The Difference Between Term, Whole, and Universal Life Insurance

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Let me give you a very simple explanation of life insurance, the history behind it, and the three types: term, whole life, and universal life.

THE LIFE INSURANCE MORTALITY TABLE

Let’s say that we look at a mortality table from the time a baby is born until they finally passed away. This mortality is measured by the commissioner standard ordinary table where they measure the deaths per thousand at every age, starting at age zero, up to age one hundred, one hundred and ten, one hundred and twenty.

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We know that clear back in 1958; that was a very popular mortality table. If you took a one thousand thirty-year-olds in America, there were 2.13 deaths that year per thousand thirty-year-olds. Every year we get older, there’s more of the thousand people that are dying because of accidents or illnesses or whatever.

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So let’s simplify this. If we wanted to provide a $1,000 death benefit to help the beneficiaries (the widow, the orphans, etc.). Of those two out of one thousand thirty-year-olds that were going to die that year, and we passed a hat around the room to the thousand people, how much would everybody put into the hat so we would have $2,000 to pay to the two beneficiaries.

TERM INSURANCE

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Well, the answer is two bucks. Everybody chipped in two bucks. We now have $2,000. So when the two thirty-year-olds die, we have $2,000 to pay out. That’s term insurance.

The insurance company calculates term insurance, based upon the mortality table, how many deaths per thousand. As you get older, you have to donate more money to the hat.

Pure term insurance goes up in price every year because more and more people are going to be passing away per thousand. By age sixty-five, it used to be, that probably a third of American males had died or had a serious problem.

Now, mortality is extending. So term insurance is just the pure cost of insurance

WHOLE LIFE

Well, whole life insurance was designed to not have to keep paying higher and higher and higher premiums. What could we pay at a level premium that would cover us for our whole life?

And so they would calculate maybe by age 65 or whatever.

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Well, how much would we need to pay a level premium? Maybe we might have to pay ten or twenty times that. But we pay a level premium for our whole life, and we give that to the insurance company.

They’re just like the bank (the hat holding the money), and they invested it and have to keep it safe. That is a level premium.

So what’s happening is you’re way overpaying the actual cost or the actual amount you would have to put in that hat in the early years, but you’re underpaying the latter years. What happens after age sixty-five is you keep paying that level premium. You still get covered, even though you’re not paying near what you should be at that point.

Because you overpaid the early years and that money has accumulated equity, or cash value with the insurance company.

VARIATIONS ON WHOLE LIVE

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Now after just straight whole life was created, a lot of times people said, “Well, I don’t want to pay any more premiums for my whole life.”

So what happened is they said you can pay a little bit more until age sixty-five and you can stop. Now you’ve overpaid enough that you don’t have to pay any more money.

“Well, what about twenty years, or ten years? What if I just paid one lump sum? How much would I have to pay in one fell swoop to never have to pay another premium?”

That is so much money in the insurance company’s coffers, that the interest on that, based upon your life expectancy will, cover you for your whole life. Okay, so that’s whole life insurance and it’s based upon how many years of premiums you want to pay in a level amount or a lump sum.

UNIVERSAL LIFE

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Well, back in 1980, E.F. Hutton was the brainchild behind the third type of life insurance, universal life. Now, it got its name because it is universally applicable to two different objectives in general.

One, you could get away with paying a little bit less premium than a lot of whole life back because your rate of return on the insurance cash value was actually a little bit higher than the normal rate of return or interest being credited, or dividends, in a whole life policy. This was back in 1980; interest rates were high.

So if you wanted to just have death benefit, you could probably get away, instead of paying this much money, you could pay a little bit less. Or this much money you could pay a little bit less into a universal life policy, because you were earning higher rates of return on the cash value in the insurance policy.

So that was a cheaper way to buy death benefit. In actuality, E.F. Hutton originally designed universal life for the other objective, a living benefit.

UNIVERSAL LIFE LIVING BENEFITS

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So what they were thinking is wait a minute here, because people are taking responsibility and accountability, if they were to die sooner because of an accident or whatever, and they didn’t want their widow or or their children to be orphans, relying on social programs and the government, the Internal Revenue Code has always allowed the money, this excess money in the insurance policy, to grow tax free.

