What is whole life insurance and how does it work?

What is the benefit of having whole life insurance?

What is whole life insurance and how does it work?


By Mark Rosanes

The primary purpose of life insurance is to help grieving families soften the financial impact of losing a loved one. With the right policy, this form of coverage can help families pay off loans and debts, as well as provide them with the financial means to meet daily living expenses.

Whole life insurance is among the most popular types of life coverage. Apart from providing the beneficiaries with a death benefit, this form of permanent life insurance comes with a savings component that the policyholders can tap into.

In this article, Insurance Business delves deeper into this form of coverage. We will discuss how this type of policy works, its benefits and drawbacks, and how it compares to other kinds of life insurance plans. This is part of our client education series. We encourage our normal readers of insurance professionals to pass this along to clients.

What is whole life insurance?

Whole life insurance combines lifetime coverage with a cash value component that the life insured can access while they are still alive. Almost all types of permanent life policies operate this way. What separates whole life insurance from other types of life insurance is that it provides a guaranteed minimum rate of return on the cash value.  

According to the Insurance Information Institute (Triple-I), whole life insurance is the most popular form of permanent life coverage. Life insurance is also one of the most popular types of insurance that people take out.

How does whole life insurance work?

Whole life insurance offers coverage for the entire lifetime of the insured – as long as regular premium payments are met – and pays out a guaranteed amount at the time of their death. There are two main types of whole life plans:

  1. Non-participating whole life insurance: Provides a tax-free death benefit with lifetime coverage and accumulates a guaranteed cash value that policyholders can borrow against.
  2. Participating whole life insurance: In addition to the guaranteed death benefit, this can generate dividends, depending on how the insurer performs, which are typically issued to the policyholder annually.

Most whole life insurance policies operate with level premiums, meaning the rates remain the same for the duration of the policy. Some plans follow a limited payment structure where the insured pays higher premiums in the first few years of the policy before the rates go lower in the latter years. Others adopt a modified premium model, which works the opposite, imposing lower premiums early in the policy before rates increase.

A portion of these premiums goes to the policy’s savings component, allowing it to accumulate cash value on a tax-deferred basis over time. The insured can access this amount in three ways:

  • Applying for a loan: A tax-free option, policyholders can pay the amount back, with a corresponding interest.
  • Withdrawal from the policy: If the amount withdrawn is less than the portion of the cash value attributable to the premiums paid, no taxes apply. If the amount is greater, taxes are imposed because the difference is considered investment gains.
  • Surrendering the policy: By doing so, the insured will receive the cash value minus the surrender charge. They will also need to pay income taxes on any investment gains that were part of the cash value.

One thing to note is that by surrendering the policy, it effectively terminates the plan, so this should only be done if the policyholder no longer needs coverage or if they have a new life insurance plan in place.

What are the benefits of whole life insurance?

One of the main advantages of taking out a whole life insurance plan is that it can be used as a financial tool to accumulate wealth. Here are some of the benefits of this type of permanent life policy:

  • Lifetime coverage: Policies cover the insured for life, unlike term life insurance, which ends coverage after a set number of years.
  • Tax-deferred growth: Whole life insurance allows the policyholder to invest on a tax-deferred basis, meaning they are exempt from paying taxes on any interest, dividends, or capital gains on the plan’s cash value, unless they withdraw the proceeds.
  • Access to cash value: Policyholders can borrow against the cash value of a whole life insurance policy if the need arises without incurring penalties, unlike in tax-advantaged retirement plans such as 401(k).
  • Accelerated benefits: Insureds may be able to receive between 25% and 100% of their policy’s death benefit even if they are still alive if they develop a critical illness – including invasive cancer, heart attack, renal failure, or stroke – and use the money to pay for medical bills.

What are the disadvantages of whole life insurance?

The main drawback of whole life insurance is the price. Premiums are typically more expensive compared to those of other types of life insurance policies. Compared to those for term life plans, for instance, the rates for whole life policies can be up to 15 times more expensive for the same death benefit.

Another disadvantage is that policyholders cannot easily end the policy. If they realize that they no longer need the coverage or cannot afford the monthly payments, insurers may impose a surrender charge should they decide to walk away from the plan. The amount is usually 10% of the cash value, depending on how far along they are with the policy, but decreases as the years go by.

In addition, if the insured decides to tap into the policy’s cash value and fails to pay back the loan, this can reduce the death benefit amount.

Here’s a summary of the pros and cons of a whole life insurance policy.

pros & cons of whole life insurance

How does cash value work in a whole life insurance policy?

A whole life plan’s cash value operates the same way as a retirement savings account. Both allow the value to build up on a tax-deferred basis.

