Term or permanent life insurance?

Few people who have bought insurance -- or even window-shopped for quotes -- have escaped the debate over term versus permanent insurance.

And the wrong kind of life insurance can do more damage to your financial plans than just about any other financial product today. So, the first and most important decision you must make when buying life insurance is: term, permanent or a combination of both? Let's look at each.

Term life policies offer death benefits only, so if you die, you win (so to speak). If you live past the length of the policy, you (or, more specifically, your family members) get no money back.

Permanent life policies offer death benefits and a "savings account" (also called "cash value") so that if you live, you get back at least some of, and often much more than, the amount you spent on your premium. You get this money back either by cashing in the policy or by borrowing against it.

Permanent life insurance is more expensive

As you might expect, permanent life insurance premiums are more expensive than term premiums because some of the money is put into a savings program. The longer the policy has been in force, the higher the cash value, because more money has been paid in and the cash value has earned interest, dividends or both.

The debate is all about that cash value. If you buy a policy today, your first annual premium is likely to be much higher for a permanent life policy than for term.

However, the premiums for permanent life stay the same over the years, while the premiums for term life increase. That extra premium paid in the early years of the permanent policy gets invested and grows, minus the amount your agent takes as a sales commission. The gain is tax-deferred if the policy is cashed in during your life. (If you die, the proceeds are usually tax-free to your beneficiary.)

The saying you always hear is, "Buy term and invest the difference." The fact is, it depends on how long you keep your policy. If you keep the permanent life policy long enough (and the market ever fully rebounds), that's the best deal. But "long enough" varies, depending on your age, health, insurance company, the types of policies chosen, interest and dividend rates, and more. The reality is that there is not a simple answer, because life insurance is not a simple product.

Guidelines to live by when buying

Even with all of these variables, there are some guidelines you can follow. The key is how long you plan to keep the policy. If the answer is less than 10 years, term is clearly the solution.

If it is more than 20 years, permanent life is probably the way to go. The big gray area is in between. Here is where you need an expert to run the term vs. permanent analysis for you. Of course, this assumes you keep the policy in force. Most people drop their policies within the first 10 years, but if you do your homework now, that shouldn't be the case for you.

How to choose

Categorize your insurance needs by their use. If you need $60,000 for college and your youngest child will graduate in three years, you need $60,000 of term insurance as a short-term hedge against your death, thus insuring that your child can finish his or her education. Meanwhile, if your estate will owe $200,000 in taxes at your death, you probably need permanent insurance, because you're not likely to die in the next 20 years (you hope). You also may want to re-evaluate your estate plan, but that's a different issue.

Once you figure out your needs, it's time to choose the type of policy that makes most sense for you.

Term insurance

Term insurance is relatively easy. You can buy term insurance that stops after 10 or 20 years, or that can be continued beyond age 70. You can choose for your premium to increase each year (annual renewal term) or to remain at the same amount for a fixed number of years.

Most term policies offer both a current payment schedule and a maximum rate for each year. With some policies, the company reserves the right to increase premiums if company costs increase. With others, your health may be a factor in determining rates. At certain "re-entry" ages, you may have to prove your good health in order to keep the lower premium.

Most term policies are convertible to permanent ones without evidence of good health.

Types of permanent life

The real wild card in terms of price is permanent insurance, because most policies have guaranteed and nonguaranteed portions. There are three main types of permanent insurance.

Traditional whole life: This type offers the most guarantees. The annual premium is guaranteed, and there are minimum guaranteed cash values and death benefits. Most whole life policies these days are "participating," meaning that the dividends they earn can be used to increase the cash value and/or death benefits, decrease the premiums or be refunded in cash.

If you are a conservative investor and also have trouble saving, traditional whole life makes sense.

Universal life: If you need premium flexibility, especially in the early years of the policy, universal life is for you. Universal life insurance was developed in the 1970s, when insurance-industry regulations changed to allow insurers to be more competitive with other financial-services providers.

Universal life insurance is more flexible than traditional whole life, because premiums can vary from year to year and sometimes can even be skipped. Universal life has maximum guaranteed premiums and minimum guaranteed cash values and death benefits. Instead of dividends, universal life policies earn interest at the credited interest rate determined each year.

Variable life: If you consider yourself a knowledgeable and risk-accepting investor, check out variable life. Variable life insurance has the fewest guarantees and therefore offers the greatest potential for cash-value increases.

There are required guaranteed annual premiums and a guaranteed minimum death benefit. However, there is no guaranteed cash value, and you have to select the investments for your policy.

Buyers typically are offered a variety of mutual fund accounts, ranging from money market funds to aggressive growth funds.

Not an investment tool

Life insurance should never be purchased solely as an investment. After all, some of your premiums are being used to buy death-benefit coverage and to cover other expenses (including sales commissions). Life insurance should not be purchased on children as a way to save for college, and make sure you (and your spouse) have all the coverage you need on yourselves before you buy any coverage on a child.

When you make your purchase, avoid all of the fancy riders, but do consider the waiver of premium, which suspends your premium payments but keeps the policy in place if you become disabled.

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