The debate of purchasing Term life insurance vs Permanent life insurance has been going on for years. Many would suggest to not mix insurance with investments and simply go with Term insurance, however its not one-size-fits-all solution and in most cases careful planning for long term needs leads to having a combination of Term and Whole life insurance.

What is Term Life Insurance ?

Term life insurance is the temporary, cheapest, simplest type of life insurance. Term life insurance provides coverage for only certain number of years for example 5, 10, 15, 20, 30. It guarantees fixed death benefit to the beneficiaries if you die before the end of the term, after the end of the term insurance terminates. You can choose for your premium to increase each year or to remain at the same amount for a fixed number of years.

As term insurance is the cheapest life insurance, it could be used to purchase high coverage at small premium especially when your family is young and growing and dependent on you to provide for them.

Biggest drawback of term insurance is that it ends after the term you purchased it for. As you grow older the chances of developing health issues increase and hence the premium to purchase insurance would be much higher during later years of your life.

What is Whole Life Insurance ?

Whole life insurance is a type of permanent life insurance. Premiums are much higher than term premiums primarily because part of the money is put into an investment or a savings program. Whole life insurance builds cash value by generating a return on the amount that is put into savings program. The longer the policy has been in force, the higher the cash value, as more money has been paid in and the cash value has earned interest and dividends.

Some insurance companies let you select how long you pay premiums, this basically allows you to coordinate the number of years you want to pay the premiums with your personal financial goals and timetable. For example you could plan it such that once your kids starts college you want to stop paying insurance premiums and direct that amount to pay for college tuition (The whole life premiums would be higher as you decrease the number of years you want to pay premium).

Does it make sense to purchase Whole Life Insurance?

The saying you always hear is, “Buy term and invest the difference, yourself”. It depends on how long you keep your policy and for what purpose. The goal should be to keep the policy all your life and increase cash value over a long period and pass on the benefits, tax free, to you heirs after your death.

Whole life insurance is one of the many tools that you could use for long term planning, some of the advantages are

• Forced savings – Many people don’t save any money or lack discipline to save. Some would follow hot investments and try to time the market unsuccessfully. Whole life insurance provides a disciplined way to save and you are better off even with slightly lower returns than not saving or loosing money
• Insurance for life – As the name suggests it provides insurance coverage for all your life and eliminates the problem of future insurability. Some policies contain guaranteed purchase options, which allow you to buy additional coverage at specified times, regardless of your health. Whole life insurance allows you to leave behind a “gift” for a loved one after your death. Your loved one would receive a lump sum amount tax free
• Locked in premiums – The premiums are locked at a certain amount and in some policies you choose how long you want to pay. There are other types of permanent life insurance such as universal and variable life where investments are more tied to stock market returns and return/number of years you pay premium changes with market performance, however with whole life the returns are guaranteed so the numbers of years you pay premium is fixed along with the amount you pay. Also since your 401(k) and other investments would likely be following stock market, lets keep this investment conservative
• Cash value – It builds cash value. This amount can be used in the future for any purpose you wish. If you like, you can borrow cash value for a down payment on a home, to help pay for your children’s education or to provide income for your retirement
• Estate planning – Wealthy people use Whole life insurance policy as an estate planning tool. They may have an illiquid asset, such as a farm, rental properties or a business. When that person dies, the asset may have to be liquidated rapidly at an unfavorable price to pay tax on the will proceeds. The death benefit of a whole life insurance policy can cover those costs

The Strategy I used few years ago I purchased a 30 year fixed premium term life insurance with high death benefit and also bought whole life insurance for lower amount that I will pay fixed premium for 17 years, which is when my son would go into college. The idea is once the term insurance expires the value of my whole life (death benefit + cash value) would be same as term coverage and would keep growing for rest of my life.

I am also planning to purchase whole life insurance for my son who is now 5 years old with the hope of paying premiums till he turns 25 such that he has good amount of cash value accumulated that he could use to do something meaningful after graduating ….

What’s your strategy ?

Traditionally Americans have relied on Social Security to cover their expenses during retirement however as the fate of Social Security becomes uncertain many Americans have started to shoulder the responsibility of funding their own retirement. Many rely increasingly on their 401(k) retirement plans to provide the means to meet their income goals during retirement.

What is a 401(k) plan?

401(K) plans are tax-deferred retirement savings plans for employees. The employer sets them up and each company has a slightly different 401(K). They are part of a family of retirement plans known as “defined contribution” plans – the amount contributed is defined by the employer or the employee – for 2011 each employee can contribute up to $16,500 (individuals aged 50 and older could contribute additional $5,500 a year). There are several advantages to sock away money into 401(k) plan – primary ones are

1.  Tax deferral – A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan. Your taxable income is reduced by the amount you contribute, which in turn lowers your tax burden for the year.
2. Compounding – Earnings generated produce a compound effect on your return on investments. As the earnings are also tax deferred, these earnings would generate more earnings over the years
3. Employer match – In addition to its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 100% of your first 6%.

Like any good planner you have been contributing maximum to 401(k) plan and taking advantage of employer match, what else can you do to grow your wealth? The next logical step is to consider a Roth IRA.

What is IRA?

An Individual Retirement Account (IRA) is basically an account that provides huge tax benefits when used to save money for retirement. There are several types of IRA each with their own tax implications and eligibility requirements. We would talk about Roth IRA as it is one of the best ways to accumulate and pass your wealth tax free to next generation.

How much can I contribute to Roth IRA?

