How does whole life insurance work?
You’ve come a long way since ramen noodle dinners in your college dorm room. Maybe you’re married. Perhaps you’ve purchased a home. You might have a few youngsters now who rely on you for everything. If any (or all) of these situations apply to you, odds are life insurance has come up in a conversation or two.
As you start researching life insurance policies, you’ll likely come across two of the most common: term and whole life insurance. Term life insurance, which covers you for a limited timeframe, might catch your eye with its lower premiums. Indeed, a whole life insurance policy is more expensive, but there are several reasons why paying more might make sense. Here’s a closer look at what makes whole life insurance different from a term life policy.
Whole life insurance explained
There are many different ways to build a whole life insurance policy, but, in general, whole life insurance offers lifelong coverage as well as a cash value component. The cash value always grows over time and is available for you to access during your life for any reason (although doing so will reduce your death benefit).
Benefits of whole life insurance
Because of its lifelong coverage and cash value component, whole life insurance can be one of the most flexible parts of your financial plan.
Whole life insurance covers you until the end
So long as you pay your premiums for whole life insurance, your death benefit (the amount paid to your beneficiaries after your death) is guaranteed for life — whether you die at 30 or 105. If you purchase a $1 million policy, $1 million is paid upon your death (generally income tax-free). Term life insurance only pays a death benefit if you pass away within a predetermined window of time, say, 20 years. After 20 years, your policy simply expires, and that’s part of what makes term life insurance less costly than whole life insurance. In many cases no one will ever get the death benefit (because you outlive the policy).
Whole life insurance is consistent
With a whole life insurance policy, your premiums remain the same. What you pay today is what you’ll pay in 20 years.1 So, if you open a whole life policy at age 30, you’ll pay a lower, fixed premium than someone who starts a similar policy at 45, for example. There are an array of other types of life insurance policies that allow you to adjust your premiums or death benefit as you go. There are also some hybrid offerings that combine elements of whole and term life insurance (where the premiums could change). But with whole life, the premiums and death benefit are predictable.
Whole life insurance has cash value
This is the biggest difference between term and whole life insurance. Payment of premiums on your whole life policy generates cash value that is guaranteed to grow over time. After your cash value has accumulated over several years, you can use it for any purpose that is right for you.2
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You can use your accumulated cash value to help pay your premiums. You can use it as collateral for a mortgage or other personal loan.3 You can even use the money to pay for tuition, a down payment on a house, unexpected medical expenses — anything, really (it’s your money). You can generally access your policy’s cash value tax free, as well.
Finally, just like a selling house, you can fully surrender your policy and receive the accrued cash value.4 When you do that, you may owe tax, but generally cash value from a surrendered policy is only taxed when it exceeds premiums paid. Term life insurance, on the other hand, is more akin to renting an apartment.
When your apartment lease is up, you pack up your stuff and move. Similarly, when a term life policy expires, that’s it. You simply aren’t covered anymore, and you don't receive any cash from what you've paid in.
Whole life insurance may have dividends
While they aren’t guaranteed, some insurance companies will pay annual dividends on your policy. You can simply take that dividend as cash (there may be tax consequences if you go this route). Or, you can plow those dividends back into your policy to grow your cash value and/or death benefit (and, in turn, your subsequent dividends) faster.
Whole life insurance can help in retirement
A whole life insurance policy can also play an instrumental role in supplementing retirement income. The cash value in your life insurance policy is guaranteed to grow, but the stocks and bonds in your retirement portfolios will undoubtedly rise and fall. And if the market tanks, it’s costly to sell your investments at rock-bottom prices just to generate income. However, if you’ve accumulated enough cash value in a whole life policy, you can use those funds for income while you wait for the market to recover.2 Any time you plan to utilize your policy’s cash value, it’s a good idea to speak with a tax advisor to assess the pros and cons of your situation.
The next steps
Here’s the thing you’ll learn about life insurance: There is no “one size fits all.” Everyone is painting a different financial picture. No two families are alike. What works for your neighbor might not be the best option for you. One of the best places to start is with an online calculator, which will give you a rough approximation of how much insurance you might need. But when it comes to crossing the finish line, a financial planner or professional can help you sort through the options and chart a path that’s best for you.
1 Certain product designs combine term insurance and whole life insurance, and may be subject to premium increases.
2 Your policy's cash value typically becomes a useful source of funds only after several years of premium payments, which allows the cash value to build up. Each method of utilizing your policy's cash value has advantages and disadvantages and is subject to different tax consequences. Surrenders of, withdrawals from and loans against a policy will reduce the policy's cash surrender value and death benefit and may also affect any dividends paid on the policy. Policyowners should consult with their tax advisors about the potential impact of any surrenders, withdrawals or loans.
3 Loans taken against a life insurance policy can have adverse effects if not managed properly. Policy loans and automatic premium loans, including any accrued interest, must be repaid in cash or from policy values upon policy termination or the death of the insured. Repayment of loans from policy values (other than death proceeds) can potentially trigger a significant tax liability and there may be little or no cash value remaining in the policy to pay the tax. If loans equal or exceed the cash value, the policy will terminate if additional cash payments are not made. Policyowners should consult with their tax advisors about the potential impact of their policy loans.
4 Cash value growth is not taxed if held until death. Generally, cash value from the surrender of your policy is taxed only when it exceeds premiums paid.