Whole life insurance is a type of permanent life insurance contract that covers the insured individual — usually the policy owner — until they die or reach 100 years of age, whichever occurs first.
Whole life insurance premiums never increase as a condition of continued coverage. By comparison, guaranteed level term life insurance provides coverage at a constant premium (guaranteed rate) only for the duration of an initial term, usually between 10 to 30 years, after which the insured individual may have the option to continue coverage at a much higher premium.
Like term life insurance policies, whole life contracts pay out to one or more named beneficiaries at the policyholder’s death. Unlike term life policies, which expire worthless if the policyholder outlives the term and doesn’t renew, whole life policies often generate value even as the policyholder lives.
How is this possible? To answer that question, we need to understand how whole life insurance policies work, how they differ from term life insurance policies, and when they make sense for would-be policyholders looking to provide financial security for their loved ones in life and in death.
Key Features of Whole Life Insurance
Whole life insurance shares some features with guaranteed level term life insurance, such as a fixed premium and a predetermined death benefit. Other features are unique to the various types of permanent life insurance or to whole life insurance specifically, including collateral value and tax-free dividends.
These features combine to produce a type of financial instrument that blends some familiar aspects of insurance coverage with the benefits of a relatively low-risk investment vehicle.
Like all types of insurance, whole life insurance policies assess premiums: annual or monthly payments made by the policyholder. Insurers set whole life premiums during underwriting, before officially issuing the policy.
Each policy’s premium depends on the policy’s death benefit or coverage amount — the amount to be paid to the named beneficiaries at the policyholder’s death — as well as a variety of applicant-specific factors such as current age, family health history, known health risks as determined by medical records and the results of a medical exam, and tobacco use.
Under normal circumstances, a whole life insurance policy’s premium remains constant for as long as the policy is in force, regardless of the policyholder’s age or health. Depending on the terms of the policy, the policyholder may have the option to increase the policy’s death benefit by paying a higher premium, but this is never required as a condition of continued coverage.
Unlike term life insurance policies, which frequently expire worthless when the policyholder outlives the initial term and chooses not to renew, whole life insurance policies often endure until the policyholder’s death and pay out death benefits to their named beneficiaries or those beneficiaries’ successors.
Due to the high likelihood of a payout, whole life premiums cost orders of magnitude more than term life premiums for otherwise similar policies and policyholders. Whole life premiums are lower for younger applicants.
This is not because the applicant is more likely to outlive the policy term, as is true for term life insurance, but because the applicant will pay into the policy for longer (statistically speaking) before their death.
Like term life insurance, every whole life policy has a death benefit based on the would-be policyholder’s life insurance needs and the amount of life insurance coverage the insurer is willing to underwrite based on the applicant’s risk factors.
The death benefit generally passes to the policy’s beneficiaries as tax-free income but may be considered part of the policyholder’s estate for tax purposes and incur estate tax if the policyholder dies with substantial assets.
Under normal circumstances, a whole life insurance policy’s death benefit remains fixed (level) for the policyholder’s entire life or until the policy is cashed out prior to death. But many whole life policies allow policyholders to apply policy dividends toward the death benefit, gradually increasing its value over time.
Most whole life policies also allow terminally ill policyholders (those expected to die within two years) to claim accelerated death benefits — a lump sum payment of a portion of the death benefit that proportionally reduces the remaining death benefit and premiums.
A whole life insurance policy’s death benefit is guaranteed except in cases that meet certain clearly defined exclusions. The most common of these include the policyholder dying by suicide within the policy’s first two years or being found to have materially misrepresented information on their insurance application, such as their age.
Cash Value and Surrender Value
Unlike term life insurance, whose entire value is tied up in the death benefit, whole life policies also have a cash value component that the policyholder can access before their death.
Like a savings account at a traditional or online bank, the cash value steadily accrues interest and grows in value, albeit at a relatively modest clip (tied to prevailing interest rates) that can’t match long-term stock market returns.
Whereas other types of permanent life insurance invest a portion of the cash value in market-traded instruments that can rise or fall in value, the cash value of whole life insurance can only increase over time if the policyholder makes timely premium payments.
If the policyholder temporarily becomes unable to make premium payments or chooses to stop making premium payments for any other reason, the policy’s cash value stands in for those missing payments. The cash value decreases proportionally with each premium payment made from it until the policyholder resumes regular premium payments or the cash value is depleted.
A whole life policy’s cash value is closely related to its surrender value, or the actual amount the policyholder receives if they choose to cash in the policy before their death. This is not a decision to be taken lightly, as fully cashing out (surrendering) a whole life policy voids its death benefit.
