Today I’d like to respond a bit to a clip from Dave Ramsey’s television show on Fox Business where he talks about life insurance as being “terrible” and how buy term and invest the difference is a better strategy than using any type of cash value life insurance. And just to clarify before I begin, I really agree with much of Dave Ramsey’s teaching and in terms of his advice of getting out of debt, cutting up credit cards and putting a stop to out of control consumerism.
But when it comes to life insurance he’s wrong and he completely attacks it willy-nilly. In particular I’m going to focus on his attacking all things related to cash value life insurance.
There are a few main points I’d like to make about cash value life insurance:
The first misconception about cash value life insurance is that it is a terrible cash accumulation tool. Of course I absolutely agree with Dave Ramsey when it comes to the way most agents out there structure cash value life insurance. When directed by an incompetent or unscrupulous agent (both are equally bad), it does stink as a tool for accumulating cash.
That’s why it’s important for you to understand that you need to work with a professional that knows what they’re doing, otherwise you’ll prove Dave right in that cash value life insurance is a terrible place to put your money. However, but for the few of us who know how and/or choose to structure these policies properly there can be huge benefits for doing that.
A few important basics to always keep in mind:
1. Remember money inside a cash value life grows tax deferred according to section 72e of the IRC.
2. The death benefit is paid out income tax free according to section 101a of the IRC.
3. And section 7702 of the IRC explains how the value inside a policy can be accessed without a tax consequence. That potentially tax free income can make a huge difference in your retirement plans, especially if you think tax rates increase in the future.
So, what do you think…are taxes going up, down or likely to stay the same in the future?
I rarely talk to anyone who believes taxes are going down, especially in light of the rising deficits with which our elected officials are obviously so smitten.
If we take the numbers Dave Ramsey uses in a common example, according to a 32 year old male who’s making 40k per year, he should be using 15% of his income to:
A. Buy term life insurance
B. Buy mutual funds with the rest of the money.
Dave says growth stock mutual funds are the right investment with all of the money you would be using on a cash value life insurance policy. This is the classic buy term, invest the difference advice.
So, buy a really cheap term life insurance policy and take the difference of what you would have spent on the cash value policy and plow it into growth stock mutual funds.
I forgot to mention that he always recommends you buy 10x your income in life insurance death benefit.
Sound familiar? If not, watch a little of this video to get a taste (skip ahead to 5:21, that’s where it gets really good)
The idea is that in 20 years when the term policy runs out, the money accumulating in the growth stock mutual funds will have outpaced the death benefit and therefore the death benefit is no longer needed.
On the flip side Dave proposes that funding a cash value life insurance policy with that money is a horrific mistake. In classic Insurance Pro Blog fashion, I intend to argue that point and actually show you the numbers because all talk and no facts equal a whole lot of nothing.
Let’s compare the two strategies and the shortcomings.
Tom is a father, 32 years old with 2 children and has an income of $40,000 per year, using Dave’s math we’ll use $6,000 (15% of his gross income) toward the retirement plan. According to Term4Sale.com Tom could purchase a $400,000 20 year term insurance policy at a cost of about $217 per year if he’s in perfect health and doesn’t use any sort of tobacco products.
That leaves Tom $5783 to invest into growth stock mutual funds and we’ll assume that he earns an 8.0% rate of return over that that time frame. You could obviously argue with me on that rate of return and yes it is much less than the 10% that Dave Ramsey often talks about but given recent history I think that 8.0% is probably more realistic.
In truth, we prefer to use something like 6% when we help our clients plan for the future.
If I look at the investing calculator over at Dave Ramsey’s website, it tells me that Tom should have $285,753.12 (this is the gross number) after investing $5783 per year for 20 years. Note: Other things that should be taken into consideration are taxes and costs but his calculator doesn’t provide those options. With mutual funds you will have both to consider. Now, tax rates are difficult to nail down but let’s just use a 15% federal tax rate because with Tom’s income and having two kids, that’s probably not that far off.
Wait a minute…I thought Tom would have enough saved/invested after 20 years that he wouldn’t need that term insurance anymore? Well, I guess if we assume he really does have all his debts paid off and no other lingering financial obligations this may be true.
Prudent financial planning isn’t based on a set of unrealistic assumptions.
Well, for one thing I would never assume an 8% rate of return when helping a young guy like Tom plan for his future. It’s just plain irresponsible.
What if he doesn’t hit 8%? After 20 years, it’s kinda late to go back and put more money away…the genie’s out of the bottle at that point.
As Brandon and I have stated many times, chasing investment returns is a poor substitute for having not saved enough. Not to mention, in twenty years Tom is 52 years old and has no life insurance under Dave Ramsey’s model.
How many people do you know at 52 who have no need for life insurance?
I’ve been in this industry for 13 years and I’ve only met a handful of people who were in that position at 52 and what’s more, none of them were people who made $40,000 a year.
Please don’t misunderstand me, term insurance is a valuable tool and most people like Tom should own more of it. But I don’t think the buy term , invest the difference crowd has ever considered the reality that most people’s lives don’t move in a straight line from point A to point B.
Back to the numbers
If Tom were to use a policy structured correctly as we often do for our clients, he would pay a premium of $6,000 annually which would buy a death benefit of $400,000. In 20 years, he could request the policy be “reduced paid-up” and his death benefit would be $558,488 with a cash value of $213,895.
Yeah, the cash value isn’t as much as the $285,753.12 he would hypothetically have if he invested the difference and managed to net 8% compounded. However, he can take his insurance cash value income without a tax consequence if executed properly. Also, if he chooses to leave the cash value alone, it will continue to grow and his policy will continue to earn dividends.
Does that seem like a fair exchange of value to you?
It does to me and this is the power of cash value life insurance if done correctly with an agent who cares to do the best for their client.
If you’d be interested in learning more of how this works and how it might benefit your situation, contact us.