For some parents, purchasing life insurance may seem like a good investment for themselves and their children. However, there are a few factors they should consider first.
In essence, whole life insurance is a permanent plan that lasts for your child’s entire life and does not expire. It is also locked in to a fixed annual premium that never increases.
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It is common for parents to take out such insurance for their children, expecting that the insurance will contribute to the future needs of the child. This may be for educational purposes or to cover expenses that the parents will have to make in the event that their child dies unexpectedly.
Whole life policies have two parts: the death benefit, the lump sum your beneficiary receives, and the cash value, a built-in savings and investment feature.
While there are certainly many benefits, such as tax advantages, fixed premiums, and potential collateral for loans, it is important to understand all aspects of life insurance before making this important financial decision.
Who owns the entire life insurance policy?
Suppose your parents took out a life insurance policy for you when you were a child. Who owns it now?
When parents (or even grandparents) purchase a policy on behalf of a child, they typically own the policy, even when the child is an adult. While some companies transfer ownership to the insured child when the child turns 21, most do not. This means that the insured child, even when an adult, has no legal rights to the policy.
In some cases, parents want to transfer the policy to their adult children and them bear the burden of continuing to pay the premiums, but this can place a significant financial barrier to their children's monthly expenses.
If you are the insured child and want to to start paying the premiums, you must be absolutely certain that your parents/grandparents transfer full ownership of the policy to you. Please note that policyholders are not legally required to transfer the policy to the now adult persons, even if requested to do so.
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Why Some Experts Are Against Life Insurance
For starters, whole life insurance policies are quite expensive. Personal finance celebrity Dave Ramsey explains that these policies can cost 20 times more in the first three years alone than a term life policy that offers similar coverage.
While all insurance policies take a cut of sales commissions, a life insurance policy takes 100% of your payments in those first three years. That’s why it can take more than a decade for your cash value to reflect the amount you’ve already paid in premiums and extra fees.
It's “probably one of the worst financial products out there today,” Ramsey told a caller during an episode of his series, The Ramsey Show. He illustrated this by saying that a $100,000 term life policy can cost $5 a month, while a whole life equivalent can cost more than $100 a month.
Ramsey added that the average whole life insurance policy yields 1.2%, and if you've managed to build equity and use that money, you'll have to pay the insurance company interest to use it. In short, you're losing money.
In contrast, the average annual return on an S&P 500 is just over 10%, as of May 2024. If you have the means to invest for 50 years, you'd do better with stocks, mutual funds or real estate.
Another example: PolicyGenius reports that the average cost of life insurance is $451 per month for a healthy 30-year-old with a $500,000 policy.
While these policies have a savings feature called cash value (which you can borrow from while you are still alive), the monthly rate is significantly higher than the rate on a term life insurance policy.
In general, whole life insurance policies are an unnecessary investment because their primary purpose is to pay a death benefit to your beneficiaries in the event of your death. However, once the child is an adult, most parents no longer need a death benefit to stay afloat financially in the event of the adult child's death.
For this reason, it doesn't make sense to pay for lifetime coverage. Unless you have a child with a disability who will need a significant amount of financial assistance for the rest of his/her life, buying a term life insurance policy that covers you only when needed is a better option.
You are much better off with a much cheaper term life policy if you need life insurance. You have more access to your money, you can manage your own investments, you avoid fees and you end up being richer.
What to do if you are stuck with a life insurance policy
If you are stuck with life insurance, the best course of action will depend on your specific circumstances.
If the policy has been transferred into your name after your parents have contributed money to it for years, there may come a time when you no longer have to pay premiums if you take advantage of the 'premium offset' option. This is possible once the cash value is large enough to cover the monthly costs.
This means that the cash value and dividends are used to offset or pay the premiums. However, your cash value will grow more slowly as a result, but you are not spending any extra money. You can simply let the policy grow until you are ready to borrow against it and receive tax-free income.
If you have only had the policy for a short time and can still pay premiums for years, it may be best to cancel the policy.
As mentioned earlier, the first few years are the most expensive in terms of fees and commissions, so you’d be wasting money for a while. You’d also have to accept lower returns for the next few decades. It might be best to cut your losses and take all the surrender value you can get out of the policy.
It is true that you will probably face penalties, so you probably won’t get much money back. You may also have to pay income tax on any gains if you happen to get more money back than the premiums you paid yourself. However, this can be a much better option than continuing to put aside good money for a bad investment.
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This article provides information only and should not be taken as advice. It is provided without warranty of any kind.