Initially, surrender charges (also known as surrender fees) reduce the surrender value relative to the cash value. These fees are designed to discourage policyholders from cashing out early and slowly decline over a period of years before disappearing altogether. After that point, the policy’s surrender value equals its cash value.
Whole life insurers guarantee their policies’ cash value components. However, unlike bank deposits insured by the federal government, this is a private guarantee that’s only as good as the insurer’s own finances.
Because a great deal about an insurer’s finances can change over the decades that the typical whole life policy remains active, applicants need to carefully evaluate insurers’ financial strength metrics from independent rating agencies like AM Best and S&P and choose an issuer that’s likely to be around for the long haul.
Tax Advantages of Whole Life Insurance: Tax-Free Basis and Borrowing Power
The cash value component of whole life insurance has some important tax benefits worth enumerating on their own.
The first is tax-free basis. In plain English, this means that the cash value component’s basis — the amount of the premium that funds the cash value — is not always considered taxable income when it’s cashed out.
Generally, IRA basis withdrawals are not subject to income tax, although income tax does apply to withdrawals of IRA gains (growth). IRA gains aren’t separable from the basis during the withdrawal process — that is, you can’t only withdraw contributions to avoid taxation.
Likewise, whole life basis withdrawals are usually not taxable, although they may be reduced by surrender charges in the policy’s early years. Additionally, unlike with traditional 401(k)s and IRAs, life insurance basis withdrawals are separable from growth withdrawals.
Policyholders are therefore more likely to be able to withdraw basis only and avoid income tax entirely — although it’s always a good idea to consult the policy issuer and a tax advisor before executing a withdrawal that could have significant financial implications.
The second tax benefit of whole life insurance is tax-free borrowing power. A life insurance loan uses the policy’s cash value as collateral and the principal is not considered taxable income as long as the policyholder pays back the entire loan.
However, any interest paid on the loan is generally not tax-deductible, as is the case with interest on mortgage loan payments.
Loans against whole life insurance policies have an important non-tax benefit as well. Unlike most other types of loans, including many secured loans like home and auto loans, they don’t require risk-based underwriting.
In other words, a less-than-perfect credit score won’t affect your loan amount or your ability to qualify in the first place.
Life insurance loans do have some drawbacks. As long as it remains unpaid, a life insurance loan reduces the collateral policy’s cash value and death benefit. If the policyholder dies or surrenders the policy before the loan is paid in full, this could reduce how much they or their beneficiaries receive.
Additionally, when a portion of a loan remains outstanding at surrender, the unpaid principal is considered taxable income up to the difference between the total cash value and the cash value basis.
For example, if the policy’s present cash value (not accounting for the loan) is $50,000 and the cash value basis is $40,000, up to $10,000 in loan principal may be taxable at surrender.
Tax-Free Death Benefits
As noted, whole life insurance death benefits usually pass to beneficiaries as tax-free income (as do term life insurance death benefits). This makes life insurance of any kind an important means to transfer wealth between generations.
For most whole life policyholders, that’s the end of the story. However, because life insurance proceeds add to the value of a decedent’s estate when the deceased policyholder is also the insured party — as is the customary arrangement — wealthier policyholders may trigger federal estate tax jeopardy when they die.
This only occurs if the policy’s death benefit pushes the total value of the decedent’s estate above the federal estate tax exemption — $11.7 million in 2021.
Some states have lower estate tax exemptions. In any case, policyholders may be able to avoid adding to the value of their estate by transferring ownership of their policy to a spouse or heir, removing it from their future estate.
Whole Life Insurance Dividends
Whole life dividends are distinct from interest earned on policies’ cash value components.
Technically, dividends are considered returns of premium (basis) and therefore aren’t taxable as stock dividends normally are.
However, they’re tied to the annual performance of the life insurance company’s policy portfolio, as determined by actual versus expected payouts and the insurer’s rate of return on the assets in which it invests excess policy premiums, and can vary significantly from year to year. In bad years, a policy might not pay a dividend at all.
Policyholders can use whole life dividends in a number of ways:
- To reduce the size of out-of-pocket premium payments or cover entire premium payments
- To repay a loan against the policy’s cash value
- To purchase additional life insurance coverage (and increase the policy’s death benefit) without going through medical underwriting again
- To add to the policy’s interest-accruing cash value
Policyholders can also take dividends in cash, usually via a check mailed around the policy’s anniversary date.
