What Is Whole Life Insurance?
Whole life insurance provides coverage throughout the life of the insured person. In addition to paying a tax-free death benefit, whole life insurance also contains a savings component in which cash value may accumulate. Interest accrues on a tax-deferred basis.
Whole life insurance policies are one of several types of permanent life insurance, meaning they cover you for your entire life. Universal life, indexed universal life, and variable universal life are others. You can choose a whole life insurance policy that works for you from one of these best life insurance companies.
How Whole Life Insurance Works
Whole life insurance guarantees payment of a death benefit to beneficiaries in exchange for level, regularly-due premium payments. The policy includes a savings portion, called the “cash value,” alongside the death benefit. In the savings component, interest may accumulate on a tax-deferred basis.1 Growing cash value is an essential component of whole life insurance.
To build cash value, a policyholder can often remit payments greater than the scheduled premium to purchase extra coverage (known as paid-up additions or PUA). Policy dividends can also be reinvested into the cash value and earn interest. Over time, the dividends and interest earned on the policy’s cash value will provide a positive return to investors, growing larger than the total amount of premiums paid into the policy.
The cash value offers a living benefit to the policyholder, meaning the policyholder can access it while the insured is still alive. To access cash reserves, the policyholder requests a withdrawal of funds or a loan. Withdrawals are tax-free up to the value of the total premiums paid.
Whole Life Death Benefit
The dollar amount of the death benefit is typically specified in the policy contract. But it can be changed in some instances.
Some policies are eligible for dividend payments, and the policyholder may elect to use the dividends to buy paid-up additions to the policy, which will increase the amount paid at the time of death.
The death benefit can also be affected by certain policy provisions or events. As mentioned before, unpaid policy loans (including accrued interest) reduce the death benefit dollar for dollar.
Alternatively, many insurers offer voluntary riders—for a fee—that secure or guarantee coverage, including the stated death benefit. Two of the most common such riders are the accidental death benefit and waiver of premium riders, which protect the death benefit if the insured becomes disabled or critically or terminally ill and is unable to remit premiums due.
Beneficiaries may also have decisions to make about how the death benefit is paid. The default option is to receive a lump-sum payment. But some policies also allow beneficiaries to choose to get the death benefit in installments, or to convert it to an annuity. An annuity may pay out for a set amount of time until the death benefit is exhausted, or it could pay out for the life of the beneficiary. The death benefit continues to earn interest until it is paid, and that interest may be taxable.
Types of Whole Life Insurance
There are several main types of whole life insurance, categorized based on how premiums are paid.
- Level Payment: Premiums remain unchanged throughout the duration of the policy. This is the most common type of payment plan.
- Single Premium: The insured pays a one-time large premium, which funds the policy for life. But this type of policy is almost always a modified endowment contract, which has tax consequences.
- Limited Payment: As the name suggests, you pay a limited number of payments. Premiums will be higher than they would be in a level-payment situation, but you’ll only pay them for a certain number of years.
- Modified Whole Life Insurance: The opposite of a limited payment policy, this type of whole life insurance offers lower premiums than a standard policy in the first two or three years, and higher-than-standard premiums in the later years. It is more expensive in the long run.
Whole life insurance policies are further distinguished as participating and non-participating plans. With a non-participating policy, any excess of premiums over payouts becomes profit for the insurer. However, the insurer also assumes the risk of losing money.
With a participating policy, any excess of premiums is redistributed to the insured as a dividend. This dividend can then be used to make payments or increase one’s policy coverage limits. However, dividends are not guaranteed and often vary each year, as they are primarily based on the company’s financial performance.
Advantages Explained
- Lifetime coverage: As with all permanent insurance, whole life insurance provides coverage until the insured’s death.
- Cash value you can use for loans, withdrawals, or premium payments: Part of each premium payment accumulates as cash value, which you can withdraw or borrow against during your lifetime.
- Guaranteed death benefit amount: Your death benefit is established when you sign up for your policy and stays the same while the policy remains active.
- Predictable premium payments: Your premium is also fixed at issue and will not typically vary over your lifetime (unless you choose a non-level premium option).
- Tax-free loans: While withdrawals of more than you’ve contributed to the cash value are taxed, policy loans are not.
Disadvantages Explained
- More expensive than term life: Premiums of a whole life policy are usually significantly higher than term premiums because the policy accumulates cash value and covers you for your whole life.
- Cash value may grow slower than with other policies: The growth rate of your whole life policy’s cash value is fixed when you buy it, while returns on other types of permanent coverage (such as universal life) vary based on such factors as investment returns and interest rate fluctuations, so they could be higher.
- No flexibility to adjust the premium: Unlike universal life policies, whole life plans do not allow you to change your premiums.
- Limited ability to adjust the death benefit: Your death benefit is also established when the policy is issued. While you cannot directly increase the original death benefit, you can use dividends to purchase additional coverage.