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If you want to provide financial protection for your loved ones should you pass away unexpectedly, you have a few options. You can buy life insurance, put money aside in a savings vehicle, or do both.With life insurance, you pay premiums to the insurance company and if you die while the policy is in effect, the company will pay a death benefit to your family. Some policies also come with a savings component, known as the cash value, that you can access while you’re alive.With a savings account, on the other hand, there are no monthly or annual premiums (or death benefits). You can contribute as much or as little as you want to the account, and can generally withdraw the money at any time for any reason. (Keep in mind, however, that savings accounts typically limit you to six withdrawals per month.)If you’re trying to decide whether you should invest in life insurance or a savings account, the answer is probably both. Here’s what to consider.
Understanding Life Insurance and How It Works
There are numerous types of life insurance, but they generally fall into two main categories: term life insurance and permanent life insurance. Term life insurance: This is a relatively low-cost type of life insurance that is designed to cover you for a set term, hence its name. For example, you might purchase a 20-year or 30-year term life policy. You pay a premium each month (or year), and should you pass away during that time, a benefit is paid out. If you don’t die within the time frame specified in your policy, it expires with no payout. Permanent life insurance: This type of life insurance lasts your entire life and often includes a cash value component, which you can withdraw or borrow againstwhile you’re still alive. A portion of your premium payment goes into the policy's cash value, which accrues either interest or market returns based on other investments. The cash value grows on a tax-deferred basis. Because the insurer is guaranteed to pay a death benefit to your loved ones (assuming all premiums are paid), permanent life insurance rates are considerably higher than those for term life insurance.
Benefits of Life Insurance
Whether you opt for term or permanent life insurance, there are multiple benefits to purchasing a life insurance policy.
Pays Out a Death Benefit
When you have life insurance, your loved ones will receive a lump sum of money if you die while the policy is active. This can make up for the loss of your salary and cover future living expenses for your family, like mortgage payments and your children’s college tuition. It can also provide a financial cushion for unforeseen expenses they may encounter.
Term Insurance is Relatively Low Cost
Depending on how much coverage you need and your age when you apply, you may only have to pay a small monthly fee for a term life insurance policy. In the event of your death, the payout will be significantly more than you paid for the policy.
Cash Value Can Help You Save
With some types of permanent life insurance, like whole life, your premiums are split to pay for a death benefit and an interest-bearing, savings-like account called the cash value. Your cash value will earn returns — plus dividends, if any — that can later be either withdrawn or borrowed against for future expenses, including retirement. (It is important to discuss withdrawals and/or loans with your financial advisor or insurance agent because withdrawing your cash value can collapse the policy.)
Risks of Life Insurance
Purchasing life insurance also comes with some downsides. Here are some to consider.
Cash Value Can Be a Weak Investment Vehicle
The rate of return on the cash value component may be lower than simply investing the money in a retirement or other investment account. Also, if you choose to redeem your cash, there may be fees involved which can eat into your returns.
Whole Life Insurance Can Be Costly
Whole life insurance tends to be expensive, often in the range of hundreds of dollars per month. Early on, most of your premiums typically go toward fees, not your cash value. To see the full benefits of whole life insurance, you generally have to continue paying high premiums for at least five to ten years, often longer. The same can be said of other types of permanent insurance.
Term Life Insurance Can be Costly Under Certain Circumstances
Life insurance premiums are determined by your medical profile and age. As a result, you will typically pay more for term life insurance coverage if your profile includes anything that could potentially increase your risk, such as being older and/or having any health conditions. Remember, the premium is based on the likelihood that the death benefit will be paid out.
Harnessing the Cash Value of Your Life Insurance Policy
If you have a permanent life insurance policy with a cash value, a portion of your premium is credited to the policy's cash value and can be used while you're alive. There are a number of ways you may be able to tap this benefit. For example, you may be able to:
Take out a loan that borrows against your policy's cash value when you need money.
Let the cash value grow and use it to supplement your income in retirement, for example.
Terminate — or “surrender” — your policy and receive the entire cash value (minus surrender fees).
