When you help to support a family, you’re likely to think about how your family would be taken care of if you were to die. That’s what life insurance is for. But life insurance comes in many varieties.
Permanent life insurance, which includes whole life insurance, is one of the options on the table, and it’s exactly what its name suggests: permanent. If the policy is in place when you die, it will pay a death benefit, whether you live to be 65 or 105. That’s what makes it different from the other main type of policy, term life insurance. Term will expire, and usually without being worth a dime.
Think of the difference between the two as like getting a home. Term life insurance is like renting. You pay rent each month and when your lease is up, you stop paying, move out and walk away with nothing financially (except maybe your security deposit). With term, you pay premiums each month for coverage that spans a certain period of time. If you’re still alive when that term is over, you don’t have to pay your premiums anymore, but there will be no death benefit for your beneficiaries.
Permanent life insurance is like buying a home. With each mortgage payment, you build equity in your home until you own it outright. Whether you sell the home, or leave it behind for your family, the home is an asset you own. When you pay the premiums on your permanent life insurance, you’re building value in your policy while you’re still alive, and eventually your insurance will become a valuable asset that you own.. For those reasons, permanent life insurance is typically more expensive than the same amount of term insurance for the same person.
1. HOW DOES IT WORK?
Permanent life insurance is very flexible, which means it can also be a bit complicated. But let’s take a fairly simple whole life insurance policy to explain how it works.
First, figure out how much of a death benefit you need — a financial advisor can help you think this through — then apply for that amount of coverage. The application process typically includes a health screening.
Then figure out the length of time you’d like to pay your premiums. Think about it in terms of a home loan, where you might get a 15- or 30-year loan. With life insurance you typically have many options. For instance, you could choose to pay until you reach a certain age, like 65 or 90, or over a certain number of years.
Just like with a home loan, the shorter the duration, the more you’ll owe each year for the same amount of coverage. Whole life insurance is like a fixed-rate mortgage — the premiums never change. But there are other types of permanent life insurance policies where the premiums do change.
Once the policy is in effect, if you die, the company will pay your beneficiaries the full death benefit. But let’s assume that you live for a long time. Your policy will accumulate cash value over time. In a whole life insurance policy, that cash value will never go down (unless you take the money out — which also reduces the death benefit).
Even though they aren’t guaranteed, many insurance companies also pay dividends, which can allow your cash value to grow more quickly and may also increase your death benefit if you reinvest them in your policy. You could also choose to use your dividends to pay your premiums. Doing that means you may not have to pay as much each year; it’s even possible that at some point, you may not have to pay anything at all. But that also means you won’t accumulate as much cash value.
2. WHAT CAN YOU DO WITH THE CASH VALUE?
Because your policy builds up cash value, it gives you access to money if you need it. The most common way to access your cash value is to take a loan against it. Think of it like a home equity loan. You could take the loan directly from your insurance company or you could use the policy as collateral for a bank loan. One thing to consider if you do this: Your heirs would have to pay back any loan if you were to die (if your loan is from the insurance company, the company will deduct the loan balance from the death benefit).
You could also surrender (i.e., cancel completely) some or all of the policy someday and take the cash value in its entirety (think of it like selling a house). You would lose your death benefit though, and doing this can have tax implications. So if you go this route, it’s best to work with a financial planner or professional.
3. WHO SHOULD CONSIDER PERMANENT LIFE INSURANCE?
Because permanent life insurance is more expensive than a term policy for the same death benefit, often people will buy a mix of term and permanent life insurance. Some term policies will also allow you to convert them to a permanent policy in the future without having to take another health screening.
If you’re interested in a death benefit that won’t expire and want the ability to accumulate cash value, you should consider permanent life insurance.
Utilizing the accumulated value through policy loans, surrenders, or cash withdrawals will reduce the death benefit; and may necessitate greater outlay than anticipated and/or result in an unexpected taxable event.