In our last article in the series on becoming your own financial advisor we discussed 529 plans to save you’re a child’s education and investing in stocks.
If your just arriving and want to check out the other parts here you go:
In this article, we talk about two more investment types you will want to consider in your quest to become your own financial advisor – purchasing life insurance and investing in bonds.
Investment Opportunities – Life Insurance
Life insurance is a contract with an insurance company that provides your beneficiaries with a given amount of money when you die.
There are some pros and cons that are associated with life insurance –
- Beneficiaries are protected from the financial impact and burden of your death
- Benefits pass to beneficiaries’ income tax–free and may be estate tax–free
- Cash values grow tax deferred
- Confusing products
- High associated fees
- Agents may push products you don’t need
Life insurance is bought from a local life insurance agent or online firm. There are several ratings agencies you can check to determine how good a particular firm is. For example, check out A.M. Best or Moody’s.
For most life insurance purchases, a term life policy is the way to go.
Policies should be worth 7 to 10 times your annual income – that is, enough for your family to live off 4% interest earned on the lump-sum payout from the insurance.
As I noted above, a life insurance policy is a contract with an insurance company. You pay premiums to the insurance company. In exchange for that premium, they make payments to your beneficiaries. The payouts are known as death benefits. Generally speaking, they are income tax-free and may even be estate tax-free.
There are two main categories of life insurance:
Term Life Insurance:
Term life policies offer protection for a specified period of time, typically in ranges of between one and 20 years.
The proceeds from term life policies are usually used to replace lost potential income during working years and thus provide a safety net for your beneficiaries.
Premiums -based on your health and life expectancy at the time of coverage application-are guaranteed during the term. You may be able to extend coverage beyond the term – but you’ll pay a much higher premium.
If you stop paying the premium, the insurance stops. Term life policies pay a lump-sum benefit if you die during the policy period, but they don’t build any cash value. They tend to be – in general- less expensive than permanent life insurance. Much less expensive and usually very inexpensive.
Permanent life Insurance or Whole life Insurance
Permanent life insurance combines death benefits with a savings or investment account. This type of life insurance policy is intended to protect your beneficiaries as long as you are living of course providing you pay the premiums.
Depending on the policy, the premiums for permanent life insurance may be fixed or not, and, like term life they are based on your health and life expectancy.
Permanent life insurance policies accumulate some cash value through a savings or investment component. As you can expect, they are generally much more expensive than term life policies.
Usually these policies are complicated and if you don’t understand something you shouldn’t buy it. I keep my investments and insurance separate. I see no reason to mix them and this case is far too expensive.
How To Purchase Life Insurance
What will happen to your children or other dependents when you die? If you have dependents who won't be able to pay for college tuition, mortgages or other bills, consider life insurance.
When purchasing life insurance, you should ask yourself these two questions:
- What kind of insurance should I get?
- How much insurance do I need?
Permanent life insurance policies, like whole or universal life, are often used by wealthy individuals as estate-planning tools. These policies help preserve the wealth they plan on passing to their beneficiaries. This argument is flawed.
These policies are substantially more expensive than term life. In general, these types of policies that you would choose unless your income is more than $250,000 a year or you have over $1 million in assets.
In contrast, term life insurance is the way to go if your main goal is to protect your family against the loss of your income.
As the name implies, term life policies last a certain amount of time – such as 20 years – and after that, the biggest need for the insurance is gone. For instance, the mortgage is paid off and the kids are through college.
How much insurance should you buy?
One school of thought says your policy’s death benefit should be 7 to 10 times your annual salary.
This is not very precise; however, it does provide a good starting point.
Another option is to calculate how much is needed for a lump-sum payout to create income for your family indefinitely. This option assumes your family would live off the interest from your payout – assuming 4% interest a year.
As an example, if you make $50,000 a year you would need to obtain $1.25 million in insurance for your family to continue with your “salary” ($50,000 ÷ 0.04).
Expanding our example further, if you make $100,000 a year, you’d need a $2.5 million policy ($100,000 ÷ 0.04).
Yet another option is to calculate how much money your family would need to cover normal monthly expenses and pay off debts –like the mortgage or credit card debt-as well as money to pay for your funeral and your children’s future education.
Investment Options – Investing in Bonds
Bonds are debt securities where you lend money to an issuer – e.g., a corporation or government -in exchange for the receipt of interest payments and eventually the future repayment of the bond’s full face value.
There are, of course, pros and cons to investing in bonds.
- Can be virtually risk-free -or low-risk
- Predictable income
- Better returns on bonds compared with other short-term investments
- Some bonds are tax exempt
- Potential for default
- Selling bonds before maturity can result in a loss
You can buy bonds in over-the-counter (OTC) markets including securities firms, banks, brokers and dealers.
Corporate bonds may be listed on the New York Stock Exchange (NYSE) and US government bonds can be purchased online at www.treasurydirect.gov If you buy municipal bonds (“muni’s”) the Interest payments are exempt from federal taxes and sometimes state taxes as well.
As I implied above, a bond is an IOU issued by a corporation or government so it can finance certain projects and activities. When you buy a bond, you are essentially floating a loan to the issuer for a certain amount of time. In exchange for the loan, the bond issuer pays you a set interest rate – known as the coupon rate- at regular intervals until the bond matures.
When the bond matures, the issuer repays the full face value- par value- of the bond. In general, the higher the bond interest rate, the higher the risk involved with the bond.
Bond Risk Types
Investing in bonds comes with several types of risk.
Bond Default Risk
This type of risk is the possibility that the issuer will not be able to make interest or principal payments when they are due.
Bond Prepayment Risk
This bond risk is the possibility that the bond will be paid off earlier than expected, in which case you lose out on any remaining interest payments.
Bond Interest Rate Risk
This type of risk is the possibility that interest rates will be different than you expected. If rates decline, you risk prepayment if the firm exercises what is known as a call feature. If rates go up, you risk holding a bond with below-market rates. Investing in bonds at below-market rate means you could be earning more money with something else.
General Advice For Investing in Bonds
Bonds come in different maturities and have different risk profiles. Are you willing to take on more risk to get higher rewards and how long are you willing to hold a bond?
U.S. Treasury bonds are considered one of the safest investments in the world.
Investment-grade corporate bonds pay more than Treasuries. They also come with a higher risk of default.
There are bonds known as high-yield or “junk” bonds. These bonds have even higher yields and come with a corresponding higher risk.
As I stated before, there is no federal tax on municipal bond income. If you're investing in bonds issued by your own state, there’s no state tax, either. If you want to diversify your bond investments, you might want to consider a bond fund.
In our final article in the series we will finish our discussion of investment opportunities by talking about annuities and health care savings accounts.