Life insurance and an individual retirement account are two tools you can use to plan for your later years and for your beneficiaries. Both compete for your after-tax money, as either insurance premiums or IRA contributions, and beneficiaries can inherit both free of income tax. However, the two are dissimilar in a number of ways. They each can play a role in your finances, but the roles are different.
Term Life Insurance
Term life insurance can expire before you do. If you outlive your life insurance term, your beneficiaries may regret the loss of insurance benefits after you die, especially if they must pay estate or income tax on the assets you bequeath. A return-of-premium provision means that you can get your premiums back if you outlive your term policy. Term policies offer only a death benefit. They do not build up cash value, which means you cannot borrow against them. Term life is the least expensive type of insurance, but the return-of-premium rider increases the cost.
A Roth IRA accepts after-tax contributions, which can earn tax-free returns. If you wait until age 59 1/2 and the account is five years old, you can withdraw the earnings without incurring a 10 percent penalty on early distributions. You can withdraw contributions tax-free at any time. Unlike traditional IRAs, Roth IRAs allow you to contribute at any age and do not require minimum distributions. In 2013 you can contribute $5,500 or all of your income to your IRA, whichever is less. If you’re 50 or older, the limit is $6,500. Roth IRAs have income limits that reduce or eliminate your ability to contribute -- these limits change annually.
Return of Premium
The additional cost of the ROP rider depends on the term of the policy. A ROP policy usually returns 100 percent of your premiums if you outlive it, but only a partial return if you surrender the policy before it expires. You might pay an additional 50 percent for 15-year policies, but several times the basic premium costs for 30-year policies. The actual cost depends on the rate of return that the insurance carrier assumes on the additional premium amount. For example, your premiums will be higher if the carrier assumes a 2 percent annual return rather than a 5 percent annual return. If you die before the term policy expires, the additional ROP premiums are lost.
It’s difficult to know whether you’d be better off avoiding the ROP rider and investing the savings in a Roth IRA. The largest unknown is the return you’ll receive on your IRA investments during the life of the term policy. You can use a spreadsheet to model different assumed returns, but it’s just a guess. You can lose money in a Roth IRA, but not in a ROP policy -- assuming that the carrier remains in business throughout the term. You can withdraw assets from a Roth IRA at any time, but are locked into your ROP policy unless you terminate it, at which time you will receive only a partial refund.
If you die while the term policy is in force, your beneficiary can use the proceeds to pay the estate taxes, if any, on the proceeds. You might instead place your policy in an irrevocable life insurance trust, which is free of estate tax. However, if the term policy expires, the trust becomes worthless. If you want assurance that your irrevocable life insurance trust will survive you, you might consider a permanent policy, such as whole life or universal life. As long as you pay the premiums, a permanent life policy remains intact. The cost of a permanent policy may compare favorably with that of a ROP term policy. The permanent policy might allow you to invest the cash value in stocks, bonds and mutual funds. Your beneficiaries receive the policy’s cash value in addition to the death benefit.
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