Investing with insurance: a bad risk

NEW YORK (Money) -- Question: I'm 25, make about $50,000 a year and invest $150 a month in an insurance policy for retirement. I do plan on contributing to my workplace retirement savings plan soon and also hope to open a Roth IRA, but in the meantime my adviser has suggested I increase my investment in the insurance policy to $300 a month. What do you think I should do? - Rob

Answer: I'm a big advocate of life insurance. For all practical purposes, it's the only way to assure that a family will have enough money to maintain a decent lifestyle should a breadwinner die.

So to my mind at least, a term life policy should be a core element of almost every family's financial plan. But I'm not a fan of schemes that combine life insurance protection with investing, especially investing for retirement.

Usually, the pitch goes like this: Buy an insurance policy - typically a variable universal policy, although others will do - and have part of your premium pay the death benefit while the rest goes into an investment account that grows without the drag of taxes.

Then, instead of just drawing the earnings from the policy at retirement and paying taxes on your gains, you borrow the money instead. The loans aren't taxed, so you've essentially gotten a tax-free return.

Sounds great in theory, but there are several sticking points in reality. For one thing, a slew of marketing, sales and investment fees significantly drag down your returns.

And you may not be getting a very good price on the basic insurance protection either. And while the borrowing scheme may seem like an easy enough way to turn taxable gains into tax-free payouts, there are complications there too, the largest being that if the policy lapses after you've been borrowing from it throughout retirement, you could be hit with a big tax bill at a very inopportune time.

All in all, I don't think these policies are worth the trouble. That said, I suppose you could make a case for one if someone were already maxing out tax-advantaged alternatives like 401(k)s, IRAs and the like. I don't think it's a very compelling case. I believe someone would still be better off investing in tax-managed funds and tax-efficient mutual funds before even considering investing in life insurance.

But I suppose someone who really wanted to use (or sell) one of these policies could come up with a rationale. But I doubt that even the biggest proponents of investing through life insurance would suggest that you do so before you had contributed all you can to 401(k)s, 403(b)s, IRAs and the like.

After all, it makes no sense to give up the lucrative up-front tax breaks that a 401(k) and traditional IRA offer (or the more straightforward tax-free withdrawals of a Roth IRA) in favor of an insurance strategy that's a lot more expensive and fraught with potential complications.

But that's exactly what you're doing by foregoing your workplace plan and a Roth while plowing money into this policy. And now you're thinking of compounding your mistake.

So I've got one word of advice for you: Stop. That's right. Stop investing in the insurance policy, sign up for your workplace plan and open that Roth IRA. Once you've done that, you can turn your attention to figuring out what to do with your policy and any cash value you have in it (if, indeed, you have any). For more on your options, click here.

Oh, and one more thing. If the adviser who put you in this policy comes to you with any other brilliant ideas, I suggest you turn around and walk away, fast.