Is Whole Life Insurance a Good Investment? When it's Worth it to Invest in Life Insurance
Unless you require permanent life insurance coverage, whole life insurance is generally a bad investment. If you want lifelong coverage, whole life insurance may be a good investment if you have already maxed out your retirement accounts and have a well-diversified portfolio. Just keep in mind that whole life insurance is quite expensive and can often take a decade or more to begin demonstrating reasonable investment returns. As a result, it's usually only a good idea if you're relatively young, have a high income, and want to leave money to your family.
Should You Invest in Whole Life Insurance or Term Life Insurance?
Permanent cash value life insurance policies, such as whole life insurance, include both life insurance and an investment component. However, the primary purpose of these policies is to pay out a death benefit to your beneficiaries when you die, and this benefit accounts for a significant portion of the cost of purchasing a policy. As a result, unless you want to have lifelong coverage, whole life insurance policies and other cash value life insurance policies don't make sense as an investment.
Assuming you do require life insurance, you can choose from four broad types of insurance based on your financial situation:
Type of Policy | Length | Reason for Coverage | How to Invest |
Term life insurance | 5-35 years | You have debts or upcoming expenses that are fairly significant (such as a mortgage or sending your kid to college). Or, you want income replacement if you die. | Term life insurance is solely for risk management, not investment. Contribute to your 401(k), IRA and brokerage accounts. |
Guaranteed universal life insurance | Lifetime | You want to pass on an inheritance, help your family with estate taxes, or pay some other costs after your death. | Guaranteed universal policies have little to no cash value. Instead, invest through your 401(k), IRA and brokerage accounts. |
Final expense insurance | Lifetime | Your family would have trouble covering less than $50,000 of costs at the time of your death (such as the cost of a funeral). | You shouldn’t be considering life insurance as an investment option. Put together an emergency fund and get money in your retirement accounts. If possible, buy a term policy and save faster. |
Whole and universal life insurance (cash value policies) | Lifetime | You’re considering guaranteed universal life insurance for the permanent coverage, but have a broad portfolio of investments already and want to diversify. | Through a cash value life insurance policy you can get guaranteed returns or take greater risk, such as investing the cash value in an index or actively managed portfolio. |
Because guaranteed universal life insurance policies provide permanent coverage, they are still significantly more expensive than term life insurance (typically three to four times the cost), but you save money because there is little to no investment component. Because you are paying for permanent coverage, additional administrative costs, and funding the investment account, whole life insurance policies are frequently ten times the cost of term life insurance.
Is the Cost of Whole Life Insurance Worth It?
If you want permanent coverage but are concerned about the high cost of whole life insurance, you should look into guaranteed universal policies. This can be compared to a quote for whole life insurance. You should also compare the guaranteed returns of the whole life insurance policy to your expected returns if you invested the difference in cost between the two policies. Just make sure that you:
- Prices should be compared between a whole life insurance policy and a guaranteed universal life insurance policy, not between a term life insurance policy and a whole life insurance policy. Don't buy permanent life insurance if you don't need it. If you require permanent life insurance, it will be more expensive than term coverage, and a guaranteed universal policy is the best way to estimate your coverage costs.
- For investment returns through a brokerage account, use conservative estimates. Some critics of whole life insurance make unrealistic comparisons based on annual expected returns of 8% to 10%. Furthermore, these returns are not guaranteed, and you may lose your investment. The guaranteed returns on whole life insurance are modest, but they are guaranteed.
- Take into account capital gains taxes. Investment gains in a brokerage account may be taxed at a rate of up to 20%.
If you believe you would be better off financially if you obtained permanent coverage and simply invested the difference in cost, you should do so. However, you must actually do it. Many people buy a less expensive term or guaranteed universal policy and then spend the money they saved by not buying whole life insurance.
If, on the other hand, you decide to buy whole life insurance, make sure to go with a company that has a high financial strength rating. If your insurer goes bankrupt, you may lose your coverage and investment. Furthermore, ensure that the policy allows you to receive a portion of the death benefit early if you develop a serious illness. An accelerated death benefit is a common feature.
How Whole Life Insurance Works as an Investment
When you pay your whole life insurance premiums, a portion of the money goes toward the cost of insurance, some goes toward sales and administrative fees, and the rest goes toward the cash value of the policy. Fees and insurance costs consume the majority of your premium in the early years, but an increasing amount is contributed to the cash value over time.
The cash value of your whole life insurance policy is essentially an investment account that grows at a guaranteed rate over time. The guaranteed rate of return is usually sufficient to ensure that your cash value equals the policy's death benefit when you reach the age of 100, assuming no withdrawals are made. The cash value of your policy is simply the amount of money you would receive in exchange for surrendering the policy to the insurer.
