Permanent Protection: Whole Life Insurance Overview

Some questions, answered

• What are the pros and cons of whole life insurance? 

• What are the risks of whole life insurance? 

• Is whole life insurance better than term?

How whole life insurance works 

Whole life insurance is a form of permanent life, which is coverage that doesn't expire. This is different from term life insurance, which covers you for a set duration -- say, 20 or 30 years. At the end of that duration, a term life policy ends. You could possibly renew it, but the premiums are usually very high. Whole life, on the other hand, does not have an end-date. 

Both whole life insurance and term life insurance offer a death benefit. That's the amount the insurer pays to your loved ones and beneficiaries after you die. 

Whole life insurance additionally has a savings component, called cash value. Your cash-value balance grows over time at a guaranteed interest rate. You can access those funds by borrowing against them or withdrawing them directly, as your policy allows.

Reasons to buy whole life insurance 

Whole life insurance is more expensive than term life. Specifically, your premium on a whole life policy could cost 10 or 15 times more than a term life policy with the same death benefit.¹ Because of this cost difference, it's important to evaluate whether you truly need whole life, or if a cheaper term policy can serve your needs. 

Here are three scenarios which may justify the added investment in whole life insurance.

1. You may want to use your benefits while you are living. 

Whole life insurance provides the option to use your benefits while you are living. To take that option, you’d borrow or withdraw funds from your cash-value account. You can usually also use excess cash value to pay your insurance premiums. 

Cash value is a nice perk, but it’s also critical to the longevity of your life insurance. You should know that insurers structure whole life so the cash value eventually funds the death benefit. That has two important implications: 

• Cash-value loans and withdrawals reduce your death benefit. In other words, your beneficiaries get a lower payment if you have an outstanding loan when you pass away. This is why insurers will lend against your cash-value with no repayment requirements. Because the insurer can recoup the loan, plus accrued interest, from your death benefit.

• Your beneficiaries get your death benefit, but not your accumulated cash. Unless your policy specifies otherwise, the insurer keeps your cash-value balance after you die.

You can think of cash value and the death benefit as two sides of the same coin. You can use the cash-value side of the coin while you are living. Or,  you can leave the death benefit side to friends and family. You can even do a little of both. But the benefits you take early reduce what's available for your beneficiaries later.

Note that term life insurance has no option to access your benefits early. A term life policy only has a death benefit and no cash value.

2. You want to leave your loved ones an inheritance. 

Whole life insurance should pay your death benefit no matter when you die -- assuming you have kept current on your premiums. Term life insurance, however, only pays the death benefit if you die before the policy expires. 

Without a crystal ball or an accurate psychic friend, you can't definitively structure term life insurance to be in force when it's your time to go. For that reason, whole life insurance is the more reliable inheritance plan.

3. You would like another source of tax-deferred earnings. 

The earnings in your whole life cash-value account are tax-deferred. Tax-deferred earnings are appealing if you're already maxing out contributions to other tax-advantaged accounts, like your 401(k) or IRA. 

You should know, however, that there are situations where you may incur taxes on your life insurance. Here are three: 

1. You borrow or withdraw more from the policy than you've paid cumulatively in premiums. 

2. You borrow against your cash value and then terminate your coverage. The IRS will probably reclassify the loan as a taxable event. 

3. You sell your life insurance in a life settlement. The IRS will tax you on the profits.

Key features of whole life insurance

1. Lifelong coverage (mostly)

As noted, the permanent nature of whole life insurance makes it suitable to use as an inheritance for your loved ones. However, there is one lesser-known detail of whole life insurance that could derail your estate plan. It’s called the age of maturity. 

Whole life policies "mature" when the insured reaches an age specified in the contract. On older life insurance, that maturity age might be 100. Most policies purchased recently will specify a maturity age of 120. 

At the age of maturity, the insurer may pay the death benefit to the insured directly and close out the policy.² A portion of those proceeds may be taxable, which would lower the net funding left for loved ones.³  

2. Fixed premiums

Whole life insurance premiums do not increase. You pay the same annual rate for as long as you keep the policy in force. 

3. Guaranteed death benefit 

A life insurance death benefit is a tax-free payment made to your named beneficiaries after you die. On a whole life policy the death benefit is guaranteed -- meaning your insurer cannot decrease the amount if you stay current on your premiums. 

The size of the death benefit correlates to your premium payments. A more expensive whole life policy might provide a death benefit sufficient to secure financial independence for your family after you are gone. If you have a small budget, you might obtain coverage that pays for your funeral expenses, so your loved ones don't have to.

4. Guaranteed return on cash value

Your insurer places a portion of your whole life premiums into a cash-value account, where it earns interest. On a whole life policy, that interest rate is fixed and guaranteed. 

5. Dividend payments 

Whole life policies often pay dividends to policyholders. Insurers usually calculate those dividends from profits, which result from sales, interest rates, and investment performance.⁴ 

Some whole life policies guarantee dividend payments, and others do not. As you might expect, a policy with guaranteed dividend payments will cost more in premiums than a policy without guaranteed dividends. 

The insurer pays dividends into your cash-value account. Your policy may allow you to withdraw dividends, let them accumulate, or use them to pay part of your premiums. 

Whole life insurance FAQs