Protect your family without breaking the bank

Ask Money Magazine's undercover financial planner a question. Send e-mails to: themole@moneymail.com.

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(Money Magazine) -- Question: What's the best type of life insurance? Should I buy term, whole life or universal insurance?

The Mole's Answer: I firmly believe the role of insurance is to protect wealth, not to create it. A term policy is pure insurance, while whole life and universal policies are a mixture of insurance and investments. For reasons I'll explain below, I think the optimum solution is to buy a low-cost term insurance policy and invest the rest yourself, outside of any insurance wrapper. But the optimum solution may not work for everyone.

Insurance products are so complex that you might need a Ph.D. to actually understand some of them. Here are the basics of the three life policies you mentioned.

Term life insurance: Typically provides a fixed amount of insurance for a specified number of years. Because it doesn't carry an investment component and has a fixed expiration date, it's very inexpensive.

Whole life insurance: Combines life insurance with a savings plan that builds up cash value.

Universal life insurance: Also combines life insurance with investing. This is typically more flexible than whole life, as the policy holder often has choices in how the savings component is invested.

Many financial planners will refer to term insurance as temporary insurance, and whole and universal as permanent insurance. Buying permanent insurance may bring more of a sense of security for your family. But let's examine the economics first.

When you buy a permanent policy, you pay for two things: The premiums that go toward the "death benefit," which is the payment made to your beneficiaries when you die, as well as payments into an investment account. The investment account builds a "cash value" for the policy which you can borrow against or withdraw, less fees, if you cancel.

If you buy whole life insurance, look at the portfolio of the insurance company you are buying the policy from. You can do this by perusing its financial statements, and I'll bet you'll see that it's mostly in bonds. Therefore, you should expect the return from the investment portion of your insurance to be similar to that of a bond portfolio, minus commissions and fees.

Buying a universal life policy often gives you options on how your money is invested, but those options usually have one thing in common - extremely high costs. Not to mention that the premiums for the death benefit of these vehicles increase as you age, until you could eventually find yourself paying ten times the amount you first started paying.

It is also important to ask how you would get out of the policy if you wished to, and how much that would cost you. Both permanent policies usually charge "surrender fees" if you try to cancel the plan. I'm always suspicious of any product that is easy to get into and hard to get out of.

So what is the optimum solution? Because the investing portion of the premium in both whole and universal life is so expensive, I tell clients that they would likely be far better off if they buy an inexpensive term life policy, and invest the savings on their own.

This solution gives you the protection you need for your family, and allows you to build the investing component for a fraction of the cost charged by an insurance company and financial planner.

I've often heard other planners argue for permanent insurance by saying that you can borrow against it, that it's more tax-efficient, and that it's a great estate planning vehicle. But I'm still convinced that in the vast majority of cases, there are far more efficient vehicles to address those needs.

I do believe that permanent insurance can be a forced savings vehicle for those clients who would have a hard time saving otherwise. If I get a client to buy term and they end up spending the savings rather than investing it, I have done them a disservice. An expensive investment is better than none at all.

But it's important to know the motivations of anyone trying to sell you something. The truth is that financial planners make far more from selling whole and universal life insurance than we do from selling inexpensive term insurance.

If you are a disciplined saver, I strongly recommend buying term and investing the rest. If you need a forced savings vehicle and you can't find that vehicle elsewhere, then you may want to consider a permanent policy. But either way, make sure you understand what it is you're buying and how much it's costing you.

Ask Money Magazine's undercover financial planner a question. Send e-mails to: themole@moneymail.com.