How much would you pay for peace of mind? To be secure in the knowledge that your loved ones won’t go wanting after you die?
If you’re like most people, your answer is probably “a lot.” Which is good, because one of the most reliable ways to get this peace of mind is also very expensive. It’s whole life insurance, a type of life insurance policy without a set expiration date.
Unlike term life insurance, which pays out only if you die while the policy is in effect, whole life insurance builds value over your entire lifetime. It’s best viewed as an investment in your long-term financial security, albeit one with significant costs and drawbacks. And it’s complicated enough that you’ll want to get comfortable before learning how it works.
What Is Whole Life Insurance?
Whole life insurance is a type of permanent life insurance contract that covers you indefinitely. Whereas term life insurance has a set, temporary term that usually doesn’t last longer than 30 years, whole life coverage lasts until you die or stop paying your premium, whichever comes first.
Some whole life policies do end at a predetermined age, typically 100 or older. But most people don’t live that long.
Like term life insurance policies, whole life contracts pay out to one or more named beneficiaries when you die. Whole life policies also build cash value over time. That’s a big difference over term life policies, which expire worthless if you outlive the term and don’t renew.
Sounds like a great deal, right?
The biggest catch is that whole life insurance is much more expensive than term life. Premiums typically cost five to 10 times as much as a term life policy with the same death benefit. That’s because virtually every whole life policyholder who keeps paying their premium triggers the death benefit. Insurers have to make sure they turn a profit on most policies after accounting for that payout.
Whole life insurance has some other disadvantages as well, but it does make sense for some people. Keep reading to find out how the typical whole life policy works.
How Whole Life Insurance Works
If you’re familiar with term life insurance, you’ll see some similarities in whole life insurance. Both types of insurance have fixed premiums and usually have fixed death benefits, for example.
Whole life coverage differs from term life insurance in important ways. The biggest difference, and the defining feature of whole life insurance, is the cash value component.
How Cash Value Works in Whole Life Insurance
Unlike term life insurance, whose entire value is tied up in the death benefit, whole life policies also have a key living benefit — a cash value component that you can tap while you’re still alive.
Your policy builds cash value when you pay more into it than required by your monthly premium schedule. Known as paid-up additions or PUAs, these excess payments generate equity, similar to the equity you might build up in your home as you pay off your mortgage.
Like a savings account at a traditional or online bank, your policy’s cash value steadily grows in value as long as you continue to make premium payments. This growth is tied to prevailing interest rates, so it’s low when interest rates are low and increases as they rise. It rarely approaches long-term stock market returns.
Remember, your life insurance policy’s cash value of whole life insurance only increases over time if you make timely premium payments. If you temporarily become unable to make premium payments or choose to stop making them for any other reason, the policy’s cash value automatically stands in for those missing payments. That means it decreases proportionally with each premium payment made from it until it’s depleted or you start making payments again.
Financial Strength and Cash Value
Whole life insurers guarantee their policies’ cash value components and death benefits. However, unlike bank deposits insured by the federal government, this is a private guarantee that’s only as good as the insurer’s own finances.
That’s why it’s so important to consider your insurer’s financial strength. A great deal can change over the decades that your whole life policy is likely to remain active, after all. Before buying a policy, review potential insurers’ financial strength ratings from independent rating agencies like AM Best and S&P — and choose one that’s likely to be around for the long haul.
Withdrawals and Loans Against Cash Value Life Insurance
As it builds, whole life’s cash value creates financial flexibility. It’s a lot like the equity in your home — the more you have, the more you can do with it.
You can access your policy’s cash value by withdrawing it or borrowing against it. You aren’t expected to repay withdrawals, but unpaid life insurance loan balances accumulate interest charges until you repay them in full. The interest rate on a cash value loan is much lower than a credit card or personal loan because the cash value loan is secured by the value of your life insurance policy. That reduces the risk to the insurer.
Whether you withdraw or borrow against your cash value, your policy’s death benefit falls. This often occurs on a dollar-for-dollar basis, but some whole life policies penalize withdrawals by reducing the death benefit more than the withdrawn amount. The only way to restore your death benefit is to pay back into the cash value.
Cash value loans aren’t taxable. Nor are withdrawals against what you put into the cash value. However, if you withdraw your policy’s cash value gains, you may have to pay income taxes on that portion.
How Surrender Charges Work in Whole Life Insurance
A whole life policy’s surrender value is closely related to its cash value. The surrender value is the actual amount you receive if you choose to cash in the policy before your death. Like cash value, surrender value increases over time, albeit not as fast as you might like.
Cashing out a whole life policy is a big decision. Fully surrendering your policy cancels the policy and voids its death benefit, meaning your beneficiaries won’t get anything from it when you die.
And surrendering a policy early in its life could cost you. Depending on the policy, surrender charges or surrender fees cut into the surrender value for the first five to 15 years of the policy’s existence. From there on, the policy’s surrender value equals its cash value.
Insurers impose surrender charges to discourage policyholders from cashing out too early. They do slowly phase out over time, so cashing out in year nine is likely to sting less than cashing out in year four. But if you fully surrender your policy, you’ll still have to pay taxes on any cash value gains.
