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 includes 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. Universal life, indexed universal life, and variable universal life are others.
Coverage Amount
The more coverage you want, the higher your premiums will be.
A common guideline is to purchase coverage equal to 10-15 times your annual salary.
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.
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 Part of each premium payment goes toward the policy's cash value, which can be withdrawn or borrowed against later in life.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, the cash value 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.
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.
The Bottom Line
Whole life insurance generally has a level premium and death benefit, and provides a guaranteed benefit upon the death of the insured, regardless of when they die. Part of the premiums you pay for a whole life policy go to a savings component known as the cash value. Those funds are invested with a guaranteed return, and after they’ve grown big enough, you can borrow from or withdraw from the cash value, tax-free.
This and the fact that whole life covers you until death (as long as you pay your premiums) offer clear advantages over term life insurance.