How Whole Life Insurance Works

Whole life insurance is a great way to protect your family’s future while also accumulating cash value, which can help you throughout your life. 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 life. In contrast, term life insurance expires after a certain number of years and does not accrue cash value.

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

How does whole life insurance work?

Whole life insurance is a flexible, tax-advantaged financial product that can help you reach many financial goals throughout your life. Here’s how whole life insurance works.

Your coverage never expires. Whole life insurance doesn’t have a term; that is, it covers you for your entire life. 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. With whole life insurance, your premiums will stay the same until you have finished paying for your policy, either when you get to a certain age or after a set number of years. When you finish paying premiums on a whole life insurance policy, your coverage will remain in place and you won’t owe any more; it’s sort of like paying off your mortgage.

One thing to note about premiums, some whole life insurance policies have a term insurance component. If your policy has Blended Term insurance, there is a chance that additional premiums could be required in the future if there is a substantial drop in the dividend scale of the company.

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 the company performs better than we assumed, we may pay a dividend to our policyholders (which we’ve done every year since 1872). With whole life insurance, you can use dividends to purchase paid-up insurance, which can increase your death benefit and accumulated cash value more quickly than your policy’s guarantees. You could also use dividends to reduce the amount of premium you owe each year. Finally, you could take your dividend as cash. Your financial representative can help you figure out how best to leverage your dividends.

You will accumulate cash value. Your policy will accumulate cash value that’s guaranteed to grow over time and is not tied to the market — meaning it won’t decrease as a result of a drop in stock prices. In addition, if you choose to use dividends to buy additional paid up 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 in a matter of a few days. When accessing your cash value, you have a few options to consider.

  • A loan against your policy. 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 while there is 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 is generally a good option in the event of an emergency or for larger, infrequent needs such as remodeling a home.
  • Surrender a portion of your policy. When you surrender your policy, you will 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. This allows you to keep some life insurance death benefit in place. In addition, 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 the basis that you paid into the policy. 
  • 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 the basis that you paid in, you will owe ordinary income tax on that amount. 

If you’re thinking about using your cash value, your financial representative can help you think through the best options for your situation. One thing to keep in mind, it does take time to grow your policy’s cash value, so using it in the early years generally is not advisable.

You could use it in retirement. You’ve worked hard your entire life and have sacrificed to save money for your retirement. But investments in 401(k)s, IRAs or other accounts are subject to the will of the market, which means you could have bountiful years or down years. 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. That allows your suppressed market assets time to rebound. Otherwise, should you access those accounts while they are down, you would essentially be selling at a loss.

The insurance company may pay your premiums if you become disabled. If you have the optional waiver of premium benefit on your policy, the company will pay your premiums if you ever 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 health exam. If you have the optional additional purchase benefit on your policy, you will be able to purchase additional insurance when you reach certain ages (22, 25, 28, 31, 34, 37, and 40) without having to take a health exam. That means that changes in your health won’t affect your ability to get more insurance.

When to review your whole life insurance policy

While it’s a good idea to check in regularly (usually once a year) with your financial representative, in many cases, you won’t need to make changes to your whole life insurance policy. But there are a few times when you may want to revisit your insurance coverage.

Changes in your family situation. When you have a change in your family situation, like a divorce or the birth of a child, you want to review your policy to make sure the beneficiaries listed are still correct.

Changes at work. Over time, your situation at work may change. Your company could alter or eliminate benefits, or there’s a chance that your income will increase, perhaps substantially. As it does, you may want to add to your whole life insurance coverage in the future.

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 trump what’s in a will. That means any time you’re updating your will, it’s a good idea to also look at your insurance policies or other accounts to make sure the beneficiaries listed match what’s in your will.

With its guaranteed death benefit and guaranteed growth, whole life insurance can help you reach a multitude of financial goals, making it an important component of your overall financial plan.

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