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What is whole life insurance?
By Martha C. White MONEY RESEARCH COLLECTIVE
A whole life insurance policy is a type of permanent life insurance that has a guaranteed death benefit to be paid out after the policyholder’s death as well as a cash value portion that functions as a savings vehicle during the policyholder’s lifetime.
There are benefits of whole life insurance — as well as potential downsides. This in-depth guide addresses those factors to help you determine if this kind of policy is the best life insurance to meet your needs.
Table of contents
- How does whole life insurance work?
- How much does whole life insurance cost?
- What type of life insurance policy is right for you
- Summary of Money’s guide to whole life insurance
How does whole life insurance work?
Whole life is a kind of permanent life insurance. The life of the policy lasts the duration of the insured’s lifetime (provided that premiums are paid in a timely manner). Unlike term life insurance policies, whole life policies have a cash value component that grows in worth over time. The amount of money beneficiaries receive after the policyholder’s death — the face value of the policy — is fixed and guaranteed.
Like the death benefit, whole life insurance premiums are fixed and contribute to three different buckets:
- Funding the policy death benefit
- Operating costs of the insurer
- Cash value account contributions
What does whole life insurance cover?
Death benefit
- The policy’s face value is the amount of money your loved ones — or other beneficiaries — will receive in a tax-free lump sum after your death.
- This payout can be used without restrictions. Death benefit funds can be used to defray final expenses, or for estate planning, debt settlement or income replacement.
- While the death benefit is fixed, if there are outstanding loans against the cash value portion of the policy at the time the insured dies, that debt is deducted from the amount the beneficiaries receive.
- Coverage for centenarians is one exception when it comes to how long a policy lasts. Many insurers have what they call a maturity date, which would be when the insured person turns 100 or 120 years old. If the policyholder is still alive, insurers have a few different approaches: some pay the death benefit and close the policy, some offer policy extensions and others make no changes to the policy.
- Minimum coverage for whole life insurance policies is generally $100,000, and many have payouts of $1 million or more.
Cash value
- This is considered a living benefit since it functions as an investment vehicle and savings account that the policyholder can use during his or her life.
- Investment returns are considered “guaranteed” in that insurers set a bottom threshold for the interest rate.
- This portion of the policy is partially funded by premium payments and earns interest, tax-free, that adds to the cash value.
Riders
Riders, also called endorsements, are add-ons to insurance policies that increase coverage or modify the standard policy terms. One rider available for whole life policies, for instance, is a maturity extension rider that will extend a policy’s maturity date further into the future. Another common insurance rider is an accelerated death benefit rider, which lets the policyholder tap some of the death benefit if they are still alive but seriously ill.
You may also have the option to purchase a “waiver of premium rider.” Only offered by some insurance companies and on some policies, this add-on effectively preserves your death benefit by waiving your required premium payments if you become disabled, seriously ill or are critically injured.
Eligibility
Whole life insurance eligibility depends on a number of factors, including age, gender, employment history and occupation, medical history and lifestyle (smokers and extreme-sports athletes, for instance, might have a harder time getting coverage or pay higher premiums for a policy).
Most insurers require you to undergo a medical examination before they will underwrite a whole life policy. There are some insurers, though, that offer a no-exam life insurance alternative. You can expect to pay more for this option, though, and not every company offers it.
Cash value of a whole life insurance policy
The cash value of the policy gives you a chance to earn tax-deferred returns, essentially functioning as a low-risk investment or “forced” savings account. This accrued value can supplement your other earned or investment income in retirement, or can provide funding for college tuition or other pressing financial obligations. (Although similar in some ways, this is not the same as an annuity.)
A cash value account:
- Gains value slowly but does so at a guaranteed rate of return, shielding you from market volatility
- Earns tax-deferred interest, so long as the account is kept in good standing
- Increases in value more quickly in the initial years before slowing later in life. This is because a greater portion of your premiums fund your insurance in your later years
- Remains with the underwriting life insurance company even after the policyholder’s death, unless the policy has a rider that allows for transferability
Policyholders can tap into the earnings of their cash value account in four ways:
- Taking a loan – The earnings accrued in your cash value account serve as collateral for this loan, which you can take tax-free. The funds in a policy loan are provided by your insurer, and you pay it back to them along with interest at a modest rate.
