I may sell investments to buy whole life insurance. Is that smart?

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Q. I’m thinking of selling some of my investments to buy a whole life policy that has a guaranteed return. I know I shouldn’t sell when stocks are down and I don’t need the life insurance, but I can’t stomach the volatility. What should I consider?
— Investor

A. We understand why stock market volatility has been making you uncomfortable.

When structured properly for cash accumulation, permanent insurance like a whole life policy can be a valuable tool with many benefits, but it’s not right for every investor.

Let’s start with the pros.

A whole life policy can accumulate cash value that’s tax-advantaged, guaranteed to grow and never declines in value, said Matthew DeFelice, a certified financial planner with U.S. Financial Services in Fairfield.

Just as you might “invest” in a home renovation to add value to your home, purchasing a whole life insurance policy can add significant value and stability to your financial plan, he said.

“When you pay whole life insurance premiums, a portion goes towards the cost of insurance, some is put towards sales and administrative fees, and the rest goes towards the policy’s cash value,” DeFelice said. “In the early years, fees and the cost of insurance use up the majority of your premium but, over time, an increasing amount is contributed towards the cash value.”

He said one of the biggest benefits of using whole life insurance in this way is the tax-free nature of accessing your cash. Withdrawals are taken first from your “basis,” which is the amount you’ve paid into the policy. So for example, if you fund the policy with $100,000, the first $100,000 you withdraw is considered a return of your basis and is tax-free, he said.

After that, you can still access the additional cash in the policy tax-free by taking policy loans.

‘You’ll be charged interest on the loans, usually in the range of 5% to 8%,’ he said. “You aren’t required to pay back a life insurance loan, but if the principal and interest aren’t paid before you die, the loan balance and fees will be deducted from the death benefit.”

Additionally, when borrowing from your cash value, you have to be careful not to borrow too much, DeFelice said. If the amount of the loan plus interest owed reaches the total cash value of the policy, the policy can lapse, he said.

The cash value within a whole life policy has an impact that extends to your entire portfolio of assets.

“If you’re retired and relying on selling stocks and bonds to generate income, a recession could throw a monkey wrench into your financial plan,” DeFelice said. “You either need to reduce your income or sell more assets at lower prices to generate the same amount. If you have a whole life insurance policy with enough cash value, you can use it for supplemental income rather than selling any stocks or bonds, and wait for the markets to recover.”

That being said, you need to determine if whole life insurance is a “good” investment for you.

That’s a tricky question because a “good” investment is relative to each person’s situation, DeFelice said.

“It depends entirely on multiple factors, including but not limited to your age, your health — life insurance requires you to go through medical underwriting before buying — your financial resources, your invested assets, family needs, etc. – just to name a few,” he said. “I will say that while it can be a great way to build a tax-free pot of cash, it should not be viewed as a stand-alone alternative to traditional investing.”

“I would not recommend selling all of your mutual funds, stocks and bonds and using that money to fund a whole life policy,” he said.

DeFelice said he would never recommend putting all your eggs in one basket. Plus, a cash accumulation whole life policy works best when used in conjunction with traditional investment portfolios.

Additionally, there is a limit to how much money you can put into a whole life policy in the early years. For example, you can only fund the policy with so much money for a given death benefit. The more you dump in, the higher the death benefit needs to be, and therefore higher insurance costs will need to come out, he said.

Because of the low, fixed returns, it takes time for the cash to build up to a meaningful level, even if you are compressing the premium payments to the first five to 10 years, he said.

“I would say you need at least 15-plus years of growth within the policy before you start tapping the cash,” he said. “:Therefore, we wouldn’t recommend whole life insurance as an investment if you’re older, as you have less time to see quality returns and enjoy the benefits of using that cash.”

It is also essential to understand that the policy’s cash value is not added to your death benefit. That means if you pass away and the cash value has not been used, you may lose it, DeFelice said.

You should also note that whole life policies have “surrender fees” in the early years of coverage, typically the first eight to 10 years, he said. So if you decide to get back into a “traditional portfolio” after a few years, it will cost you to unwind your life policy.

“A whole life policy has many advantages when used properly by the right individuals, but it is just not the type of investment you make simply as a market alternative when you are risk averse,” he said.

Depending on whether your assets are invested within retirement or non-retirement accounts, you may want to consider investing some of your funds into a Fixed Index Annuity (FIA) instead, DeFelice said.

“These products also have surrender charges in the early years but can offer many benefits to people with low tolerance for market risk,” he said. “Your money won’t technically be invested in the market, but the return you earn each year is linked to the performance of a specific market index, like the S&P 500.”

Typically, these products will limit your upside with caps and participation rates, but will also limit your downside, DeFelice said, and he offered this example.

If an FIA has an 80% participation rate and a cap of 10%, your annuity would get credited with 80% of the market index gains up to 10%. Conversely, if the market index is down 5,10 or 15- plus percent in a given year, your annuity would simply earn 0% but would not go down in value.

“You gain the potential for market-like returns on the upside without taking on the risk of declines,” he said. “And if structured properly they can also provide you with guaranteed lifetime income. Even if you spend down the account value to zero, you would continue to receive income from the annuity carrier for as long as you live.”

However, he said, not all FIA’s are created equal, and like any investment the devil is in the details. These products can be complex and are not suitable for everyone, he said. It would depend on your liquidity needs and time horizon, and it is not recommended for all of your invested assets – only a portion.

The bottom line is you should speak with a qualified financial planner who can offer you some options to consider given your risk tolerance and time horizon before making any quick emotional decisions.

“Your asset allocation should be made based on what you need to accomplish with this money over time,” DeFelice said. “Obviously if you are retired and need income now you have different needs than someone in their 40s or 50s who is still working. Proper planning may help alleviate some of your risk aversion and make it easier for you to stomach the inevitable corrections when they occur.”

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This story was originally published on Aug. 30, 2022.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.