The most you can contribute in 2011 is $5,000. Individuals aged 50 or older can contribute up to $6,000 for the year. IRA contributions are limited by your qualifying income. For IRA purposes only, qualifying income means wages, self-employment income, alimony, and nontaxable combat pay. For example, let’s say you have wages of $3,500 and no other income. Your can contribute maximum up to $3,500 to your Roth IRA for the year.

Are there any eligibility requirements for contributing to IRA?

You can contribute to Roth IRA as long as your earned income is under the threshold limit prescribed by IRS. In fact, there is even an income threshold where you’re only eligible for a reduced contribution, which is known as the phase-out limits.

These limits refer to your modified adjusted gross income gross (MAGI) and not your gross income; this amount is calculated when you complete your federal income taxes on Form 1040, which is sent to the IRS.  In case you don’t know your exact AGI, you can refer to your last year’s 1040 form and look for the reference to AGI, which is normally line 37.

These income or compensation eligibility limits, as stated by your AGI, for Roth IRAs for the years 2011 and 2012 appear in the table below:

Roth IRA Income Limits 2011

Roth IRA Income Limits 2012

What are the advantages of contributing to Roth IRA?

Tax deferral – Roth IRAs allow you to deposit after tax money and then have it grow and get withdrawn tax free. Ultimately, this means that you’ll spend more money by paying taxes now, but in the long term, you’ll save money by not paying taxes on the earnings growth in Roth IRA account when you eventually retire

Passing wealth to heirs - Unlike Traditional IRA accounts —, which are taxed at withdrawal time — you do not have to begin taking minimum distributions at age 70 ½. Since you are not required to take minimum distributions, you can leave every single penny of your Roth IRA intact for your designated beneficiary. This is fantastic, isn’t it ?

Even better is the fact that your heir will face a choice upon your death: Either withdraw the whole amount by December 31 of the fifth year after your death OR begin receiving minimum distributions based on his or her life expectancy. Under either choice, all the proceeds should be tax-free (with the exception of estate taxes)

Asset Protection - IRA like other retirement accounts – 401(k), pension plans, and social security receive Federal Creditor Protection. This means that creditors cannot seize assets in an IRA. In case someone files a lawsuit against you or you file a bankruptcy due to some unforeseen loss – your Roth IRA account is protected just like your other retirement account

To me this is very powerful long term wealth accumulation strategy…. are you taking full advantage of it?

It’s time again, let’s reflect upon the year gone by and plan for the year ahead. Federal Reserve recently published latest numbers on consumer credit; it’s again on the rise after a short blip during 2008 pullback.

Consumer borrowing has been rising for last 40 years

It has been increasing for last 40 years, while the standard of (material) living has improved, American households’ need to borrow money also increased to either buy luxuries or going into debt was the only way to afford basic needs due to flat wages. In either case it’s a viscous circle – amount left after paying interest on borrowed money is not sufficient to meet the needs so you borrow more.

The only way to break this viscous circle of debt and achieve financial freedom is to understand your spending patterns. Create a strategy to spend less than you earn so that you can accelerate the process of getting out of debt by paying your creditors sooner – let’s call it defensive strategy. Of course you can play offensive and increase your earnings, however no matter how much you earn if you don’t play defensive sooner or later you end up joining viscous circle.

“Beware of the little expenses; a small leak will sink a great ship.” – Benjamin Franklin

First things first – Do you know how much your family spends each year on various categories such as Food, Clothing, Interest payments on borrowed money ?

Answered “No”? Don’t feel left out, many households I talk to don’t have a clue where they spend money. Tighten you belt and spend few hours either alone or with your partner and

• Start with a piece of paper writing down expenses you incurred in last one week, it’s much easier to remember
• Categorize them in various categories like Groceries, Utilities, Rent, Mortgage, Insurance, Dining out, Clothing, Gas. Keep it high level at this point instead of going too granular
• Once you are done for a week, if you spend using Credit Cards try to compare your list with Credit Cards recent activity online
• Surprised to realize how many items you missed? That’s the point of this exercise
• Done for a week now do the same for a month. This time include your income and tax categories

Were your expenses less than income? If so, congratulations you are already on the right path. Our goal is to spend less than you earn and ultimately save atleast 30% of your income, which will be used to generate more income and ultimately achieve financial freedom

My household is saving about 50% of our annual income

Now that you know your last month’s income and expense, to sustain tracking for future months and years use mint.com – it’s free money management tool or if you prefer use spreadsheets. I would recommend using money management tool as you can focus more on creating strategies on cutting spending or saving more instead of focusing all your energy on manually tracking expenses. Personally I use Quicken; it is a paid personal finance software.

Create a Budget
Refer to you last month’s categories and expenses and create a budget in which ever tool you plan to use (spreadsheet, mint.com, quicken or something else). Create more granular categories – for example instead of Dining out, create may be Coffee, Breakfast, Lunch, Dinner etc. Also differentiate these categories as

• Mandatory (absolutely needed – rent, groceries, commute to work etc)
• Discretionary (The one’s you can control – clothing, eating out etc)

Allocate money to each of these categories such that they are either less than or at the very least match your income.

Sticking to the Budget
Make sure you allot some budget to the things you like to do, else like all diet plans you would very soon loose interest in becoming financially fit. Spend on fun stuff in moderation

Track on a weekly basis how you are doing against your budget, the goal is to inspect and adapt – if you realize you have a need to spend money on a certain category try to identify another category from where you can cut this way you are still within your over all budget.

Once you are couple of months into this, you would start feeling comfortable and get good understanding of your spending to better allocate against various categories

Over past few years as I started to track my income and expenses with good budgeting I am able to save almost 50% of my household’s income, what is your income expense ratio?