Unlike term life insurance, whole life insurance provides guaranteed coverage for your entire life. But that doesn't mean it's the better option.
One of the questions people often have with term life insurance is what to do once the term expires and they’re left without coverage.
One of the ways the life insurance industry has dealt with this question is by offering different types of life insurance that don't expire.
The most common example of a permanent life insurance policy is whole life insurance. Here, we break-down everything you need to know about whole life insurance, including:
- What is whole life insurance?
- How does whole life insurance work?
- Whole life insurance cash value
- Types of whole life insurance
- Whole life insurance pros and cons
- Is whole life insurance a good investment?
- Whole life insurance vs. universal life insurance
- How much does whole life insurance cost?
- Is whole life insurance worth it?
Read on to learn more.
What is whole life insurance?
Whole life insurance definition: A life insurance policy that guarantees payment of a death benefit in exchange for level premium payments. Another way to define whole life insurance is that it’s a life insurance policy guaranteed to remain in force for the insured’s lifetime or to a maturity date, as long as required premiums are paid.
It is designed to provide coverage for the life of the insured. As long as the policy owner pays the required premium, the insured will always have life insurance coverage. Unlike term, there is no expiration on whole life insurance.
A whole life policy’s premium and death benefit typically remain the same for the life of the insurance contract.
As with term life insurance, the death benefit of whole life insurance can be claimed tax-free by the policy’s beneficiaries in most circumstances.
How does whole life insurance work?
When you buy whole life insurance, the insurer establishes a premium amount for the life of the policy. The premium amount typically does not change for the life of the policy. If you pay $200 a month today, you’ll owe $200 a month 10 or 20 years from now.
The premium amount is based on a number of factors. Ultimately it is formulated in a way that the insurance company can cover the death benefit and its expenses for providing life insurance coverage while still turning a profit.
The amount is designed so that you pay more of the cost of insurance upfront. This enables the company to recoup as much of its expenses before you pass away or surrender the policy.
Whole life insurance cash value
Each whole life premium payment goes toward paying the insurance company’s fees and charges for providing the insurance.
When you first buy a whole life insurance policy, it actually costs the insurance company less to provide your coverage. That’s because you are less likely to die in the early years of the policy than you are later. Plus, like all goods and services, the expenses incurred by a life insurance company increase over time with inflation.
Because the insurance company doesn’t require all of your premium dollars at the beginning of the contract, it sets aside a portion of it for later. This money becomes the policy’s cash value, which earns a set rate of interest each year. It’s the cash value that the insurance company will use to pay the higher expenses and costs later in the policy.
For example, if $150 of your $200 monthly premium payment goes toward fees and cost of insurance charges, the remaining $50 is added to the policy’s cash value.
The policy’s owner can access the cash value. This is often done by withdrawing part of the cash value as you would withdrawing money from your bank savings account.
Another way to collect the cash value is by cashing out the whole life insurance policy. This means you surrender the policy and collect the total accumulated cash value. When you surrender a whole life insurance policy, you no longer pay premium on the policy and it no longer provides a death benefit when you pass away.
Types of whole life insurance
Here are some of the variations in whole life insurance policies:
Level premium whole life insurance
This is the traditional type of whole life insurance in which the premium amount remains the same throughout the life of the policy.
Participating and nonparticipating whole life policies
A participating policy is a dividend-paying whole life insurance policy. The insurance company pays an annual dividend to whole life policy owners based on their profit for the year. The policy owner can use the dividends toward premium payments, add them to their policy’s cash value or receive them in cash.
A non-participating policy does not pay dividends. That makes this type of whole life insurance less expensive than a participating policy.
Indeterminate premium whole life insurance
This is a nonparticipating whole life insurance policy with adjustable premiums. The insurance premium is set annually to reflect the insurer’s mortality experience, investment earnings, and expenses. The premium amount can not exceed a guaranteed maximum rate. Premiums generally start out lower than other whole life insurance types.
Limited payment whole life insurance
This type of whole life insurance can be either participating or nonparticipating. Premiums are paid over a shorter period but still retain lifetime protection. These policies have higher premium amounts and accrue cash value faster than ordinary life policies since they are paid over a shorter period.
Single premium whole life insurance
This is a limited payment whole life policy allowing insureds to purchase guaranteed lifetime protection for a single upfront lump sum payment and thus have an immediate cash value.
Final expense whole life insurance
This is a type of whole life insurance designed to cover funeral expenses and other common costs when you pass. Final expense insurance is a whole life policy because the policy does not expire as long as premiums are paid. The premium amount is fixed for the life of the policy.
Because the policy is designed to just cover final expenses, the death benefit will be small compared with traditional whole life insurance. That makes final expense insurance more affordable. In addition final expense whole life insurance is typically simplified issue, which means there is no medical exam required.
