Although there are quite a few CPAs on my mailing list, the vast majority are not, so today I will explain the basics of a personal balance sheet and how certain transactions, including the purchase of life insurance, impact one’s net worth.
The four main categories affecting one’s net worth are assets, liabilities, income and expenses. Double entry bookkeeping uses debits and credits to record all transactions. Debits increase assets and expenses (while credits decrease them) and credits increase liabilities and income, with debits decreasing them. The difference between assets and liabilities is net worth. An example may be helpful in understanding how the process works.
Let’s say a person buys a house with nothing down. An asset (the house) will be debited for the purchase price and a liability (the mortgage) will be credited for the same amount. Thus, the individual’ net worth is not affected by this transaction.
As another example, if you received a gift of $1,000 and put it in your checking account, the entry would be to credit revenue and debit checking, each for $1,000. In that case, your net worth increased by $1,000, as your assets increased by that amount with no corresponding liability.
If subsequently you invested the $1,000 in a mutual fund, your net worth wouldn’t change, as one asset is decreased (checking account) and another is increased (mutual fund) by the same amount.
Now let’s look at how the purchase of life insurance affects one’s net worth. The premium for term insurance is an expense, so one’s net worth is decreased by the amount of the term premium. But the premium for a whole life policy isn’t always recorded as an expense. Let’s look at how a whole life premium is accounted for at three different times during the life of a policy.
This example uses the premium ($20,790) for a $1 million policy on a 47 year-old male preferred non-smoker. Since there is no cash value in year one, the entire premium is an expense (debit life insurance expense for $20,790 and credit checking account for same).
Jumping ahead to year three, the cash value is $20,450. So the entry is credit checking for the premium ($20,790), debit an asset account, life insurance cash value, for $20,450 and debit life insurance expense for $340 ($20,790 – 20,450). So yes, this gentleman paid $20,790 for life insurance, but his net worth was only decreased by $340.
Looking at year four, the cash value is $42,915, so the entry is credit checking for $20,790, debit life insurance cash value for $22,465 ($42,915 – 20,450) and credit income for $1,675. In this case, even though his checking account was decreased by the premium, his net worth actually increased by $1,675, as his cash value increased by $1,675 more than his premium.
No one I know, myself included, likes paying life insurance premiums. However, when viewed from this perspective, it makes paying them as painless as possible..