- Taking a withdrawal – Although you can take a direct withdrawal from your cash value account, there are a few caveats: Withdrawals are not reversible and will lower the payout your beneficiaries will receive when you die. In addition, if the withdrawal amount exceeds the value of the premiums you have paid, the withdrawn funds are taxable. Withdrawing the entire cash value amount is equivalent to letting the policy lapse.
- Surrendering the policy – A “surrender” is essentially a cancellation of your policy. This eliminates the death benefit, and in return you receive the money that is left after associated charges and fees, which is known as the cash surrender value. If that amount is larger than your cumulative premium payments, you will have to pay tax on the excess.
- Using it to pay premiums – Instead of paying premiums out of pocket, policyholders with significant accrued value can use those funds to make monthly premium payments. This option is typically used most often for retirees on fixed incomes struggling to afford their premiums. If the cash value portion is exhausted and you don’t resume making payments out of pocket, you run the risk of your policy lapsing.
Dividend-paying whole life insurance policy
You can earn dividends as well as the guaranteed cash value and death benefit payout with what’s known as a “participating whole life insurance policy.”
Policyholders collect dividends if the insurance company generates surplus profits. The dividends serve as a partial refund of your paid premiums. Policyholders can access this value in the following ways:
- As a payout via cash or check
- As cash value account contributions
- As an advance on premium payments
- As payment if you want to buy additional coverage
If you are considering taking a loan from your cash value account, you should be aware of the following:
- If you mismanage your loan funds, you run the risk of your policy lapsing, your tax-deferred status being canceled and the death benefit amount being reduced or eliminated.
- You have to pay tax on any withdrawals or loans that are greater than the cash value amount your policy has accrued.
- When you die, outstanding loans and withdrawals will be taken out of the death benefit, reducing the payout your beneficiaries will receive.
- Both withdrawals and loans are associated with a higher risk of the policy lapsing.
- Expect to wait at least a decade before your cash value account accrues enough money to borrow — a function of the low returns these policies provide.
How much does whole life insurance cost?
Whole life insurance can cost tenfold what term life insurance does. Its added benefits and flexibility make it considerably more expensive than other kinds of life insurance policies.
As a rule, monthly premium payments tend to fall between $40 and $300, but the exact cost of whole life insurance is influenced by the following factors:
- Your personal profile and medical history
- The underwriting guidelines your insurer follows
- The type of whole life insurance policy
- The amount of coverage you choose to carry
- The addition of any riders to your standard coverage
Whole life policy premiums take into account:
- Age and gender – Younger policyholders pay lower premiums, women typically pay less than men.
- Medical history – You can expect to undergo a medical exam as well as provide information about your family medical history. If you have any pre-existing conditions, or if your parents suffered from any chronic conditions, expect your premiums to be higher.
- Tobacco use – Smokers as well as users of chewing tobacco pay premiums as much as 20% higher than nonsmokers with otherwise similar profiles.
- Hobbies – Risky pastimes such as skydiving can raise your premiums.
- Occupation – People in high-risk professions such as law enforcement, firefighting, construction and aviation can expect higher premiums.
How much life insurance coverage do I need?
While some sources, especially online, will tell you the general rule is to purchase 10 to 15 times your income, the amount of life insurance coverage you purchase should depend on the policy’s intended purpose. If you’re buying insurance as income replacement for your loved ones, the Insurance Information Institute recommends you buy enough coverage to replace your salary and any services you provide for your family — such as tax filing or childcare.
It’s also advisable to factor in other sources of income your loved ones may have access to as well as any “hidden income” you might be bringing in (such as health insurance you may have through your workplace, for example). Other important considerations include the number of dependents you have, the number of years they will require your financial support and your estimated final expenses or burial costs. Those who do not have dependents and have enough to cover their final expenses may not need insurance at all.
What type of life insurance policy is right for you?
There are two primary categories of life insurance products: term policies and permanent policies. Determining which is the best life insurance for you depends on how much you want to spend and what you want your policy to do. This might sound simple, but making the best choice entails significant research and the use of a life insurance calculator, which is why some experts recommend hiring a financial advisor to help you walk through your insurance options and choose the right one for you.
Term life insurance is the more straightforward of the two, with just three policy types. This makes it a good option for younger families, people on a tight budget and those who only need life insurance for a finite period of time.