Understanding Savings Accounts and How They Work
A savings account is a deposit account that’s designed for holding money you don’t need right away. These accounts are offered by traditional banks, online banks, and credit unions, and they pay interest to help your money grow. Interest is expressed as an annual percentage yield (APY). An APY tells you how much interest you expect to earn on your money in one year. The funds in a savings account are liquid. However, they are generally less accessible than the money in a checking account. Checks can’t be written against them, and you’re often limited to six withdrawals or transfers per month. If you exceed the bank’s transaction limit, you’ll likely be charged a fee.Savings accounts are federally insured up to $250,000 per account holder, so you can’t lose your money (up to the limit) even if the bank goes belly up.
Benefits of Savings Accounts
Here’s a look at some of the benefits of opening a savings account.
Earn Interest on Your Deposits
The money you keep in a savings account earns interest and compounds, meaning you earn interest on the interest that’s added to the account, helping your money grow over time. Online high-yield savings accounts typically offer the highest interest rates.
Early Access to Your Money
With a savings account, you can access your money when you need it. There are no waiting times or holding periods, and you won’t have to pay any surrender fees or other fees to withdraw your funds.
Freedom to Miss Payments
With a savings account, you can create a “forced savings” plan by setting up a recurring automated transfer from checking to savings each month. However, if money gets tight, you can simply cancel the transfer without any consequences. If you miss payments on a life insurance policy, by contrast, the policy could be canceled and you could potentially lose everything you’ve paid in thus far.
Downsides of Savings Accounts
Savings accounts also have some drawbacks. Here are some to keep in mind.
Low Returns
Traditional savings accounts generally pay a relatively low APY. While high-yield savings accounts can pay 25 times the national average for savings accounts, these accounts generally don’t pay enough interest to hit long-term savings goals, like retirement or a child’s college education. For that, you may want to consider riskier investments like stocks or mutual funds.
Taxes
The interest you earn on a savings account is considered taxable income. Life insurance cash value accounts, on the other hand, generally grow tax-free.
No Death Benefit
Unlike life insurance, there is no death benefit with a savings account. This means if you die before you have had enough time to save enough money for your family and do not have life insurance, they could be left in financial distress.
Savings Account vs Life Insurance Account
Here are some of the major differences between a savings account and a life insurance cash value account.
Savings Account
Life Insurance Account
Low returns
Potentially higher returns
May have no fees
Costly premiums
Earns taxable interest
Tax-advantaged savings
No death benefit
Death benefit
Flexible monthly savings amount
Monthly payments often fixed
Can access money any time
Waiting period before you can access savings
Do I Still Need Life Insurance When I Already Have Good Savings?
It can be a good idea to have life insurance even if you already have good savings. A general rule of thumb is to have at least 10 times your annual income in life insurance coverage. Many people don’t have that much socked away in a savings account (or other savings vehicles). As a result, your savings may not be enough to support your family, especially if you die young or have multiple dependents.
Can You Combine Both Accounts?
Yes. Life insurance vs a savings account generally isn’t an either-or proposition. Many people have a life insurance policy and a savings account (as well as a retirement account). A savings account allows you to put aside money for a rainy day, while a life insurance policy covers you in ways that a savings account generally cannot. In addition, it’s a good idea to have a retirement account to maximize your financial security.
The Takeaway
Life insurance and savings accounts are two ways you can build financial security for your family. It’s generally a good idea to keep at least three to six months’ worth of living expenses tucked away in a separate high-yield savings account to cover the unexpected expenses or loss of income. However, in some circumstances it is more appropriate to have at least 12 months of expenses saved. When it comes to life insurance, you may want to get a policy that would pay at least 10 times your annual income. By balancing savings with life insurance, you can keep your family covered now and into the future.If you’re looking for the best return on your savings, it generally pays to shop around. With Lantern by SoFi’s online banking marketplace, it’s easy to compare high-yield savings accounts based on APY, fees, and balance minimums. Lantern can help you compare online savings accounts and find today’s best rate.
Frequently Asked Questions
Does life insurance work in the same way as a savings account?
Is life insurance more expensive to sustain than a savings account?
Can my life insurance be used for emergencies?
Can I borrow using life insurance as collateral?
Who receives the dividends of the life insurance?
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About the Author
Jason Steele
Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.
