What is whole life insurance and how does it work?

Whole life insurance is a type of permanent life insurance that provides financial protection for your entire life, so long as you pay your premiums as agreed. In addition to an assured death benefit, whole life insurance has a built-in savings component called cash value.

If you have loved ones who depend on your income, you probably need life insurance. Whole life insurance provides a number of benefits, but it’s also expensive compared to other types of policies. Let’s break down how whole life insurance works and when it makes sense.

What is whole life insurance?

Whole life insurance is the most common type of permanent life insurance. It’s sometimes referred to as ordinary life insurance.

Unlike term life insurance, which only pays a death benefit if you die within a specific number of years, whole life policies and other forms of permanent life insurance will pay a death benefit no matter when you die as long as your policy remains in force. These policies also have a cash value component that grows over time.

There are a few important differences between whole life policies and other types of permanent life policies, like universal life insurance and variable life insurance:

• Whole life insurance has a guaranteed death benefit. As long as you make your premium payments, your loved ones will receive a death benefit when you pass. Universal life and variable life policies offer long-term financial protection, but the death benefits aren’t guaranteed.

• Cash value grows at a guaranteed rate. With universal life and variable life, cash values fluctuate based on market conditions. The cash value of a whole life insurance policy grows at a rate guaranteed by the insurer.

• Whole life premiums stay the same throughout the life of the policy. Universal life and variable life offer greater flexibility in that you can adjust your premiums if your needs change.

• Many whole life policies pay dividends. If you buy participating life insurance, your whole life insurance policy may pay dividends, depending on its financial performance.

How much does whole life insurance cost?

The cost of a whole life policy depends on several factors, namely your age, health, and the face amount of the policy, i.e. how much the insurer will pay out to beneficiaries when the policyowner dies.

Whole life is more expensive than other types of life insurance, including other permanent life options. Premiums on a $500,000 policy, even for a healthy person in their 30s, can cost a few hundred dollars a month. Older people will pay more.

Pros and cons of whole life insurance

Whole life insurance offers several benefits for those seeking lifelong coverage, but it isn’t the right choice for everyone.

Benefits of whole life insurance

Some of the most important benefits of whole life insurance compared to other types of life insurance include:

Guaranteed death benefit

Whole life insurance is a good option if you want to leave an inheritance to family members or make a substantial gift to charity when you die. It can be an especially helpful estate-planning tool for parents of special-needs children who want to provide long-term financial security.

Permanent coverage

Whole life insurance lasts your entire life. The permanent coverage is a key advantage over a term life insurance policy, which only pays a death benefit if you die within the policy’s term, typically between 10 and 30 years.

Cash value

You can borrow against the cash value or make withdrawals from it. Some people use the cash value of whole life insurance to supplement their retirement income. The insurer guarantees the growth rate of the cash value.

Fixed premiums

Whole life insurance premiums don’t change during the life of the policy. While you don’t have to worry about the cost increasing, the downside is that there’s little flexibility. Also, premiums cost a lot more in the early years than the cost of insuring your life.

Potential for dividends

If the insurer pays life insurance dividends, your cash value can grow faster than your carrier’s guaranteed rate. You can use the annual dividends to grow your policy’s death benefit or cash value, reduce your premiums, or take them as cash. Bear in mind, though, that dividends aren’t guaranteed.

Disadvantages of whole life insurance

While the guaranteed death benefits, lifetime coverage and cash value are appealing, there are some drawbacks to whole life insurance that you need to be aware of.

High premiums

Perhaps the biggest disadvantage of whole life insurance is the high cost. A whole life policy can be up to 15 times more expensive than a 20- or 30-year term policy with a similar death benefit. Dollar for dollar, term policies allow you to buy a much larger death benefit.

Insurers maintain level premiums throughout the life of the policy by charging younger policyholders substantially more than it costs to insure them in the early years. The company uses the high premiums that younger people pay to offset the costs of insuring older people’s lives.

Slow cash value accumulation

The cash value accumulation rate that whole life insurance carriers guarantee is relatively low. Universal life insurance and variable life insurance offer higher potential growth, though both require you to assume some market risk. If you don’t need lifetime coverage, skipping permanent coverage altogether and investing the money you’d save on premiums will often yield better returns.

Lack of flexibility

A disadvantage of those fixed premiums and guaranteed benefits is that whole life insurance doesn’t allow for much flexibility. Unlike universal and variable life policies, whole life insurance doesn’t give you the option to adjust your premiums and death benefit amounts.

High surrender fees

Canceling a whole life policy can get complicated. You can surrender your policy in exchange for the cash value, minus fees. The amount you’d receive is known as the cash surrender value. However, these fees can run as high as 10% to 35% of the policy’s cash value. Usually, the fees are especially steep in the early years, then decrease later on.

Complexity

Because it’s both an insurance product and a savings/investment product, whole life insurance can get confusing. Usually, you’ll need to shop for coverage through a life insurance agent instead of getting quotes online.

How whole life insurance works

As with other life insurance policies, your whole life premiums and death benefits are determined during the underwriting process. Typically, the insurer assesses your risk through a health questionnaire, a life insurance medical exam and third-party information, such as your prescription history and driving record.

Whole life premiums are significantly higher compared to other life insurance policies. With any life insurance policy, your premiums go toward the insurer’s overhead expenses, along with the cost of insuring your life. But with whole life coverage, a portion of the premium also goes toward cash value. Because the insurer pays a death benefit as long as you keep the policy active, the cost of insuring your life is high. After all, everyone dies at some point.

When you die, your beneficiaries will receive a lump-sum death benefit that’s typically tax-free. However, any remaining cash value that’s left at the time of your passing will go to the life insurance company instead of your beneficiaries.