Pros of Whole Life Insurance
As we’ve seen, whole life insurance has significant tax benefits for policyholders and their heirs. It’s also a source of long-term financial flexibility and can stand in as high-value collateral for policyholders who don’t own their own homes and don’t plan to purchase real estate.
- Whole Life Insurance Has Substantial Tax Benefits. Whole life insurance has a number of key tax benefits. Over time, whole life policies grow into rich sources of tax-free basis that policyholders can withdraw at will. Whole life policies also provide low-cost, low-tax borrowing power and, at least under normal circumstances, tax-free windfalls for policy beneficiaries.
- Whole Life’s Cash Value Enhances Financial Flexibility. As guaranteed collateral against low-interest loans, whole life’s cash value component is a valuable source of financial flexibility on par with equity in owner-occupied real estate. If you don’t plan to purchase and build equity in a home of your own, a whole life policy loan can stand in for a home equity loan or line of credit. And even if you don’t want to borrow against your policy’s cash value, you can use that value to cover premium payments when money is temporarily tight.
- Whole Life Dividends Can Offset Policy Costs and Further Enhance Financial Flexibility. Whole life’s dividend is the most flexible part of the policy. You can use your dividends to reduce or eliminate premium payments, increase your death benefit, boost your cash value’s interest-earning power, pay off a life insurance loan, or simply pad your bank account. The choice is yours.
- Whole Life Premiums Get Cheaper Over Time Due to Inflation. Absent a voluntary increase in coverage or a voluntary reduction in death benefit, a whole life insurance policy’s premium cost stays constant as long as the policy is in force. Even if you become gravely ill, the premium never changes — guaranteed — as long as you pay your premiums. In fact, as the years go by, the constant premium actually gets cheaper due to the steady value-eroding effect of inflation.
Cons of Whole Life Insurance
While there are many positive aspects to whole life insurance, there are also some disadvantages to consider. A whole life insurance policy doesn’t reach its full potential until it has been in force for a number of years and remains much more expensive than guaranteed level term life insurance. For many would-be policyholders, it’s overkill.
- Cash Value Does Not Accrue Immediately. A whole life insurance policy builds cash value over a period of time, not right away. In most cases, cash value doesn’t really begin to accrue until the policy’s third year, after which value builds steadily (absent loans or surrenders) for a period of many years. Policyholders who expect to be able to borrow against their policies immediately may be in for a surprise.
- Surrender Charges Can Persist for Years. Every whole life policy levies surrender charges for premature withdrawals. Surrender charges may apply for as long as 15 years from a policy’s effective date, albeit at lower levels than soon after issuance. Before finalizing your insurance contract, carefully read the surrender clause to understand when you can begin to withdraw funds without penalty.
- Whole Life Coverage Is Much More Expensive Than Term Life Coverage. Whole life is much more expensive than level term life insurance, which doesn’t have a cash value component and expires worthless if the policyholder outlives the term and chooses not to renew for another term. If you only expect to need life insurance coverage for the duration of a 20- or 30-year term at most and you have other sources of long-term investment growth and income, such as tax-deferred retirement accounts or taxable securities accounts, term life insurance combined with a diversified market investing strategy could be a better choice for your long-term financial needs.
- Whole Life Insurance Is Complicated. Whole life policies are governed by detailed, dense contracts that differ by insurer and policy design. It’s risky to shop for and purchase whole life insurance without the help of an unbiased insurance agent and a financial advisor acting as a fiduciary — that is, in your financial best interests.
- Whole Life Benefits Can Have Adverse Tax Consequences for Wealthy Policyholders. Whole life insurance death benefits don’t always have tax consequences for beneficiaries. However, for wealthier policyholders in danger of exceeding the lifetime estate tax exemption, they can incur federal or state taxes that eat into their net value and deprive beneficiaries of what’s rightfully theirs.
The key to deciding whether whole life insurance (or any permanent policy) works for you is to decide why you are buying insurance.
If you expect to need insurance coverage for longer than 30 years, you seek a source of long-range financial flexibility that’s not tied up in real estate, and you hope to supplement your retirement savings and increase your standard of living (and quality of life) in your later years, a whole life policy could be suitable for your needs.
The key to whole life insurance is to map out exactly what your overall financial picture is before going down that road. Once you have decided to invest in a whole life policy, commit to it and understand its benefits and limitations so that you can best use the policy to achieve your financial goals.
But be sure to consult a financial professional who is aware of all of your needs and concerns before making this decision. And don’t go with the first offer of coverage you receive. Solicit multiple life insurance quotes to make sure you get the most favorable terms available to you.