As the portion of the premiums that go towards the policy’s cash value grows, the insureds can borrow against or withdraw from the accumulated amount. Typically, the cash value builds up faster the younger the policyholder is and slows down as they grow older due to the increased risks associated with age.

Policyholders can tap into the cash value and use it for whatever they deem necessary, including as monthly premium payments to their whole life insurance plans. One thing to note is that any outstanding loans and withdrawals can reduce the amount their beneficiaries are set to receive.

However, most whole life insurance plans only pay out the death benefit, regardless of how much cash value the policy has accumulated over the years. Often used as a way for insurers to minimize risk, this amount reverts to them at the time of the insured’s death – unless the policyholder purchases a special type of rider that gives the beneficiaries ownership of the accumulated cash value. More on this later.

What is the difference between term life insurance and whole life insurance?

Despite being in the same insurance category, term life and whole life policies have several key differences. Here are some of them:

Coverage period

Unlike whole life policies, which provide lifetime coverage, term life insurance covers the policyholder for a set term, usually 10, 15, 20, and 30 years – the longest plan that one can take out. It pays out the benefit if the insured dies within the specified period, meaning they can only access the payment in the years that the policy is active.

Premium prices

Premiums for term life plans also tend to be lower as it is more likely that the policyholder will outlive the policy. Term life insurance, however, can be renewed or converted into a permanent life plan.

Cash value

Term life policies do not accumulate cash value, unlike whole life insurance. This means the insured cannot borrow against their policies or get any cash value back if they cancel.

The table below summarizes the key differences between whole life and term life coverage.

Key difference between whole life & term life insurance

What is the difference between whole life insurance and universal life insurance?

Permanent life insurance plans come in two main types – whole life insurance and universal life insurance. While both types of policies have key similarities – like providing lifetime coverage and combining the death benefit with a savings component – there are also major differences. These include:

Flexible premiums

Unlike whole life plans where premiums stay the same for the duration of the policy, universal life insurance uses a flexible premium structure, which the policyholder can adjust depending on their coverage needs. This, however, is subject to certain limits. That is why this type of coverage is also called adjustable life insurance.

Cash value guarantee

While the cash value in whole life plans provide guaranteed returns, the returns for universal life insurance are based on how the market performs. The main drawback of this is that it can result in the plan becoming underfunded. This, in turn, can cause premiums to rise significantly and if not paid, can lead to the termination of the policy.

The table below sums up the key differences between whole life and universal life insurance.

key differences between whole life & universal life insurance

How much does whole life insurance cost?

Compared to those for a term life policy, whole life insurance premiums can be significantly more expensive. An analysis done by the comparison website Finder of annual insurance rates reveals a difference of thousands of dollars between a term life and a whole life plan.

Just like other types of life insurance, premiums for whole life policies are impacted by a range of factors, including:

  • Age
  • Gender
  • Height and weight
  • Past and current health conditions
  • Family’s medical history
  • Eating habits
  • Smoking status, including marijuana
  • Substance abuse
  • Credit rating
  • Criminal history
  • Driving record
  • Hobbies and activities

Additionally, the cost of a whole life insurance policy can be influenced by the following:

  • Payment period: Policyholders may opt to pay the entire policy in a certain period, 10 or 20 years for instance, pushing up premiums significantly.
  • Guaranteed return rate: Some insurers offer a higher guaranteed return, which can also increase rates.
  • Dividend crediting: Receiving your dividend payments as a credit toward premiums can lower the amount policyholders have to pay annually.

What types of riders can whole life insurance policyholders access?

Life insurance companies offer a range of add-ons that policyholders can purchase to access extra coverage and help them make the most out of their insurance policies. These riders come with corresponding costs. Here are some add-ons available for whole life insurance policyholders.

  • Accelerated death benefit rider: A standard inclusion in most policies, this pays out the benefit if the life insured gets seriously ill or becomes disabled.
  • Child life insurance rider: Provides a small benefit to cover funeral or burial expenses for children.
  • Early or enhanced cash value rider: Adjusts the surrender charges if the policyholder needs to surrender the policy in the first few years.
  • Estate protection rider: Helps offset estate taxes that may be due.
  • Guaranteed insurability rider: Allows the insured to increase the death benefit without going through another full application process.
  • Long-term care insurance rider: Enables the policyholder to use a part of the death benefit of if they require long-term care. This is often a cheaper option than taking out a separate long-term care policy.
  • Overloan protection rider: Prevents the policy from lapsing due to loan balances exceeding the cash value.
  • Waiver of premium rider: Allows the policyholders to stop paying premiums if they become critically ill or disabled.

Is taking out whole life insurance worth it?

