How Does Whole Life Insurance Work?

Lynn Leritz is a vice president of Insurance Solutions.

You’ve come a long way since ramen noodle dinners in your college dorm room. Maybe you’re married or have a partner. Perhaps you’ve purchased a home. You might even have kids relying on you. If so, the topic of life insurance has probably come up in a conversation—or at least popped into your mind.

As you start researching life insurance policies, you’ll likely come across two of the most common: term life and whole life insurance. Term life insurance, which covers you for a limited time frame, might catch your eye with its lower premiums. But while premiums for whole life insurance can be higher, there are many reasons why it might make sense for your family.

Let’s take a closer look at how this powerful form of coverage called “whole life insurance” works and the benefits it can offer.

How does whole life insurance work?

Whole life insurance is a type of permanent life insurance, which means it doesn’t have an end date—it covers you for your entire lifetime. (In contrast, term life insurance expires after a certain number of years.)

With whole life insurance, as you pay premiums, your policy builds equity, which is your accumulated cash value. This tax-advantaged money can be used any time and for any reason—to pay for a child’s wedding or college expenses, to remodel your home, to start a business or to supplement retirement income.¹

Term life insurance, on the other hand, doesn’t accrue cash value. You pay your premiums, and if the term of your policy ends while you’re still alive—called outliving your policy—that’s it. You’ll need to purchase a new policy, likely at a higher cost, to have coverage.

Characteristics of whole life policies

If you’re still unsure about whether whole life insurance belongs in your financial plan, consider these points:

Your coverage never expires. 

Whole life insurance doesn’t last only for a term. Instead, it covers your entire life. That’s one of the biggest differences in term life insurance vs. whole life insurance. As long as you pay your premiums, your death benefit is guaranteed for life, generally tax-free, regardless of when you die.

Your premiums remain level. 

The cost of whole life insurance premiums will stay the same² until you’ve finished paying for your policy, which happens either when you get to a certain age or after a set number of years. Once you reach that point, your coverage will remain in place, and you won’t have to make any more payments. It’s sort of like paying off your mortgage.

Your policy is eligible to earn dividends.

At Northwestern Mutual, the cost of our insurance is based on certain assumptions, like how many death claims we expect to pay in a year. Whenever outcomes are better than what we assumed, we may pay a dividend to our policyholders. While a dividend isn’t guaranteed, we’re proud that we’ve paid one every year since 1872.

With whole life insurance, you get to decide how your dividends will be used. Here are some of the choices:

• Purchase additional insurance, which can increase your death benefit and accumulated cash value more quickly than your policy’s original guarantees. When you use your dividend to purchase additional insurance, it sets a new level of guarantee from which the policy’s values can’t fall from one year to the next
• Reduce the amount of premium you owe each year.³
• Take it in cash to use for anything you want.³

Your Northwestern Mutual financial advisor can help you figure out the best option for you.

You’ll accumulate cash value.

Your policy will accumulate cash value that’s guaranteed to grow over time and isn’t tied to the stock market—meaning it won’t decrease after a drop in stock prices. And if you choose to use dividends to buy additional insurance, your accumulated cash value and death benefit can increase even faster, compounding over time.

You can access this cash value at any time for any purpose, and you’re typically able to get the money quickly.¹ When accessing your cash value, you have a few options to consider.

• Take a loan against your policy.⁴ You can take a loan against your policy from the insurance company. Repayment of the loan is flexible, but interest will accrue. If you die with a loan against the policy, your death benefit will be reduced by the amount of the loan. Another option is to use your policy as collateral for a loan from your bank. This may be a good option if you have a financial emergency or for larger, infrequent needs, such as remodeling a home.
• Surrender a portion of your policy. When you surrender your policy, you’ll no longer have your insurance. In many cases, when people need to access their cash value and no longer need their full death benefit, they surrender a portion of their policy. They keep some life insurance death benefit in place. This can also be helpful from a tax perspective. That’s because when you surrender a policy, you’ll owe ordinary income tax on any cash value above money that you’ve paid in (or “basis”).
• Surrender your entire policy. In this case, you can take all the cash value in your policy, but you also surrender all your life insurance. If your cash value is worth more than what you paid in, you’ll owe ordinary income tax on that amount.

If you’re considering tapping into your cash value, your financial advisor can help you think through the best options for your situation.

