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Investing in life insurance
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October 12, 2001: 11:10 a.m. ET
Should I invest in life insurance policies or an IRA?
MONEY columnist Walter Updegrave
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NEW YORK (CNNmoney) - A financial advisor suggested that my wife and I invest in whole life and variable life policies. My understanding is that these policies are better than an IRA because I can withdraw my money tax free. Do you think these are good investments?
I'm all for owning insurance as a way to protect the financial security of one's family in the event a breadwinner dies, leaving loved ones without an income. But this notion of peddling policies as a supercharged retirement account really bugs me, because I don't think most of the people buying these policies realize the risks they're taking. Hey, maybe the guys selling the policies don't realize the risks. Regardless, however, I advise you to proceed with extreme caution. Here's why.
Handle with care
It's true that whole life and variable life policies can generate gains that are free of taxes as long as those gains remain in the policy. The return in a whole life policy comes in the form of dividends paid by the company. Variable policies, on the other hand, typically have several investment options that are much like mutual funds. So the gains you earn depend on the performance of the investment options you choose. In both cases, of course, the insurer siphons a healthy amount off the gross return to pay for things like sales commissions, marketing expenses and other costs.
Now, if you simply withdraw money from your policy, you would pay tax at ordinary income rates on any gain. In other words, you would have something much like an IRA -- that is, a tax-deferred investment -- except that you would also be paying for insurance protection, plus, in most cases I think it's safe to say, higher expenses than you would incur in an IRA. So if you look at these policies as tax-deferred investment vehicles, they don't seem to be a better alternative than IRAs. In my mind, their higher expenses make the lousy alternative.
The tax wrinkle
Ah, but if you can cast the policies' returns as tax-free, well, that would give them an advantage. But are the returns tax free? Well, they are if, instead of just withdrawing your money, you borrow it from the policy. And, in fact, that's the gimmick on which these policies are based: you invest money, let its value build and you then borrow against the policy's value, usually with no- or low-cost loans.
The problem with this little gimmick is that under some circumstances it could lead to a tax nightmare. Let's say that after borrowing several hundred thousand dollars from your policies, you and your wife find yourselves short on cash. So short that you can't afford the policy's premium and you let it lapse. In that case, most of the loans you took out would immediately become taxable income and you could be stuck with a huge tax bill. Oh, there is one way to avoid the tax bill. If you die, the policy's death benefit would repay the loans, erasing your tax liability. But I doubt that most people would see this as a very attractive solution.
My advice: buy insurance if you need insurance protection, but don't muddy the waters by using insurance as an investment vehicle, especially a vehicle based on the smoke and mirrors of supposedly tax-free returns. 
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