[ Related read: Do You Really Need Final Expense Life Insurance? ]
Guaranteed issue/acceptance whole life insurance
This is a type of whole life insurance in which you are automatically approved for coverage once you apply. There is no underwriting involved and nobody is turned down for coverage regardless of health.
To reduce the risk, many insurers use a graded death benefit when issuing guaranteed issue life insurance policies. This means the amount of the death benefit will change over time. In the first years of the policy, a guaranteed issue whole life contract may not pay the full death benefit. Instead, the policy might pay out 110 percent to 120 percent of premiums paid.
Guaranteed issue/acceptance policies are also more expensive than standard whole life while offering smaller death benefit amounts.
A graded death benefit changes the way an insurer pays the death benefit. If a natural death occurs during the first 2 to 3 years of a policy, the insurer will pay 110 percent to 120 percent of the premiums paid. In other words, they won’t pay the face amount of the policy but will reimburse the paid premiums, plus 10 to 20 percent. After the waiting period, the insurer will pay the full face amount of the policy if a natural death occurs.
[ Related read: What Are the Different Types of Life Insurance? ]
Whole life insurance pros and cons
People who are considering life insurance should weigh the pros and cons of whole life.
Advantages of whole life insurance
The main benefit of whole life insurance is the ability to maintain life insurance coverage at a level cost for your entire life. Even if you incur health problems down the road, you will be able to count on the ability to leave a death benefit to your surviving beneficiaries.
Another potential benefit of whole life insurance is the tax treatment. The cash value inside the policy grows tax-deferred, unlike many interest-bearing accounts. You can also withdrawal some of the cash value on a tax-free basis or take out a policy loan. Plus, the policy’s beneficiaries do have to report the death benefit as taxable income.
Disadvantages of whole life insurance
The main disadvantage of whole life insurance is that it is considerably more expensive than a similar term policy.
Why is whole life insurance more expensive than term? Because it provides a guaranteed death benefit. In order to provide that guarantee, the price of coverage is substantially higher than term life insurance, which has no such guarantee. The expense charges in a product with guarantees are a lot higher, and typically that makes them very expensive products.
Because of its cost, many people surrender their whole life policies after a time and get little to nothing in return, similar to paying a mortgage and having it foreclosed on.
Another disadvantage of whole life insurance is that you may not need life insurance coverage for your entire life, yet you’ll be paying the higher premium anyway. As you reach or approach retirement, you may owe little to nothing on your mortgage and have grown children that no longer depend on your income. That’s why many people opt for a term policy that will last until retirement age or shortly after.
Is whole life insurance a good investment?
Many insurance companies and agents promote whole life insurance and other cash-value policies as investment vehicles. Proponents of this strategy may try to convince you to use whole life insurance as a tax-advantaged way of saving money for retirement or other purposes. Let's examine the many disadvantages to this approach.
Cash-value life insurance has more fees and charges than other types of investments, including:
- Sales charges that include the selling agent’s commissions.
- Administration fees for maintaining the policy, including accounting and record keeping.
- Mortality and expense risk charges. When a policy is issued, the insurance company assumes the insured person will live to a certain age. This charge compensates the insurance company in the case the insured person doesn’t live to the assumed age.
- Cost of insurance. This is the cost of actually having insurance protection. It is based on the insured person’s age, gender, health, and death benefit amount.
Many financial experts believe you should stick with a term policy. Then you can invest the difference between the cost of a term and a permanent policy. Doing so, they say, would generate a greater rate of return than relying on permanent life insurance as an investment. Plus you would save on the cost of your life insurance.
Permanent life insurance does not accumulate cash value for several years. From an investment standpoint, this can make the overall rate of return much lower than a traditional account.
For example, if you make an initial premium payment of $10,000 for a cash value insurance policy, you won’t have $10,000 in cash value. That’s because most of the money you contribute early on is used to pay for the cost of the life insurance coverage. In fact, depending on how much you contribute, your cash value may be negative in the initial policy years.
On the other hand, an initial $10,000 investment in stocks, bonds, or mutual funds is worth that amount until the investment either grows or decreases in value.
Traditional savings accounts also offer more flexibility than life insurance. A 401(k) or IRA enables you to start and stop contributions anytime. Whatever you have contributed continues to earn interest.
You don’t have that option for life insurance. To keep the policy going, you must continue paying the necessary premium. Otherwise, it can lapse and you’ll lose the insurance coverage.
Also, it’s possible to lapse an insurance policy by withdrawing too much of the cash value. If this occurs, it could result in you owing taxes on the overdrawn amount.
Also, keep in mind that the money you remove from the policy will reduce your death benefit.
And whereas 401(k)s and IRAs allow you to deduct your contributions from your tax obligations, life insurance contributions have no such tax treatment.
