Whole life insurance is a type of permanent life insurance which remains in force from the time you buy it until the end of your life, provided you pay the policy’s premiums on time. This contrasts with a term life policy, which remains in force for only a set period of time before expiring. Whole life also has a savings component, called cash value, which may give you some additional flexibility in your financial planning. Whole life insurance is intended primarily to help your loved ones or other beneficiaries maintain their financial security after your death.
How does a whole life insurance policy work?
A whole life insurance policy is a contract between you and an insurance company. This contract stipulates that, provided you pay an amount of money known as a premium, the insurance company will pay a death benefit upon your passing. The death benefit will go to the people you designate as beneficiaries, such as your spouse and any children. Your beneficiaries will not have to account for this money as gross income, so it will not be taxed. (It’s still a good idea to make your tax preparer aware you’ve received a life insurance payout, as they can advise you on current federal and state rules.)
You choose the amount of the death benefit when you buy the policy. The premium is set by the insurance company. They base it, partly, on the amount of death benefit you’ve chosen — the higher the death benefit, the higher the premium. The insurance company usually requires payment of the premium in annual installments.
As a type of permanent life insurance, a whole life policy remains in effect until your death. The insurance company will not revise your premium, regardless of market conditions. It cannot cancel the policy if your health takes a bad turn. Nor can it change the amount of your death benefit (there are some exceptions to this, which we will explain later in this article).
Understanding the cash value component
Whole life insurance also features a savings component, called cash value, that can benefit you while living.
The policy’s cash value is essentially an investment account that you can fund by making premium payments in excess of the minimum required by the insurance company. The insurance company will then use those additional payments to fund its own investment portfolio, and reward you in the form of a tax-free dividend. Whole life policies guarantee typically a modest return, while other types of cash value policies offer varying degrees of financial risk and reward.
The cash value can be put to use in several ways. You can use it to increase the death benefit, pay your premium, take out a low interest loan from the insurance company, or make a withdrawal. These withdrawals are not taxable unless their amount exceeds the amount of premium you’ve paid. You can also choose to leave the cash value alone, letting it grow over the years to help supplement your retirement savings.
Note that if a loan is unpaid at the time of your death, the insurance company will reduce the amount of death benefit for your beneficiaries to cover the balance.
You also have the option to surrender the policy. If your financial situation changes and you decide you no longer want the policy, you can surrender it and receive its cash value back from the insurer.
Whole life versus term life insurance
Whole life is different from another common insurance type, term life. Both types of policy provide a death benefit to your beneficiaries in return for your paying a premium. However, some differences lie in how each type of policy is structured.
Unlike whole life, term life is not permanent. A term life contract stipulates that the policy will remain in force for a set number of years, then expire. So you might purchase a term life policy with a 25-year term when your child is born. This ensures coverage until that child is an adult and is presumably able to take care of themself financially. Or, you might purchase a policy with a 30-year term when you buy a house, ensuring your spouse can use the death benefit to pay off the mortgage.
Additionally, a term life policy has no cash value component. It is strictly insurance, with no savings mechanism.
Pros and cons of whole life insurance
Whole life is just one of several options for life insurance. When you decide it’s time to buy coverage, you ought to understand some of the pros and cons of this type of policy.
- Cash value — The cash value component of a whole life policy can provide some flexibility in your financial planning, ideally as part of a broader portfolio.
- Fixed premium — What you pay for the policy is guaranteed to remain the same for as long as the policy is in force. Unlike with many other kinds of insurance, the insurer cannot adjust the premium based on market conditions, or any changes to your health.
- Lifelong coverage — A whole life policy will remain in force until your death.
- No additional exams — Whole life typically requires a medical exam when you purchase the policy. But even if your health takes a turn for the worse, the insurance company will not ask you to do any additional exams.
- Surrender option — You can surrender a whole life policy (cancel your coverage), and receive its cash value back from the insurer.
- Affordability — A whole life policy costs significantly more than a term life policy — six to ten times more, by some estimates.
- Complexity — Whole life insurance offers a wider range of features than a term life policy; but these features can be confusing to many, and unnecessary for those who simply want life insurance to help keep their family financially stable.
- Cash value return — The cash value of a whole life policy is guaranteed to provide a monetary return, but it tends to be lower than other investment options. It’s also important to note that with many whole life policies, the cash value reverts to the insurance company upon your death, rather than being paid to your beneficiaries.
When shopping for life insurance, it’s a good idea to contact an agent or compare quotes online. Independent insurance agents typically represent multiple insurance companies. They’re licensed by the state, and trained to understand your needs to match you with the type of policy that will best suit you and your family.
Who should get whole life insurance?
Because of its cost and other drawbacks, whole life is often not an ideal purchase for many insurance buyers who would be better served by a term life policy.
With that said, there are some situations in which whole life might make sense for you. A recent article in Forbes outlines the following such situations:
- You’re intending to use the death benefit to fund a trust that’ll support your children upon your death.
- The value of your estate exceeds the current estate tax exemption, and you intended the death benefit to help your beneficiaries pay those taxes.
- You own a business and assign a business partner as a beneficiary, to help that partner purchase your shares after your death.
Forbes also states that you should consider whole life insurance if you need coverage for longer than 30 years, which is typically the longest period available for a term life policy. As stated earlier, a whole life policy will remain in effect until your death, unless you choose to surrender the policy.
Whole life provides a death benefit, and more
Whole life is one of many types of life insurance. It offers not only the insurance you need to make sure your beneficiaries have some financial stability after your death, but a cash value component that can bring added flexibility to your financial portfolio. While a whole life may not be right for you, you owe it to yourself to understand how it works when considering your life insurance options.