Whole Life Insurance Dividends
Whole life dividends are distinct from interest earned on the cash value component.
Technically, whole life dividends are annual returns of premium. They therefore aren’t taxable as stock dividends normally are.
However, they’re also tied to the annual performance of the life insurance policy’s investment portfolio. This performance is determined by two factors: actual versus expected payouts and the insurer’s rate of return on the assets in which it invests excess policy premiums.
The portfolio’s performance can vary significantly from year to year, depending on market conditions. In bad years for the broader market, a policy might not pay a dividend at all.
Let’s say you do get a whole life dividend in a particular year. You can use it to:
- Reduce the size of out-of-pocket premium payments or cover entire premium payments
- Repay a loan against the policy’s cash value
- Purchase additional life insurance coverage — and increase the policy’s death benefit — without another medical exam or further underwriting
- Add to the policy’s cash value
You can also take your annual dividend as a check or electronic transfer and spend it as you see fit. In any case, your dividend should arrive around the policy’s anniversary date.
Whole Life Insurance Death Benefits
Every whole life insurance policy has a predetermined death benefit. This benefit goes to your named beneficiaries after you die. It’s tax-free, so they get the entire amount.
If your insurance contract has a level death benefit, your benefit won’t increase unless you use your dividends to purchase additional coverage. If your contract has an increasing death benefit, your beneficiaries get the death benefit plus the policy’s cash value. Remember, cash value loans and withdrawals reduce the death benefit if you don’t repay them while you’re still alive.
Pros & Cons of Whole Life Insurance
Still thinking about applying for a whole life insurance policy? Before you make the leap, consider these benefits and drawbacks.
Pros of Whole Life Insurance
Whole life insurance offers financial flexibility, federal tax benefits, and even the potential to beat inflation.
- Significant Tax Benefits. Over time, whole life policies grow into rich sources of tax-advantaged funds that you can borrow against or withdraw at will. Under normal circumstances, they also provide tax-free windfalls for beneficiaries. If you’re wealthy enough to trigger the estate tax when you die, this is a massive benefit.
- Cash Value Component Offers Financial Flexibility. Whole life’s cash value component offers the same degree of financial flexibility as real estate. If you don’t plan to purchase and build equity in a home of your own, a whole life policy loan can stand in for a home equity loan or line of credit.
- Dividends May Provide a Return on Investment. You can use your whole life dividends to reduce or eliminate premium payments, increase your death benefit, boost your cash value’s interest-earning power, pay off a life insurance loan, or simply pad your bank account.
- Hedge Against Inflation. Your whole life insurance policy has a level premium, meaning its premium cost stays constant for the life of the policy unless you add coverage. In real terms, your policy actually gets cheaper over the years due to inflation.
- Savings for Final Expenses. Even a modest death benefit should be enough to cover the cost of your funeral and burial. Indeed, many insurers specifically market small-dollar whole life policies for this purpose. They’re known as burial insurance policies.
Cons of Whole Life Insurance
Whole life insurance has some significant drawbacks, including high premium costs, complex policy structure, and fees and charges that sap policy value.
- More Expensive Than Term Life Insurance. Whole life is much more expensive than level term life insurance. If you only expect to need life insurance coverage for 20 or 30 years at most and you have other sources of long-term investment growth and income, term life insurance is a better choice for your long-term financial needs.
- More Complicated Than Term Life Insurance. Whole life insurance contracts are dense and difficult to understand. It’s risky to shop for and purchase whole life insurance without the help of a financial advisor acting as a fiduciary — that is, in your financial best interests.
- Cash Value Takes Years to Build. Your whole life insurance policy builds cash value over a period of time, not right away. In most cases, cash value doesn’t really begin to accrue until the policy’s third year, but it’s likely to be low for years longer. Don’t expect to be able to borrow against your policy for a while.
- Surrender Charges Eat Into Gains. Surrender charges may apply for as long as 15 years from a policy’s effective date, although they decline over time. Always read your policy’s surrender clause to understand when you can withdraw funds without penalty.
- Tends to Underperform the Stock Market. Insurance salespeople often market whole life insurance as a good investment, but history doesn’t bear this out. High fees and poor investment strategies mean your whole life policy is likely to underperform the broader stock market in the long run.
Do You Need Whole Life Insurance?
If you only need financial protection for part of your life — say, 10 to 30 years — then you don’t need whole life insurance. Term life insurance provides more coverage at far lower cost, and as your net worth grows, your other assets provide the security your family deserves.
That doesn’t mean whole life insurance has no place in your financial plan. If any of the following situations apply to you and your family, you’re a good candidate for whole life.
You Need Financial Flexibility Not Tied to Real Estate
If you have significant equity in your home, you can apply for a home equity loan or line of credit to access it. But that requires a credit check and reduces the equity in your home, which can cut into your gains if you plan to sell before paying back what you borrowed.
