Buy term and invest the difference, BTID dates back to the 1970s. It was first started by a man referred to as Arthur William. It has since gained more popularity since its inception.
There have been claims that this strategy is just a mere academic argument or business gimmick with the intention of making people replace whole life policies with term life insurance policies.
Is this true?
This article is going to answer this question by discussing all matters pertaining to the term life insurance policies as well as permanent life insurance policies.
What Does Buy Term and Invest the Difference Mean?
BTID is a practice that advocates for the replacement of permanent life insurance policies with term life insurance policies; with the difference being allocated to other investment opportunities like mutual funds.
The investments to be made with the amount of money saved will vary from one individual to another based on their investment strategy, with the sole motive of maximizing returns.
There is no doubt that life insurance coverage plays a major role in our retirement plans. However, policies in the United States have brought about a reduction in retirement benefits. This has made a lot of people, mostly from the middle-income society, wonder what they can do to ensure they can have a better life after retirement.
The introduction of this investment strategy has offered them the best solution by ensuring they have a safe and sound investment plan for their retirement.
Previously, whole life insurance plans were the best bet in ensuring one retires comfortably. The policy would come with an investment account, whereby the money is paid as premiums would be invested in other areas. The returns realized would be used to pay premiums or take additional coverage.
These investments could even be used as security when the insured is in need of a loan. With the advent of term life insurance policy coverage, whole life insurance policies have become less popular. The reason is that term life insurance is more accessible due to its lower costs. It, however, does not come with investment opportunities.
Does This Strategy Really Work?
It would prove very difficult to answer this question because your insurance needs do not necessarily have to be the same as that of another person. However, generally speaking, it would make more sense to purchase term insurance, which is less expensive, and use the amount saved to invest in other income-generating opportunities.
It is important to note that the saved amount would not be realized in whole life insurance policy coverage as the premiums paid in such plans are way more expensive.
To best answer this question, many factors have to be considered. While it may suit others to buy a term life insurance and using the remaining amount for other investments, many others will be well suited for permanent life insurance plans. However, if you opt for the former, you have to ensure to make good investment decisions to avoid losing more money.
Whole life insurance policyholders usually receive about a 3% return on their investment. This is way below the 12% return on investment which would have been realized if the person had invested in the stock market.
Even if you factor in the taxes charged on proceeds from investments made in the stock market, returns made from whole life insurance will still be considerably low compared to those realized in buy term and invest the difference. These further prove the importance of buying a term life insurance and using the amount saved to invest in other areas.
The Risks Involved
The strategy of buying a term life insurance and investing the difference can be effective in ensuring that you live a comfortable life after retirement. However, it does not have to be the best thing as there are some risks involved. These are;
People May Not Always Invest the Difference
The logic behind this investment strategy lies in the proper implementation of investments with the amount of money saved. Sadly, many people end up not investing the amount saved. It could be that you have an emergency that forces you to spend the money you would have put up for investment.
Some emergencies may be crucial requiring you to dispose of some of the investments already made. The end result is that you will not have any money left to invest after buying a term life insurance. Since no investments would have been made, you will only have your term life insurance policy to safeguard your family’s future in case you die.
May NOT Always Suitable to Buy Term
Despite term life insurance is cheap; you will have to part with more money if you are at an advanced age or if you suffer from a serious illness. You may be able to take a policy now at normal rates.
However, circumstances may change making term life insurance unsuitable for you in the future. Under certain circumstances, you may even not be eligible for a term life insurance policy. For example, there is a cut-off age for term life insurance.
Important Things to Note
Many people will not have an idea on what plan best suits them. Should you go for a permanent life insurance plan or should you choose to buy a term life insurance and put the difference in investments? Before we go ahead to answer this, let us consider the following.
- Term life insurance policies are only cheap during the first few years. After attainment of the level premium term age, you will start paying more premiums. The premiums will increase exponentially and go above the premiums paid in whole life insurance policies after about 20 years.
- Beneficiaries of whole life policyholders are assured of a death claim on condition that the insured never stopped paying premiums. The opposite can be said about term life insurance policies. In fact, less than 3% of insurance companies go on to pay death claims in term life insurance. This is so because a majority of people do not die within the time stipulated in their term life insurance policies; which makes them less expensive. This has been used by companies offering buy term and invests the difference to market themselves as the whole life insurance policies to be expensive.
- In most whole life insurance policies, the premiums paid by the insured are usually invested in other areas. After paying your premiums for about 20 years, the return on investments made will be enough to cover your premiums. This means that any premiums paid after 20 years can be fully directed in investment opportunities while you still have your life insurance.
Which Way to Go?
The truth is that many factors come into play when deciding which is the best between the two plans. For example, it would not make perfect sense to opt for whole life insurance if you think your investment skills are better than those of the insurance company.
