Many financial experts advise consumers to “buy term and invest the difference”. This is a reference to buying a low-cost term life insurance policy, then investing your money in more conventional financial products for higher returns than life insurance policies typically provide.
But there may be times when a whole life insurance policy is a better choice than term life insurance. To make that determination, it’s important to know what whole life insurance is, how it works, and what specific benefits it provides.
What Is Whole Life Insurance?
Whole life insurance is a type of permanent life insurance policy that provides both a death benefit and a cash value accumulation provision. As soon as your policy is active, the death benefit can be paid to your beneficiaries, even if you only made a few premium payments.
But as you make your premium payments, part of that premium goes toward the cash value of the policy. Though the cash value portion of your payment is small in the first few years the policy is active, it will grow more rapidly with each passing year.
As funds are added to the cash value, the balance will also earn interest. When interest is added to regular contributions from your premium payments, the cash value of the policy will grow by increasing amounts.
Unlike term life insurance, whole life insurance is permanent coverage. The policy will remain active as long as you continue to make your premium payments. And the policy death benefit, when paid to your beneficiaries, will generally be tax-free.
How Whole Life Insurance Works
Like most financial products, whole life insurance has several components:
You’ll need to apply for coverage, during which your health will be carefully evaluated by the life insurance company. Not only will the application include a list of health questions, but your medical records will be checked from third-party sources, and you’ll generally be required to submit to an insurance medical exam.
At the time of application, you’ll be required to submit the first premium payment. If your application is declined, the payment will be returned to you.
Though you’ll be given an estimate at the time of application, the exact amount of your premium won’t be determined until your application has been underwritten by the insurance company. The premium will be based on a combination of factors, including your age, gender, health, the health history of your family, your occupation, and any high-risk behaviors or activities you engage in.
Once your policy has been approved and the premium determined by the insurance company, it will remain level for life. Premiums can be paid annually, semiannually, quarterly, or monthly, depending on the options offered by the insurance company.
It’s even possible the cash value of your policy will build to a level that is sufficient to pay the premiums for the rest of your life. This is referred to as paid-up life insurance.
Some life insurance companies pay dividends on their policies. These companies are known as mutual insurance companies. It refers to a private insurance company that’s owned by its policyholders. Because of that ownership, policyholders will be entitled to profits generated by company operations.
This is different from corporate life insurance companies, which are public companies owned by their stockholders. It is their stockholders, not the policyholders, who will be entitled to payment of dividends. Having a life insurance policy issued by a corporate life insurance company does not automatically entitle you to receipt of dividends.
A whole life policy serves as the base life insurance plan. But just like buying a new car, you can add options to your whole life policy. Those options, referred to as riders, can be added to a policy though it will usually result in a higher premium.
Popular policy riders include:
Term life insurance rider. This provision gives you the option to add term coverage to your whole life policy to increase the death benefit. For example, you may want to add a term rider to your base policy to cover a large debt, like a mortgage on your home. Once the loan is paid, the rider will no longer be needed and can be canceled. Term riders can be cost-effective, because the additional premium paid is much lower than the cost of an equivalent amount of whole life insurance.
Waiver of premium. This provision suspends the policy premium, while keeping the policy in force, if the policyholder becomes disabled.
Accelerated death benefit. This is sometimes referred to as a living benefit, since the policyholder can access part or all of the death benefit while still alive. For example, if the policyholder develops a terminal illness, he or she may be able to access a portion of the death benefit of the policy while still alive. The amount taken will be deducted from the death benefit upon the policyholder’s death.
Accidental death. This rider will provide additional death benefits if the death of the insured is the result of an accident. It may pay double the face amount of the policy, which is referred to as double indemnity.
Guaranteed insurability. Allows you to purchase additional insurance, at specific time intervals, without the need for medical qualification.
Whole Life Insurance vs. Term Life Insurance
At the core, whole life insurance and term life insurance are very similar. Once approved, you’ll pay premiums to purchase a specific amount of life insurance, which will be paid to your beneficiaries upon your death. But there are differences between the two and how each works, and those differences can be extensive.
Terms: While whole life insurance is permanent, term insurance is issued in specific terms, which are typically five, 10, 20 and 30 years. At the end of the term, you may have the option to renew the policy, but the premium will be significantly higher, based on your age.
Cash value: Whole life insurance policies come with this feature that adds an investment provision to your policy. You can take a loan against the cash value while the policy is in force, or receive the entire balance (less fees) if you cancel the policy. Term life insurance policies do not have cash value.
Premiums: Whole life insurance premiums are fixed for life. Because of the cash value provision, whole life insurance premiums are many times higher than those for term life insurance policies with a comparable death benefit. Term life insurance premiums are fixed only for the duration of the stated term. At the end of the term, you may have the option to renew the policy into a similar or reduced term. Either way, the premium will be increased based on your age at the time of renewal.
Main Components of Whole Life Insurance
Whole life insurance policies have two main components, the death benefit and the cash value.
The death benefit, or face value of the policy, is the amount of money that will be paid to your beneficiaries upon your death. It’s the primary purpose of a whole life insurance policy.
The cash value is the investment provision in a whole life policy, and one of the primary features distinguishing it from term life insurance. It is derived from a portion of the premium payments you make for the policy. But because of fees paid (through your premiums), the cash value accumulation is minimal in the early years of the policy. Beginning around the fifth year the policy is in place, the portion of the premium going toward the cash value begins to rise steadily.
The cash value is an investment account within the policy that provides interest payments. As the policyholder, you can access the cash value by taking a loan against it. When that happens, a portion of your premium will go toward repayment of the loan, eliminating the need for a separate payment.
