Whole Life Insurance Explained

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.

Key Takeaways

Whole life insurance lasts for an insured’s lifetime, as opposed to term life insurance, which is for a specific amount of years.
Most whole life policies feature level premiums, meaning the amount you pay every month won’t change.
Whole life insurance has a cash savings component, known as the cash value, which the policy owner can draw on or borrow from.
The cash value of a whole life policy typically earns a fixed rate of interest.
Withdrawals and outstanding loan balances reduce death benefits.

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. 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.

Interest is charged on policy loans with rates varying per insurer, but the rates are generally lower than you’d get with a personal loan or home equity loan.

However, withdrawals and unpaid loans also reduce the cash value of the policy. Depending on the policy type and the size of its remaining cash value, a withdrawal could chip away at the death benefit or even wipe it out entirely.

Note: Whole life insurance is different from term life insurance, which only provides coverage for a certain number of years, rather than a lifetime. Term life does not have a cash savings component and only pays out a death benefit.

Whole Life Insurance Cash Value

A cash value life insurance policy is similar to a retirement savings account in that it allows investments to accumulate tax-deferred interest.

Part of each premium payment goes toward the policy’s cash value, which can be withdrawn or borrowed against later in life. The cash value of a life insurance policy grows quickly when the insured is young. But because more of the premium is needed to cover the cost of insurance as the insured ages, the cash value grows more slowly as they get older due to the higher risks associated with age.

The insured can access their policy’s cash value by borrowing against it or by withdrawing money in a partial cash surrender. Surrenders will reduce the final death benefit of your policy.

You can also use the cash value to cover your monthly premium payments instead of paying out of pocket. Or you can surrender the whole policy to receive the entire available cash value (minus any surrender fees). However, the policy will be terminated and the death benefit will no longer be available to your beneficiaries.

Some companies in the U.K. and Australia offer insurance bonds with their policies, which provide some tax advantages.

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.

Death proceeds are non-taxable to the beneficiary. 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.

As is the case with any kind of permanent policy, it’s important to thoroughly research all insurers being considered to ensure they’re among the best whole life insurance companies currently operating.

Uses of Whole Life Insurance

As with any kind of life insurance, a whole life insurance policy gives individuals and their families financial security against the loss of a breadwinner. For families that rely on the income of a single person, a whole life policy can provide financial security against the sudden loss of an income provider.

But unlike term life, whole life can also be used as an investment. Once the cash value has grown big enough, you may be able to withdraw or borrow from it to pay for large purchases such as a home. Some people also use whole life cash value to supplement their income in retirement when markets are low.

Whole life insurance is also useful for businesses as a contingency plan for the loss of a key employee or partner. If a key employee passes away, a whole life policy can provide a financial offset to the loss of their skills or expertise. If the deceased is part owner of the company, a whole life policy can provide the remaining owners with enough capital to buy out the deceased partner’s share of the business.

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.

Whole Life Insurance vs. Term Life Insurance

Whole life insurance is similar to term life insurance, in that both types of policies offer a payout upon the death of the insured. However, there are important differences. While whole life insurance offers a guaranteed death benefit for the entire lifetime of the insured, a term policy only pays out if the insured dies within a certain time frame—usually 10, 20, or 30 years.

There are other considerations as well. In order to provide greater benefits, a whole life policy requires significantly higher premiums than a term policy with the same coverage limit. Whole life premiums are typically fixed throughout the policy duration, while term rates increase at each renewal as the insured grows older.

Advantages and Disadvantages of Whole Life Insurance

Advantages

Lifetime coverage
Cash value you can use for loans, withdrawals, or premium payments
Guaranteed death benefit amount
Predictable premium payments
Tax-free loans

Disadvantages

More expensive than term life
Cash value may grow slower than with other policies
No flexibility to adjust the premium
Limited ability to adjust the death benefit

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 modified or limited premium policy).
Tax-free loans: While you will need to pay interest on loans you take out against your cash value, you won’t be taxed on any cash value you borrow.

Disadvantages Explained

More expensive than term life: The premiums for whole life insurance can be two to three times higher than for term life insurance.
Cash value may grow slower than with other policies: Whole life insurance cash values tend to accumulate slowly compared to other permanent policies or investments.
No flexibility to adjust the premium: Once you choose your policy, you typically can’t adjust the premium payments as your financial situation changes.
Limited ability to adjust the death benefit: It can be difficult to adjust your death benefit after the policy has been issued.

Example of Whole Life Insurance

Imagine a 35-year-old woman named Sarah who purchases a whole life insurance policy for $500,000 with a monthly premium of $300. The policy has a cash value component that grows over time, starting with a cash value of $5,000.

At Age 40: The cash value may have grown to $10,000, and she can borrow against it or make partial withdrawals if needed.
At Age 50: The cash value may increase to $25,000. If Sarah decides to take a loan against the policy, she can borrow up to 90% of the cash value, or $22,500.
At Age 65: Sarah passes away. The insurance company pays her beneficiaries the full death benefit of $500,000. However, if she had an outstanding loan of $10,000, that amount is deducted from the death benefit, leaving her beneficiaries with $490,000.

The Bottom Line

Whole life insurance can offer lifelong protection and an avenue for cash value accumulation, making it an option for some individuals looking for life insurance coverage. However, it’s important to understand that it is often more expensive than term life insurance. Before committing, it may be helpful to compare different types of life insurance and consult with a financial advisor to determine what best meets your needs and budget.