who used to work for a large company that pushed insurance sales.

Better Uses for Your Money

This is particularly true of young doctors, but the chances are astronomical that you have better things to spend your money on than a whole life policy.  Most young doctors have student loans to repay, malpractice insurance premiums to deal with, term life insurance, a house to save up for, retirement accounts to fund, and emergency funds to set up to name just a few of the ways in which money will be spent.  Any and all of these expenditures and investments should be much higher on your priority list than a whole life insurance plan.

I have often talked about creating a strong financial foundation from which to build the rest of your goals and plans, and whole life insurance is almost the last thing I would I would recommend adding, after the space under your mattress has been filled with money.  That is a bit of an exaggeration but, as you begin to build your financial foundation is the worst time to add a whole life policy as paying off debts, building up your retirement accounts, and saving for big purchases is a far more important use of your hard earned money.  If you are in the market for life insurance, get some cheap term life insurance that will cover your needs and not affect your budget in the same way that whole life does.

Things Change

One of the constants of life is that life changes, and I don’t say that to seem deep or like I took a philosophy class in college, it is simply the truth that not everything will remain constant.  Whether that means spending 5-10 years as a pediatrician and then changing courses to go into psychiatry or it could mean that after 15 years you are simply burned out and want to completely change careers.  Whatever changes you make or end up happening, you will need to adjust your budgeting to account for the new level of income.

Say that you decide to go down to working part time in order to pursue a passion that you had not been able to indulge in previously.  With part time income comes a reduction in expenses and reduced ability to save for retirement. Being able to adjust those expenses to account for new levels of income should be part of everyone’s financial plan, and luckily most expenses can be reduced fairly easily.  However, one major expense that cannot be reduced is the premiums you pay on whole life insurance. These premiums are far higher than you would be paying for term life insurance and stay with you for life. What about if you keep your job and nothing changes on that front, but you realize that in your haste 10 years ago you bought a far larger whole life insurance policy than you needed?  Well, you will be paying the premiums on that amount of insurance regardless of how much insurance you actually. Committing to something fixed that comes with that large of a price tag simply does not make sense in a world where things can change in an instant.

Negative or Low Returns

Remember in the beginning when I said that part of the pitch is that whole life insurance also utilizes an investment component?  Well it absolutely does and that investment component can help supplement your other investments and provide great cash value for not only you but your heirs as well, or so the pitch often goes.  The problem for those who read the small print in the illustrations (and especially for those who don’t read the small print) is that the returns you’ll be getting from the investment accounts inside the whole life policy will be either negligible or negative for the first 10 or so years.  Because the cash value will be less than the premiums paid in, as the insurance company has expenses and needs to pay out that fat commission to the insurance salesperson. So, you will be in the red for a long time as you put your hard earned money into this product.

But when you cross that threshold where the cash value is more than the premiums you pay in, you’ll be set right? Well, no.  The problem is that most people are misled or confused by the numbers they are looking at and see the dividend rate as the rate of return for the investment account.  Many whole life products generate a rate of return of about 2% for the investment account which means that for years of being in the red and exorbitant premiums you paid you’ll be making slightly less than inflation.  To put that in perspective, it is almost better to put the money under your mattress because even though you won’t earn that 2% you also will not have spent tens of thousands of dollars on the product that you’ll never see again.  

The Benefits

To close out this post I wanted to take a look at some of the benefits that are pitched for a whole life insurance plan and break down what they actually do for you.  Many insurance agents are happy to tell you about all the great tax advantages that whole life insurance provides, but I want to put those in context of what else is available on the market.  

  1. Death Benefit: One of the features of the whole life insurance policy is that your heirs receive the death benefit tax free, which is admittedly very nice.  However, unless you are looking at an irrevocable trust, most inherited assets like a house or investments come with a step up in cost basis, which is a fancy way of saying tax free.  So, do not be fooled by thinking this will provide something that’s unique.

  2. Protected Growth: One of the most trumpeted benefits of the whole life plan is that your dividends/interest has tax protected growth.  This is absolutely true because the dividends/interest represent an overpayment of those expensive premiums you have been dumping into the policy.  While this does sound good, you get this in plenty of other types of accounts like a 401k or a Roth IRA.

  3. Tax Free Borrowing:  This one probably makes me the angriest because of course you can borrow money tax free, you can do that your 401k and most other accounts.  You cannot borrow the money interest free however, just like in every other situation in life. If I borrow $500 from a friend, I’m not paying taxes on that because it’s not income.  But I will likely have to pay some amount of interest on that loan.

Now we will take a look at some of the things you will miss out on by funding a whole life policy over other investment accounts.

  1. No Reduction in Taxable Income: Those with higher levels of income want to max out their retirement accounts so that it reduces the taxable income they have to pay on.  However, a whole life policy does not provide that advantage because you are paying premiums on a policy, not investing in retirement.

  2. No Loss Harvesting: Usually when you sell an investment at a loss you can use that to offset taxable gains you accrued through tax loss harvesting.  However, if you surrender a whole life policy at a loss that does nothing to offset gains, you have just lost money.

  3. Non-deductible Interest: Remember that money you borrowed from this policy that was tax free but not interest free?  Unlike most other assets you can borrow against, the interest is not deductible to you.

From my time at the large financial firm, they were insistent on pushing whole life insurance policies.  This was the best way for us to get paid as it resulted in a big payday initially and we would get what were called trails, so we could keep profiting off your insurance policy years after it had been in place.  If you are a young doctor or other medical professional and get approached by a salesperson who wants to buy you dinner and pitch whole life insurance then get the free food and pass on the policy. Please let me know if you have more questions around this or want more clarification.