Ultimately, you should use life insurance for its intended purpose: to provide for your family and loved ones in the event you pass away unexpectedly. For this purpose, term life insurance is appropriate.
Whole life insurance vs universal life insurance
Similar to whole life insurance, universal life (UL) is a type of permanent coverage that can cover an individual for his or her entire life.
Universal life is much more complicated and typically more expensive than whole life.
In a universal life policy, your premium payments support the amount of coverage you elect to own, also known as the face amount. Each premium payment is placed in the policy’s account value. From that account, the insurance company deducts fees and charges for providing the insurance. Whatever is left over is considered the policy’s cash value, which earns interest.
The amount of premium you pay and the death benefit you receive can vary from month to month and year to year. This is largely dictated by how much interest is credited to the policy.
If your policy earns excess interest, you accumulate more cash value. Over time, this can result in a higher death benefit. It can also reduce the amount of premium needed to keep the coverage active.
But if your policy does not earn enough interest to cover policy charges, you could lose your life insurance coverage. It’s not uncommon for policyholders to have to dramatically increase their premium payments to make up for the lack of interest their policies earned in their early years.
What makes universal life even more complex is that there are multiple ways a policy can earn interest:
- Fixed UL credits interest based on a fixed interest rate determined by the insurance company.
- Variable UL policies allow the policyholder to invest in mutual fund-like subaccounts. The interest you earn will vary based on the performance of those investments.
- Indexed UL is considered a hybrid of fixed and variable UL. It credits interest based on the upward movement of a market index, such as the S&P 500. But the policy’s cash value won’t decline if the index loses value. It just remains the same if there is a market loss. In exchange for offering downside protection, the insurer applies a cap to interest growth.
The upside of universal life is its flexibility. You can vary your premium payment from month to month. Plus, your death benefit can actually increase over time, depending on how much premium you pay and the interest the policy earns. There is also a cash value component you can access via withdraws and policy loans.
The downside is that UL is the most expensive type of life insurance. It is also the most complex to understand. There is also the risk of losing coverage or having to increase your premium if the policy doesn’t credit enough interest to pay fees and charges.
How much does whole life insurance cost?
Whole life insurance cost anywhere from 5 to 15 times more than a comparable term life insurance policy. That’s because whole life is guaranteed to pay out a death benefit as long as the owner pays the premium, as opposed to term life insurance that expires after a specified period. Plus, whole life insurance features a cash value component; term life insurance does not.
As with term life insurance, there are many variables that affect the cost of whole life insurance, including:
- Your age. The older you are, the more you will pay. For example, one source showed that the average whole life insurance rate per month for $100,000 death benefit is $41 for people in their 20s. It increases slightly to $48 for those in their 30s. People in their 40s pay an average of $65 while those in their 50s pay $95.
- Gender. Because men have lower life expectancies than women, they will typically pay more for coverage.
- How much coverage you elect. The higher your face amount, the more your premium will be. For example, one source showed the average monthly premium for a 35-year-old male is about $100 for $250,000 in coverage. It nearly doubles to $197 a month for $500,000 in coverage.
- How long you want to pay premium. Whole life insurance policies may give you the option of choosing how long you want to pay premium. While policy owners traditionally pay premiums for the life of the policy, you may also have the option of paying over 10 years, 20 years, or paying through age 65. If you choose one of the latter three options, you still get lifetime coverage; you’re simply accelerating the payment amount and building cash value faster. A 30-year-old who chooses to make lifetime payments on a $100,000 policy would pay $48 a month. The 10-year option would cost $239 a month, the 20-year option would cost $145 and the age 65 option would cost $122.
- Additional features you add. Some whole life insurance policies typically offer optional riders that provide additional coverage. These riders often require additional premium above the cost of the base policy.
- Underwriting factors. The less risk you pose to the insurance company, the less you will pay in premium.
[ Related read: How Much Does Life Insurance Cost? ]
Is whole life insurance worth it?
For many people, it doesn’t make sense to pay such a larger amount for life insurance just to have a guaranteed lifetime benefit. Not to mention, many life insurance buyers can’t fit the appropriate amount of coverage of whole life insurance in their budget. That means sticking with whole life coverage would cause you to be underinsured, which can be detrimental to your family if something happens to you.
A 30-year term life insurance policy will be considerably cheaper than a whole life insurance policy. That gives you coverage for a good portion of your working years.
If you can afford whole life insurance at a young age, it may be worth considering because you can still buy it at a decent cost. You can ensure you have coverage for a lifetime and not have to worry about future health concerns affecting your ability to get coverage later after a term policy expires.
[ Related read: How Much Life Insurance Do I Need? ]
Jack Wolstenholm is the head of content at Breeze.
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