Likewise, if your investment skills are poor, it would not make sense to opt to buy term insurance. Going for a term life insurance on the fact that the investments you make with the remaining amount will enable you to live a good life after retirement.
It does not take into account the fact that death could happen anytime. It also fails to appreciate the fact that your assets, which are to be inherited after your death, will be subject to government taxation.
Life insurance takes care of this because your beneficiaries will receive non-taxable benefits. Even after you retire from your job, you will still need to have life insurance policy coverage.
One thing is for sure, many people take life insurance policies as investments especially the whole life insurance. If this applies to you, then you need to decide on a plan that best suits your needs. To further illustrate what insurance plan you will need to take, let us look at the arguments that are in favor of whole life insurance and those in favor of buying a term life insurance.
Whole Life Insurance
There are quite a number of arguments that favor whole life insurance policies as great investment vehicles. Some of the benefits associated with this insurance plan include the following.
No Taxes on Growth
The cash-value component in whole life policies enables its holders to be exempted from their tax obligations. This only applies to the growth in investment which is realized in the form of dividends and interest. The policyholder is only taxed when withdrawing the funds. This benefit is also enjoyed in other forms of investment.
Claim Before Death
A claim can be made on the whole life insurance policy even before the insured dies. This happens when the insured suffers a terminal illness such as cancer, stroke, or heart attack. This is referred to as accelerated benefits and is meant to help the insured cover the hospital bills or enjoy the limited period left before he dies.
The result is that beneficiaries would not receive the full amount of benefits that could be given in case of death. This does not happen only to whole life insurance, but to many other investments. However, the charges involved in accelerated benefits are usually higher than normal charges.
The amount of money invested in a whole life policy can be used for other purposes, like paying for college fees or acquiring a new asset. However, when money is removed from a retirement scheme to be used for other purposes, such withdrawals are usually met with a 10% penalty.
You will also have to pay income tax for the amount withdrawn. Other schemes do not allow its members to withdraw any amount before the due date. Additionally, it makes no sense to make a withdrawal to funds meant to cover future expenses.
In any case, you will have to pay the interest accrued on the amount taken. Failure to pay the withdrawn amount will result in beneficiaries receiving fewer funds.
Keep It for Long
Another benefit of whole life insurance is that the insured does not lose his coverage even in old age. This is contrary to term life insurance which is lost after the period specified in the policy expires. This means that you can keep the insurance coverage even when you are above 90 years old.
Term Life Insurance
Term life insurance also has its own set of benefits as an investment. Some of the arguments that are in favor of term life insurance include the following.
It is Cheaper
The most notable argument in favor of term life insurance is its incredibly low cost. The cost of term life insurance may be 90% lower than the cost of whole life insurance, with both having the same death benefit.
The major reason for its low cost is the fact that a claim can only be made if the insured dies within the time set in the policy. A majority of people taking this policy end up losing their money; which happens when the policy expires before death.
For those who are tight on budget, a whole life insurance policy may be out of reach for them. Term life insurance offers them a solution by ensuring the beneficiaries are guarded against the risk of death but at a much lower cost.
Coverage for a Limited Time
Time life insurance covers only a limited period of time after which it expires. This is the main reason why it is cheap as compared to other types of life insurance plans. Many people only need life insurance coverage for the duration they are working.
This should be to cover for their family’s expenses in the event that the person dies early. When such a person retires, he will have his retirement savings released and would not need life insurance anymore. For such people, whole life insurance is a no-go-zone as they only need coverage for a short period of time. Term life insurance enables them to do this.
To add to this, most people take up whole life policies for the sake of passing their accumulated assets over to their family without having to pay taxes.
With time, however, this is not the case anymore. A person can still pass his estate without having to meet any tax obligations. In the US, any estate that is worth less than 2 million dollars cannot be taxed.
No Cash Value
The major thing that whole life insurance agents use to market it is the fact that the plan can be used for savings and investment. This does not happen in a term life insurance plan; which is why they cost low. However, the lack of cash value in term life insurance is not a bad thing as people can buy term and invest the remaining amount.
The cash value, that is present in whole life insurance, offers the owner the benefit of growing his capital without being taxed. For example, you can choose to deposit your money in the IRA account or a 401k account. In such a case, you will still enjoy similar benefits to those of a whole life insurance owner as the growth in your investment will not be subjected to any tax.
Pros and Cons of Buying Term Life Insurance and Investing the Difference
Let us have a look at the advantages and disadvantages of a term life insurance policy.
Pros are Here
Pay Less Premium
The premiums involved in a term life insurance is low compared to that in a whole life insurance policy. This means term life policyholders will save a lot of cash which can be put into other productive use.
Availability of Cash
In case you have an emergency, you can withdraw your investments almost immediately. This does not happen in whole life insurance policies which generally take 5 to 10 years for you to be eligible for any withdrawals.
