Life insurance as a savings account

(Money Magazine) -- Question: I'm 33, make about $150,000 a year and am starting from scratch to plan for retirement. A person close to me wants to sell me life insurance with a cash value feature as a way to save. Can you help me here? What do you think is my best option? --Carlos R., Houston, Texas

Answer: I'm not sure what "a person close" to you means. A relative? Friend? An acquaintance or co-worker? But whoever it is, the first thing I suggest you do is put some distance between you and that person, at least as far as your finances are concerned.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Ultimate Guide to Retirement

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Why? Quite simply, when it comes to saving and investing for retirement, life insurance isn't the first place to start. In fact, as options go, it should be way, way down on the list, if it makes the your list at all.

That's not to say you don't need life insurance. If you have people who are dependent on your income -- a wife, children, other family members, whatever -- you want to be sure they'll be taken care of in the event of your untimely death.

But the type of policy you want to provide that assurance is what's known as a term life policy. You pay an annual premium and the insurance company promises to pay a death benefit to your beneficiary if you die while the policy is in force. What makes a term policy ideal for basic insurance protection is that it gives you the biggest bang for your buck -- the most death benefit for your premium dollar -- which frees up more of your money for other things, including saving for retirement.

With a cash-value life insurance policy, on the other hand, only a portion of your premium goes toward the death benefit. The rest goes into the cash value or investment component of the policy, which, depending on the type of cash value policy, could be anything from something akin to a savings account with interest paid by the insurer to mutual fund-like investments.

As I see it, this approach has several drawbacks. Since only some of your money goes toward the death benefit, you have to shell out more money to get the equivalent death benefit you receive with a term policy. The costs you pay by investing through a life insurance policy also tend to be higher than what you'll pay for retirement investments outside the policy, and higher costs generally translate to lower returns.

These hybrid insurance-investment policies can also be complicated and difficult to assess. Finally, the value of one of their most highly touted tax advantages is, in my opinion, often overstated.

So if life insurance isn't the answer, how should you get a leg up on your eventual retirement?

Fortunately, there are plenty of retirement saving and investing vehicles around that are more cost-effective, more convenient and offer more straightforward tax benefits.

At the top of your list should be any retirement savings plan at work, such as a 401(k). Aside from relatively generous federal contribution ceilings -- up to $16,500 this year, plus another $5,500 for people 50 or older (although specific plans may set lower limits) -- 401(k)s offer a number of advantages, one of the biggest being that neither the pre-tax dollars you contribute, nor the investment earnings they generate, are taxed until withdrawal. Most employers will also kick in matching funds, typically 50 cents on the dollar for the first 6% of salary you contribute. In a sense, that amounts to getting paid extra to save for retirement.

If your employer doesn't offer a 401(k) -- or you've contributed as much as you can to your plan but can afford to save even more -- then you'll want to consider a traditional or Roth IRA. The contribution limits are lower than those for 401(k) accounts: 5,000 this year, plus another $1,000 for those 50 or older. But assuming you meet the eligibility rules, IRAs can be an excellent way to build a retirement nest egg, especially if you get started early in life, fund it to the max for many years and stick to low-cost investments like those on our Money 70 list of recommended funds.

If you've exhausted these possibilities and still have bucks you want to sock away for retirement, you can move on to tax-efficient investments in taxable accounts, such as index funds, ETFs and tax-managed funds.

One final note: Make sure your beneficiaries are prepared to deal with your policy's payout in the event of your death.

That's always a smart thing to do. But it's an especially relevant move now given that the New York State attorney general announced last week that his office is investigating the life insurance industry over whether beneficiaries of policies on military members and nonmilitary federal employees have been disadvantaged by having death benefit proceeds placed in low-yielding accounts.

Whether insurers have actually done anything wrong is far from clear at this point. But whatever the eventual outcome of this probe, for now at least the broader lesson is to make sure your beneficiaries understand how to handle policy proceeds -- which often amount to more money than many individuals have ever seen in their lives -- so that they can maximize the benefit from any payout.