Tapping the equity in your whole life insurance policy is even easier. You don’t have to jump through any credit hoops or repay on any particular timetable — although faster repayments reduce your total interest costs.
If you own your own home, there’s no reason you can’t use both sources of equity. Two is better than one, after all.
You Want to Protect Your Wealth From Taxes and Probate
Whole life insurance has considerable tax advantages, including tax-free death benefits, tax-deferred cash value accumulation, and tax-free or low-tax loans and withdrawals.
Whole life insurance also allows you to avoid sending your entire estate through probate. When you die, your policy’s death benefit goes directly to your beneficiaries — often within days or weeks of them filing the claim. If you died with lots of assets and debts, the probate process can take years, during which your beneficiaries won’t see a dime.
You Want to Supplement Your Income in Retirement
Whole life insurance dividends offer a nice income supplement during retirement. They probably won’t be enough to live on, especially in bad years for the policy’s investments. But they’ll help you maintain your standard of living after you stop working full-time — or perhaps serve as a slush fund for post-retirement travels or hobbies.
If you don’t care about leaving your entire death benefit to your heirs, you can further supplement your income in retirement by withdrawing from or borrowing against your policy’s cash value.
Whole Life Insurance FAQs
Whole life insurance is complicated, but that’s not necessarily a reason to steer clear. With the answers to these common questions in hand, you’re well on your way to understanding the basics of whole life.
What’s the Difference Between Whole vs. Term Life Insurance?
The biggest differences between whole and term life insurance are:
- Term Length. Whole life policies last indefinitely, for your entire life or until you stop paying premiums. Term life policies are temporary, usually lasting no more than 30 years.
- Cash Value. Whole life policies build cash value over time. You can borrow against or withdraw your policy’s cash value for added financial flexibility. By contrast, term life policies have no value of their own. You can’t borrow against them, and if you outlive the policy term, you get nothing.
- Premiums. Whole life insurance premiums are much more expensive than term life premiums. Expect to pay at least five to 10 times more for the same amount of whole life coverage.
What’s the Difference Between Whole vs. Universal Life Insurance?
Universal life insurance is another type of permanent life insurance policy, but it offers fewer guarantees and less predictability than whole life. On the other hand, it has the potential to be cheaper than whole life insurance.
Whole life insurance coverage offers a guaranteed death benefit and lifelong coverage as long as it’s paid up. Universal life doesn’t have a guaranteed death benefit, and the amount your beneficiaries get depends on how much you pay into the policy.
Whole life insurance has a level premium that stays the same for your entire life. Universal life insurance has an adjustable premium that allows you to increase or decrease your contributions as your financial situation allows. However, if your premium payments lapse for too long or you pay too little into the policy over time, you could forfeit the death benefit.
Both whole life and universal life have a cash value component. Whole life’s cash value is guaranteed and grows at a predictable rate. Universal life’s cash value is less predictable and can rise or fall based on the performance of underlying assets, such as mutual funds.
How Much Does Whole Life Insurance Cost?
It depends on your age when you buy the policy, how much coverage you buy, your health, your family health history, and other factors. Expect to pay at least five times what you’d pay for an identically sized term life policy — and more than that if you’re comparing against a shorter term policy, such as a 10-year or 15-year term.
How Much Whole Life Insurance Do I Need?
It depends on your objectives. If your policy has a specific purpose, such as covering the cost of your funeral and burial, it can be small — say, a death benefit of $10,000 or $20,000.
If you’re looking to supplement your income in retirement, you’ll need considerably more — enough to throw off a five-figure dividend every year. And if you’re looking to put multiple dependents through college or cover other major financial obligations later in life, you could need even more.
When in doubt, ask your financial advisor. Just make sure they’re not also an insurance salesperson and don’t get a commission for recommending specific whole life policies. If they’re truly looking out for your best interests, they might advise you to steer clear of whole life altogether.
What Is Modified Whole Life Insurance?
Modified whole life insurance is to traditional whole life insurance what an adjustable-rate mortgage is to a fixed-rate mortgage. Premiums remain low and level for five to 10 years, then adjust upward for the remainder of the policy. Often, the adjusted premium is higher than the level premium on a comparable traditional whole life policy.
Term life policies can be modified in this way as well, with lower premiums early on and higher premiums later. Depending on the type of policy, modified life insurance may be known as:
- Modified whole life insurance
- Modified term life insurance
- Graded life insurance
- Modified premium life insurance
Final Word
The key to deciding whether whole life insurance works for you is to decide why you need insurance.
If you expect to need insurance coverage for longer than 30 years, a whole life policy could make sense. Same deal if you’re looking for long-term financial flexibility that’s not tied up in real estate or you hope to supplement your retirement savings in your later years.
Whole life insurance has significant tax benefits too, although these tend to be clearer for high net worth policyholders.
Regardless, always consult a financial professional who understands your financial needs and concerns before making this decision. Ideally, this person should be a fiduciary bound by law and ethics to act in your best interest.
Finally, don’t go with the first offer of coverage you receive. Get multiple life insurance quotes to make sure you get the most favorable terms — and lowest premiums — available.