Death Benefit Plus Investment
When you die, your family will not only receive your death benefit but will also have the proceeds from your investments. This is unlike in a whole life policy where the family only receives the death benefit; the cash value of the policy disappears after the death penalty is paid.
It is Flexible
If you happen to go through a hard financial time, you can always choose to stop your investments and continue when you are back on track. This is not the case with whole life policies that require you to continue paying premiums without stopping.
Let’s Find the Cons
No Continuity in Coverage
A term life insurance means that you will be covered only for the duration set in the policy. By the time this period ends, you will still be in need of insurance coverage. The sad thing is that it would be expensive to get new term insurance coverage when you are old.
There is NO Guarantee
There is no guarantee that your term insurance benefits will be realized. A claim can only be made if the insured happens to die before the period stated in the policy expires. Failure to this will lead to a loss of the premiums paid for the duration of the coverage.
Returns Will Be Taxed
The investments made with the amount remaining after taking a term life insurance policy will be subjected to tax. This is unlike that held in a whole life policy which is only taxed when being withdrawn.
Requires High Discipline
After buying a term life insurance policy, many people may be tempted to spend the remaining amount rather than investing it. To be at par with a person taking whole life policy, you will have to have discipline and invest the remaining amount wisely.
Is buy term and invest the difference better than a whole life insurance policy? Let us have some illustrations of the two life insurance plans to know what is best.
Term Life Insurance Illustration
Take, for example, a 40-year old man who does not smoke and is in perfect health at the time of taking the policy. This man can obtain a 20-year life insurance policy that promises to pay $2 million as death benefit while paying as low as $960 premiums each year. The man’s family will get a benefit of $2 million if the man dies before the 20-year period ends.
It is evident, from this illustration, that a term life insurance offers a high rate of return when the insured dies before the period stated in the policy expires.
On the other hand, it offers a zero rate of return in case the insured is still alive at the time when the policy term expires. In such a case, the plan will only help to achieve peace knowing that your family will not suffer in the event that you die.
What happens if you would have opted to invest the $18240 that you would otherwise have paid as premium for 20 years, in the stock market? The average rate of return in the stock market is 8%, meaning that the $18240 paid as premium would have grown to $51920 before any tax is deducted.
This makes it necessary for one to choose between the idea of investing $18240 over a period of 20 years and getting $51240 as returns, or, put the $18240 in term insurance with the possibility of receiving $2 million as a return.
Whole Life Insurance Illustration
What if the man mentioned above would have chosen a whole life insurance plan. He would have paid a total of $18740 annually as premiums if he chose a permanent life insurance plan.
As you can see, the yearly premiums paid in the whole life insurance is almost the same as the premiums paid for the entire 20 year period of a term life insurance.
Let us look at the facts below.
- After paying a total of $93700 as premiums for five years, your cash value will be $39760.
- The cash value after 10 years will be $131260 whereas you will have paid $ 187400 as premium.
- The cash value after 20 years will be $374800. By this time, you will have paid $363260 as premiums.
If the man would have opted for a term life insurance plan and invested the remaining, he would have $961612 at the end of the 20 year period.
Some people may argue that the 8% rate of return that applies to investments made in the stock market is not guaranteed, whereas the cash value in whole life insurance is guaranteed. This is indeed true.
However, you can opt to put the saved amount is a saving account. Supposing the savings account gives you a 1% rate of return, you will have a total of $417342 after 20 years, which is above the $374800 you can get in a whole life insurance policy after 20 years.
Does BTID Suit Everybody?
Not everyone is suited to buy term insurance. The need for this investment strategy will largely depend on your future goals and your financial situation. For example, whole life insurance policies are best suited for those who want to avoid estate tax.
If you live in a state that taxes estate beyond a certain value, whole life insurance policies would help to reduce the size of your estate as whole life insurance policies are not considered as part of your estate.
This would mean that you will have used a legal way to avoid paying taxes while at the same time ensuring that your family will have a bigger amount given to them as a benefit. In such a case, buying a permanent life insurance policy would be the ideal solution.
Permanent life insurance policies would also be ideal for those who have a family member with special needs. In such a case, it would be best to take up this type of insurance plan where the plan will be held in trust by an irrevocable life insurance trust.
This would ensure that the family member with special needs will live a decent life even after your death. The same applies if your family history has a condition that would involve high medical expenses in the future. In such cases, the affected person may not qualify for term insurance in the future which necessitates the early buying of permanent life insurance policies.
Whereas buy term and invest the difference is a good strategy of securing a bright future for yourself and your loved ones, it may not always be the best strategy to use. Several factors, most of which have been discussed here, play a role in determining the best strategy to use.
The bottom line is that all these plans have one common agenda; to save as much as possible, avoid unnecessary taxes, maximize returns, and enjoy a better life after you retire.