Whether whole life insurance is worth it depends on a person’s goals and circumstances. For those who value predictability, a whole life insurance policy may be worth considering as it offers permanent coverage with premiums that stay the same regardless of a person’s age or health status. It also builds cash value over time that policyholders can tap into to pay for medical bills or other expenses.

Why would you buy whole life insurance?

Whole life insurance is a valuable financial tool with several compelling reasons to consider it:

  • Coverage for life: Whole life insurance guarantees coverage for your entire life or up to age 100 or 121, provided you keep up with premium payments. Even if your policy lapses, you retain access to its cash value, unless you used it to cover premiums.
  • Continuing death benefit: Your heirs receive the policy's value tax-free, regardless of your lifespan. This enduring benefit provides financial security for your loved ones.
  • Rider flexibility: You can include a rider that allows you to access part of the death benefit for long-term care needs, without waiting periods common in long-term care policies.
  • Borrowing privileges: You can borrow against your policy's cash value tax-free, up to its value. This can serve as a financial safety net.
  • Predictable coverage: Whole life insurance offers straightforward terms. You enjoy a fixed premium, a stable interest rate on cash value, and unchanging terms throughout the policy.
  • Guaranteed maximum expenses and interest rate: There are guaranteed limits on what the insurance company can charge you and a guaranteed minimum interest rate on your cash value growth.
  • Flexibility in financial hardships: In times of financial difficulty, you can use the cash value to cover premiums and keep the policy intact.

Whole life insurance is ideal for various scenarios:

  • Estate planning: It helps cover potential estate taxes, ensuring your beneficiaries receive their intended inheritance.
  • Supporting dependents: Whole life policies guarantee financial support for dependents, aiding with medical bills and daily expenses.
  • Long-term care needs: You can add long-term care coverage, accessing your policy's benefits for healthcare costs.
  • Tax-free investments: The tax-free growth of cash value complements existing investments, offering additional financial security.
  • Business owners: Whole life insurance safeguards business stability, serving purposes like succession planning, key person insurance, or collateral for loans.

It's important to note that whole life insurance typically comes at a higher cost compared to other insurance types. The cash value growth may also be more limited depending on policy performance.

The decision to purchase whole life insurance depends on your specific financial situation and goals. If you seek lifelong protection, want to build wealth, and value guarantees, whole life insurance is worth considering.

Can you cash out a whole life insurance policy?

Yes, you can cash out a whole life insurance policy, but there are important considerations:

  • Withdrawal limits: You can withdraw a limited amount of cash from your whole life insurance policy. The maximum you can withdraw without taxation is typically up to your policy basis. This basis represents the total premiums you've paid into the policy.
  • Tax implications: Withdrawals exceeding your policy basis, essentially dipping into the policy's gains, are subject to taxation at your ordinary income rate.
  • Impact on death benefit: Keep in mind that cashing out your policy will reduce the death benefit payable to your beneficiaries.

While cashing out provides access to funds, it's crucial to understand the implications. You may face tax consequences, and reducing the death benefit could leave you less protected.

Before making this decision, consider your financial needs, alternatives, and the long-term impact on your insurance coverage. Consulting with a financial advisor is often advisable to make an informed choice that aligns with your financial goals.

How long does it take to build cash value on whole life insurance?

The time it takes to build cash value in a whole life insurance policy varies:

Whole life insurance:

Cash value in whole life insurance accumulates at a fixed rate. Over time, this cash value grows steadily, making it a reliable long-term savings vehicle.

You can expect to see higher cash value growth within several years, often around 3 to 5 years after starting the policy.

Universal life insurance:

On the other hand, universal life insurance cash value growth depends on the performance of underlying investments.

The time it takes to build cash value can vary significantly, influenced by market conditions and investment choices. It may take longer to see substantial cash value growth compared to whole life insurance.

The timeline for cash value accumulation can differ from one policy to another. Several factors come into play: premium payments, policyholder contributions, and investment performance.

Our advice? Review your policy terms. Speak with your insurer or financial advisor. Doing these can help you understand the projected growth of cash value in your life insurance policy.

At what age should I buy whole life insurance?

The younger and healthier you are, the lower the cost of a life insurance policy.

If you are thinking of starting a family, it's best to acquire life insurance at that point or even a few years before. Doing this can enhance affordability over the long term.

By obtaining coverage earlier, you can lock in lower premiums and secure financial protection for your loved ones.

This strategic approach ensures that you benefit from lower rates while you're in good health, which can save you money in the future. It also offers peace of mind, knowing that your family is safeguarded financially in case of unforeseen events.

While there is no one-size-fits-all answer, the principle remains clear: the sooner you invest in whole life insurance, the more advantageous it is for both your financial security and cost savings

What about you? Do you think whole life insurance is worth considering? Do you have an experience about permanent life policies that you want to share? Use the comments section below for your thoughts.

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