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Why would they want to penalize people who are trying to take ownership and and be self reliant? So it has been a sacred cow.

So the cash inside of the insurance policy from overpaying the premiums would earn interest or dividends without paying tax. It is one of the very few vehicles in the Internal Revenue Code that allows you to accumulate your money tax free, and actually, if you needed to, you could access the money tax free, and when you die the death benefit blossoms in value and transfers tax free.

UNIVERSAL LIFE TAX ADVANTAGES

What E.F. Hutton thought is, “Wait a minute here.” A lot of people were going in here like this last example and its whole life. They were paying one huge amount of money and they just wanted to have insurance the rest of their life, and be done with it.

And Hutton said, “Wait a minute! All that money, however fast you put it in, is tax free, and you can access it tax free if you do it the smart way in the Internal Revenue Code.”

So Hutton said, “Wait a minute, why don’t we, instead of trying to get the most insurance for the least premium, if we’re using it for a living benefit, let’s flip it.”

“How about we take the least amount of insurance the IRS will let us get away with, and put in the most premium that they will allow, take the least death benefit, put in the most money, and this turns into a tax free accumulation cash cow!”

8:08
That’s the original intent that E.F. Hutton had behind universal life. And even though you can minimum fund it, and usually have a really good rate of return, and it was a little bit cheaper than most whole life policies, even though whole life came out and had to compete, and later on had to sort-of shape up.

Universal life could be used to get a really good death benefit for a very affordable premium, or, you can do the opposite and take the least amount of life insurance, the IRS will let you get away with, and put in the most money. All this money inside the insurance contract would accumulate tax free, and then, you could use it as a living benefit.

EXAMPLES OF UNIVERSAL LIFE

For example, in 1980, I had many people who would throw in a lump sum, let’s say $500,000. Back then, interest rates on universal life was like 11 3/4% to 15 1/2%.

Because of doing that, many people, I remember, would earn a gross of 11% tax free interest on their cash in their universal life policy, and on the average only 1% of that actually paid for that line right there; the actual cost of the chance of you dying.

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And so what were you netting, in this example? Simply 10%. So people were earning a net rate of return within 1% of the gross rate of return. If your earned eight, you would net seven. If you earned eleven, you would net ten.

Well, what that did, if you were earning ten, that means this $500,000 in 7.2 years would double in cash value to a million. If you were really earning ten, you could pull out $100,000 a year out of that million and it would be tax free for your retirement.

So E.F. Hutton was thinking, “Why are we trying to have people just buy term insurance and invest the difference in mutual funds, when a 12% yielding mutual fund, after you have to pay tax of 25% or 33% on that, you’re earning 12% and netting 8%.”

On an insurance contract back in 1980, you could earn eleven and a net ten, and because it’s tax free, you could outperform even their mutual fund portfolios paying higher interest, but it was taxable or just tax-deferred.

That is why universal life came out.

IN SUMMARY: TERM, WHOLE, AND UNIVERSAL LIFE INSURANCE

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So here are the three: 1) Term insurance is the pure cost of insurance. That term component is in all types of insurance.

2) Whole life insurance has a term component. You’re just overpaying the earlier so you can underpay or not pay in the latter years.

3) Universal Life can be designed the same way. You can minimum fund it or you can maximum fund it, but generally speaking, universal life is designed for those people who wanted to use it, both for living benefits (tax free accumulation and tax free cash flow – accessing the money tax free) and then when you ultimately died, it would blossom in value, meaning whatever was in there would increase in value and pay out tax free.

These are actually in three sections of the Internal Revenue Code: Section 72(e) allows you to accumulate the money tax free, 7702 allows you to access the money tax free, and section 101(a) means that whatever is left in there will actually blossom and transfer income tax free in a death benefit.

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So those are the three basic types of life insurance.

In other educational videos you can learn about all kinds of options like fixed, indexed, variable life, and whole life. Those are the three basics, and hopefully this will help you understand how they are priced, and how you can put in more funding or over-fund them or you can minimum-fund them based upon your objectives.