Whole life insurance falls under the umbrella of permanent life insurance. The features that characterize this category are coverage that lasts the duration of the policyholder’s life and the ability to earn and grow a cash value component. There are several kinds of permanent life insurance, including:
- Universal life policies
- Variable life policies
- Variable-universal life insurance policies
- Survivorship life policies
- Single premium life policies
Whole life vs. term life insurance
Here are key features and characteristics of whole life insurance products as they compare to term life:
Pros of whole life vs. term
- Coverage is for your entire life — no expiration date
- Premiums are fixed
- Includes an investment component
- Ability to earn dividends in some instances
- Ability to take a loan against or withdraw cash value
- No use restrictions on loans or withdrawals
Cons of whole life vs. term
- Premiums can be as much as 10 times higher
- Modest investment rate of return
- Initial commission fees can be high
- Accruing sufficient cash value for a loan takes at least 10 years
- Cashed-out value is subtracted from death benefit amount
- Withdrawals may be subject to income tax
To read more about the differences between these policies, check out our guide to Term vs. Whole Life Insurance.
People who benefit from whole life insurance
A whole life policy is the best choice for people seeking long term coverage who have the means to pay the relatively higher premiums, such as:
- Parents – Whole life can provide financial protection for your children by funding education, establishing trusts, providing for special needs and more.
- Couples – Coverage can pay for your spouse or partner’s everyday living expenses as well as unforeseen financial future needs.
- Older adults – Retirees and seniors on fixed incomes can supplement their own retirement savings or Social Security income as well as cover funeral and burial costs that otherwise would be paid by your heirs.
- Business owners – Whole life can help you keep a business running even if you die unexpectedly, cover any accrued expenses, buy out a partner or make good on debts (especially those for which a critical asset like the family home was pledged as collateral).
- People with estate-planning needs – In addition to burial and funerary costs, the policy payout can help defray estate taxes and fund the cost of hiring a lawyer, financial advisor or other money-management professional.
- Business executives – Insurance taken out against key employees can help a firm buffer financial volatility, losses or a sudden insurance need in the event of that essential employee’s unexpected or accidental death.
People who don’t benefit from whole life insurance
Purchasing a whole life insurance product isn’t necessary, or even a good idea, for everyone. People who might want to think twice before buying a policy include:
- Workers with average income – Whole life insurance is expensive, and it’s not worth putting the rest of your budget at risk if you struggle to cover the premiums.
- Older adults lacking adequate retirement savings – Seniors and retirees should consider our best life insurance for seniors guide rather than assume a whole life policy is the best choice. The slow rate of returns combined with high premiums might not make a whole life policy worth the cost.
- Investors – While whole life insurance does have an investing component, you’d be better off focusing on funding your 401(k) or other retirement accounts first. While the cash value component of a whole life policy does grow, returns are modest.
What are the best whole life insurance companies?
The best company selling whole life insurance might be the one that offers you the lowest premium for the type and amount of coverage you want. Shop around and get quotes from several different insurers to see which one offers you the best overall deal. Besides looking for competitive premiums, we also recommend you look for insurers that are on strong financial footing as evidenced by the company’s AM Best Financial Strength Rating.
You may also look at the National Association of Insurance Commissioner’s complaint database to see how many complaints have been filed against the company’s life insurance products and how that compares to the national median. Lastly, check whether the insurance company you’re considering has high customer satisfaction ratings. To determine this, you may want to look up the latest J.D. Power Individual Life Insurance Study.
Summary of Money’s guide to whole life insurance
Whole life insurance provides permanent coverage for fixed premiums. Unlike term life insurance, whole life insurance policies do not expire and have a cash value component from which you can borrow. They also have dividend-earning potential and there are no usage restrictions on the funds you withdraw or borrow from the policy’s cash value account.
Because of their flexibility, whole life policies have higher premiums than term life policies. The investment portion of the policy may also have a modest rate of return when compared to other types of investments. Accruing enough cash value to borrow from, for example, may take at least 10 years.
Another consideration to keep in mind is that a portion of the premium payment will go toward the insurer’s operating costs, and initial commission fees can be high. Additionally, the cash value you withdraw from the policy is deducted from the payout amount, so if there is an outstanding loan on the cash value when you die, that balance will be deducted from the death benefit. Cash value withdrawals may also be taxed.
As you can see, permanent life insurance policies have both pros and cons. Regardless of whether or not this type of policy sounds like a right fit for you, having some form of life insurance can provide peace of mind and serve as a financial safety net for your beneficiaries. Read our guide on the best life insurance companies to start your search.