However, if you surrender your policy, you will be entitled to the accumulated cash value. But the insurance company will deduct fees, so you won’t receive the entire amount. How much those fees will be will depend upon the terms of the life insurance policy and the company that issues it.
Cash Value Caveat
The cash value portion of your policy is separate from the death benefit. When you die, your beneficiaries will receive only the face value of your life insurance policy, less any outstanding loans against the cash value. But they will not receive the available cash value balance as of the date of your death. Those funds will be retained by the insurance company.
Your beneficiaries will receive the cash value only if you add a rider to your policy specifically providing for that distribution. But, as is the case with all riders, your premium will increase once that provision is added.
Tax Advantages of Whole Life Insurance
Whole life insurance has certain tax advantages that can be an unexpected surprise for policyholders.
1. The death benefit is (usually) tax-free
Since life insurance policies are paid with after-tax funds, the death benefit is usually tax-free. The funds will pass to the insured’s beneficiaries, who will owe no tax on the benefit. This is very different from some retirement accounts, which do become taxable when distributed to the named beneficiary of the account owner upon the owner’s death.
That said, a life insurance benefit can become partially or entirely taxable if you have a large estate. That’s because life insurance proceeds are added to other assets in the estate in calculating the estate tax liability.
This won’t be a big concern for the vast majority of Americans, at least not at the federal level. That’s because there is an exemption of $11.7 million before the estate becomes taxable.
But the situation isn’t quite so clear with state level estate taxes. Though most states have eliminated their estate taxes, a handful continue to impose them. In most cases, the estate exemption is well below the federal level. For example, Oregon taxes estates as small as $1 million. When life insurance proceeds are added to the value of real estate, personal items and financial assets, an estate can easily exceed $1 million, triggering the estate tax.
2. Cash value accumulates on a tax-deferred basis
Similar to investment gains in a retirement plan, the interest earned on the cash value of a life insurance policy isn’t taxed until the funds are withdrawn from the plan.
This means the cash value of your policy will grow from two directions – contributions from your premium payments, and the interest earned on the cash value – without any immediate tax consequences.
The arrangement provides policyholders with the benefit of being able to accumulate funds more quickly than they could in a taxable investment account, which would be reduced by the income tax liability it generates each year. The lack of tax liability on the cash value of whole life insurance provides a greater ability to take advantage of compounding of interest.
3. The cash value can be accessed without tax consequences
As discussed previously, funds can be taken from a life insurance policy through a loan, the liquidation of the policy, or by the beneficiaries upon the death of the policy owner.
In the case of a policy loan, there is no tax liability, precisely because the funds are the result of a loan, not a distribution. As such, the funds are not withdrawn from the policy permanently, but subject to repayment.
The situation is more mixed in a case of a policy liquidation, or with cash value proceeds paid to beneficiaries.
The distribution of cash value proceeds can be taken tax-free as long as they don’t exceed the cost basis of the policy.
This is where we need to get into some math.
Let’s say you have a whole life policy, into which you paid $5,000 per year in premiums over 20 years. Your total cost basis in the policy is $100,000 – $5,000 X 20 years.
If at the end of 20 years you choose to liquidate the policy, you can receive up to $100,000 in cash value from the policy without incurring a tax liability. This is because the distribution will not exceed the amount you paid for the policy in premiums over 20 years.
But if you receive distributions of $150,000 in cash value, $50,000 – the amount by which the distribution exceeds your cost basis – will be taxable at ordinary income rates, which are typically higher than capital gains.
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Who Is Whole Life Insurance Right For?
Most consumers will be better served with term life insurance than with whole life insurance. This is due primarily to the much lower premiums, which will not only save consumers money, but also enable you to purchase a larger policy.
But there are situations where whole life insurance will be a better choice.
When you have a higher-than-normal risk of serious health conditions. If cancer, heart disease, diabetes or other health conditions are prevalent in your family history, a term life insurance policy may be difficult to get in the future. Serious health issues are a big reason why you would want to keep a whole life policy in place for as long as possible.
You purchase life insurance early in life, and cost is no object. Just like term life insurance, whole life insurance premiums are much cheaper with a policy taken early in life. If you want to lock in permanent coverage in your 20s or early 30s, you can do it with a whole life insurance policy.
When you aren’t able to save money, and you like the concept of forced savings that whole life insurance policies provide. Unlike term life insurance, which provides only a death benefit, whole life insurance adds an investment provision to the plan. It’s a way to both maintain life insurance coverage and save money over the long term.
You like the idea of a permanent base life insurance policy, and plan to add term policies when and if necessary. The most basic limitation of term life insurance is that the policy will eventually end (or become prohibitively expensive upon renewal). You may want to maintain a whole life insurance policy for permanent coverage, then add or cancel term coverage based on future need.
Pros and Cons of Whole Life Insurance
Whole life insurance is permanent coverage; the policy can’t be canceled except for non-payment of premium (once the cash value is exhausted). This will be true even if your health declines after taking the policy.
Offers a level death benefit.
Premium payments remain fixed throughout the term of the policy.
Life insurance policies issued by mutual insurance companies (which are owned by their policyholders) pay dividends that are free from income taxes.
The cash value of the policy can be accessed through a policy loan.
You can surrender your policy and receive the cash value, less any fees and outstanding loan proceeds.
Premiums are much higher than they are for term life insurance, which could make it unaffordable to many consumers.
Whole life insurance policies have high fees, which are deducted from your premium resulting in very low cash value accumulation in the first few years the policy is in force.
Interest rates paid on the cash value can be lower than what you will earn on other investments.
The fixed death benefit may gradually become inadequate due to inflation and changing life circumstances.