Cash value in whole life insurance

The cash value of a whole life policy will grow over time, but accumulation is often minimal at the beginning. In fact, some policies won’t build cash value for the first two to five years.

The insurer guarantees that cash value will grow at a minimum rate. However, cash value can grow at a faster rate if the insurer pays dividends.

A whole life policyholder has several choices for how to use their cash value. Some options come with hefty fees and may reduce the death benefit, though, and so be sure to get details from your insurer first.

• Borrow from it: You can take a policy loan against the cash value, but if you haven’t repaid the loan plus interest by the time you die, the death benefit is reduced by the loan balance. Loans from a whole life policy don’t require a credit check, nor will they affect your credit score.

• Withdraw a portion: Depending on the policy, you may be able to withdraw part of the cash value, though doing so may also reduce your death benefit.

• Use it to pay premiums: You can use your cash value to offset your premiums. This tends to work well for retirees seeking to maintain coverage on a limited budget.

• Surrender it: With a cash value surrender, you’re essentially giving up your policy in exchange for your equity, i.e., the cash value. Expect significant fees if you surrender your policy early on — and at that point your policy may not have accumulated much cash value. However, after 10 or 15 years, cash value surrender fees often go away.

Whole life insurance vs. term life insurance

Unlike whole life insurance, term insurance isn’t considered an asset. It doesn’t build cash value or pay dividends. If you survive the term, the policy expires worthless. A typical term life policy offers coverage for no more than 30 years. Though you can usually renew the policy at the end of the term, you can expect higher premiums because your odds of dying increase as you get older.

The big advantage of term life insurance is that it’s far more affordable than whole life insurance. Many people don’t need permanent coverage. They need financial protection until their children are grown, their mortgages and other debts are paid off, or they’re retired and no longer collecting a paycheck. Term life insurance is often sufficient in these situations.

Policy riders and additional features

If you buy a whole life policy, you may also choose to add life insurance riders, which are optional features that typically come at an additional cost. Some common life insurance riders include:

• Accelerated death benefit rider: Allows you to access part of your policy’s death benefit if you become terminally ill. This feature is also known as a living benefit rider.

• Critical illness rider: Like an accelerated death benefit rider, but it allows you to access part of your death benefit if you’re diagnosed with a critical illness like cancer that could shorten your life expectancy, even if it doesn’t meet the definition of a terminal illness.

• Accidental death benefit: Increases the policy’s payout if you die due to an accident.

• Guaranteed insurability rider: Allows you to buy additional insurance without undergoing another medical exam.

• Long-term care rider: Provides a monthly benefit to assist with the costs of a skilled nursing facility should you require long-term care.

• Child rider and spousal rider: These riders offer a small death benefit if your child or spouse dies.

• Waiver of premium rider: Allows you to stop paying premiums while keeping your policy in force if you become disabled.

Tax benefits and considerations

You can’t take a tax deduction on your premiums on whole life insurance or any type of life insurance. However, death benefits are generally income tax-free for beneficiaries.

Whole life insurance offers additional tax advantages. The cash value grows on a tax-deferred basis. Basically, if the money stays in the policy, you won’t pay taxes on the earnings. If you withdraw more than the policy’s cost basis, i.e., the amount you paid in premiums, the earnings will be taxable. But you won’t have any tax liability if you withdraw less than you’ve paid in.

Choosing the right coverage

Your first step in choosing the right life insurance is to determine how much coverage is necessary. There’s no precise formula for calculating your exact need, but many financial planners recommend replacing at least 10 years of your salary. You may want to aim for an even larger death benefit in some situations, like if you want to pay for your children’s education.

You’ll be able to afford a much larger death benefit if you choose term life insurance vs. whole life insurance. But remember: A term policy provides only temporary coverage, while whole life insurance covers you in perpetuity.

Also consider your financial goals. A whole life insurance policy may make sense if you want the built-in savings component you get through cash value. Whole life cash value has less growth potential than cash value in a universal life or variable life policy because it’s guaranteed. However, if you’re risk-averse, whole life insurance may feel like a safe, good investment compared to the permanent life insurance alternatives.

Finding the best whole life policy

To buy whole life insurance, you’ll probably need to work directly with a life insurance agent, who can help you determine the right amount of coverage for your situation. Few carriers offer online quotes for whole life and other permanent life insurance policies. Once you’ve found a suitable policy, you’ll need to do your homework to find the best life insurance company. Here are some things you’ll want to know before signing an insurance contract:

• Number of complaints. The National Association of Insurance Commissioner’s complaint index shows you whether a company generates an above-average or below-average number of complaints relative to its size. A company that receives an average number of complaints will receive a score of 1.0, so look for a company that scores below 1.0.

• The company’s financial strength. Five independent agencies rate the financial health of insurers: A.M. Best, Fitch, Kroll Bond Rating Agency, Moody’s, and Standard & Poor’s. Because each has different standards, check the ratings of a whole life insurance company with at least two different agencies.

• Your budget. Even if you’d prefer the lifetime coverage that whole life insurance offers, the premiums may be prohibitively expensive. Make sure you feel confident that you can afford the payments in the long term.

Whole life insurance can get confusing since it’s both an insurance policy and a savings vehicle. Don’t sign a contract unless you’re confident you understand all the details.

Most permanent life policies offer something called a life insurance illustration. This document shows you how your policy’s cash value and death benefit will grow over time based on the guaranteed values, as well as the insurer’s projections. Comparing illustrations from several life insurance companies can help you choose the best whole life policy.

Conclusion: Is whole life insurance right for you?

Whole life insurance coverage may be worth it if you want to leave a guaranteed death benefit to your heirs or a favorite charity. It can also be a good choice if you’re already maxing out your retirement accounts and want another tax-advantaged way to save. But be sure it fits into your long-term financial plans and budget to avoid a policy lapse.