The insurance company may pay your premiums if you become disabled.

If you have an optional waiver of premium rider on your policy, the company will pay your life insurance premiums if you become disabled. During this time, your cash value will continue to grow without you owing any money for your policy.

You may be able to purchase more insurance without a medical exam.

If you have the optional additional purchase benefit on your policy, you’ll be able to purchase additional insurance without having to take a medical exam or go through a health history review when you reach certain milestones or ages. This benefit means that changes in your health won’t affect your ability to get more insurance down the road.

It can lead to better financial outcomes as you build retirement savings.

Whole life insurance can work alongside other financial tools like investments and deferred income annuities in a multifaceted approach to retirement savings. In fact, a study by EY found that retirement strategies involving permanent life insurance and deferred income annuities excelled compared with investment-only approaches.

You could use it in retirement.

You’ve worked hard for your money and may have sacrificed to save money for your retirement. But investments in 401(k)s, IRAs or other retirement accounts are subject to the rise and fall of the market, which means your balance will vary.

Because your whole life insurance is guaranteed to grow, your accumulated cash value can be a supplement to your retirement income, particularly during down markets. Using cash value in a downturn allows your other assets time to rebound. Otherwise, if you access those accounts while they are down, you’d essentially be selling at a loss.

Common questions about whole life insurance

Let’s walk through a few other things you should know about whole life insurance.

At what age should I buy life insurance?

Particularly with whole life insurance, the sooner you buy it, the better. The younger and healthier you are when you purchase your policy, the lower your premiums will be. Buying whole life coverage earlier in your life also means that your policy has more time to accrue cash value.

With this in mind, it’s not uncommon for parents (or even grandparents) to buy a policy for their children. Doing so guarantees they will have life insurance to provide for their own loved ones someday, even if their health changes in the future. And the policy becomes an asset the children can access throughout their lives.

How many years does it take to pay up a whole life insurance policy?

Exactly how long it’ll take to reach this point will depend on your policy. With some policies, you pay until you reach a certain age, like 65 or 100. Other policies require you to make payments for a set period of time—like 10, 15, 20 or 25 years—before the policy becomes paid up.

When you reach this point, it means your coverage will stay active even though you’re no longer required to make premium payments.

What are the potential drawbacks of whole life insurance?

While whole life insurance can be a powerful tool for protecting your family and leaving behind a legacy, that doesn’t mean it’s right for everyone. As with any other type of life insurance, there are potential drawbacks to consider, including:

• Higher premiums: Whole life insurance policies tend to have higher premiums than term policies because the insurance lasts for your entire lifetime rather than a set period of time.
• More features: Whole life insurance policies offer more benefits than term policies, and it can take some time to understand them all, especially around the topic of how cash value grows. For this reason, it’s a good idea to consult with a financial advisor to help choose the ideal policy for you.
• Opportunity cost: While it’s true that your cash value will grow over time, this accumulation is a longer-term process. So, if you’re concerned about being able to save for the near term, such as starting an emergency fund, you may want to hold off on whole life insurance for now.

When to review your whole life insurance policy

It’s a good idea to check in regularly with your financial advisor. Most of the time, you won’t need to make changes to your whole life insurance policy. But there are a few reasons that you may want to revisit your insurance coverage.

• Changes in your family. When you have a change in your family, like a divorce or the birth of a child, review your policy. Make sure the beneficiaries that you listed are still correct and that your policy provides the right amount of death benefit.
• Changes at work. Your company could change benefits, such as the life insurance they provide, or you might get a big raise. You may want to increase your whole life insurance coverage.
• As your financial plan changes. When you first get insurance, you may have little savings and a large mortgage. Eventually, your savings will grow, and your mortgage will shrink. As this happens, you may want to update your life insurance coverage.
• When you update your estate plan. Life insurance beneficiary designations supersede what’s in a last will and testament. That means any time you’re updating your will, it’s a good idea to also look at your insurance beneficiaries. Make sure they accurately reflect your wishes.

With its guaranteed death benefit and guaranteed growth, whole life insurance can help you reach several financial goals. Your Northwestern Mutual financial advisor can also show you how your insurance can work with your investments to more efficiently reach your savings goals.

Your advisor can listen closely to your goals and partner with you every step of the way—helping to co-pilot your financial plan. They can even reveal blind spots and opportunities that can otherwise be overlooked.