Due to fees and the cost of coverage, the cash value of a whole life insurance policy is quite small during the first 10 to 20 years of coverage. As a result, if you are older, we would not recommend whole life insurance as an investment because you may not live long enough to see good returns and would save money with a guaranteed universal policy.
When you buy whole life insurance from a mutual insurance company, you may be eligible for dividends as your cash value grows. Because mutual insurers are owned by their policyholders, profits are distributed as dividends on an annual basis.
While dividends are not guaranteed, the largest mutual insurers have distributed them on a consistent basis for decades. Dividends can be taken as cash, used to pay premiums, or used to purchase paid-up insurance additions. Paid-up insurance additions are a type of "reinvestment" because they function similarly to a small addition to your existing whole life insurance policy, increasing the death benefit and cash value.
The cash value of a whole life insurance policy grows tax-deferred, which is why it is frequently compared to a retirement account, such as a 401(k) or IRA. Contributions to a whole life insurance policy, on the other hand, are not tax deductible, as they are with retirement accounts.
Accessing Your Whole Life Insurance Policy’s Investment Gains
The cash value of a whole life insurance policy is not added to the death benefit if you die; it is kept by the insurer, so you must either "use it or lose it." You can get to and use the cash value by doing the following:
- Taking out a policy loan - The insurer holds your money and gives you a loan with the cash value as collateral. Your cash value grows in accordance with the policy's interest rates, and you are not required to repay the loan. The interest on the loan must be paid or it will be added to your outstanding balance. If your outstanding balance exceeds your cash value, your policy will lapse and you will be required to pay taxes on the money. If you die, the outstanding balance will be deducted from the death benefit paid to your beneficiaries.
- Getting dividends in cash - With a participating whole life insurance policy from a mutual insurer, you can receive any dividends in cash. There is no income tax as long as the amount does not exceed the premiums paid.
- Making a partial withdrawal - You can withdraw up to a certain amount from the policy's cash value, as determined by the insurer. When you are able to withdraw money, the insurer may charge a withdrawal fee or set a limit, and the amount you withdraw will be deducted from the death benefit. You can withdraw cash up to the amount of premiums paid without paying income tax.
- Selling the policy - If your spouse dies or your children become financially successful, you may no longer require coverage. Through a life insurance settlement, you may be able to sell your policy for a sum greater than its cash value but less than the death benefit. The buyer becomes the beneficiary after taking over premium payments. Depending on the terms of the settlement, any gain you make is taxed as either income or capital gains.
- Surrendering the policy - If you no longer want your policy and are unable to obtain a life insurance settlement, your cash value is the amount you would receive from the insurer if you surrendered coverage. Insurers typically impose high surrender fees during the first 10 to 15 years of coverage. This is one of the reasons why whole life insurance should not be viewed as a short-term investment.
When you withdraw or borrow money from the cash value of your policy, the insurer reduces the death benefit accordingly. As a result, you might think of whole life insurance as aided self-insurance. You pay the insurer for the benefits of tax-deferred growth, guaranteed returns, and the ability to use the money as it grows through a policy loan.
In turn, the insurer maintains premiums at the same level as the difference between cash value and death benefit decreases over time, reducing their liability. However, while your beneficiaries will receive the death benefit, they will not receive the cash value of the policy.
Also, while whole life insurance policies have surrender fees during the first several years of coverage, there are no age restrictions on making a withdrawal or taking out a loan. This is a significant advantage over a traditional 401(k) or IRA, which impose penalties for withdrawals made before the age of 59.5, because you can access the funds at any time as long as you have a sufficient cash value.
Policy loans can be a great option if you need money during a market downturn or other situation where it would be difficult or risky to withdraw funds from other investments. For example, if you own stock in a private company, it may take months to sell your shares, and you may not want to give up your position. Whole life insurance policy loans typically have low interest rates and, because there is no credit check or eligibility requirement, you can receive the funds almost immediately.
Investing in Universal Life Insurance vs Whole Life Insurance
If you're considering whole life insurance but want more options for investment and premiums, universal life insurance might be a better fit. With a few key differences, universal life insurance is very similar to whole life insurance:
- You can use the cash value of the policy to pay a portion (or all) of the premiums.
- There is a minimum and maximum premium, but you can generally pay whatever amount falls within these limits.
- Premiums are not fixed and can fluctuate.
- You have a number of options for how you want the cash value invested.
You can choose between traditional universal life insurance (rates determined by the insurer), indexed universal life insurance (tracks an index), and variable universal life insurance depending on how you want to invest the cash value (you pick from a set of mutual funds). Every universal life insurance policy includes a fixed interest rate investment option, but the returns are typically low.
When compared to whole life insurance, universal life insurance policies carry a higher risk and a higher potential return. Your cash value will typically have a guaranteed annual rate of return for traditional and indexed universal policies, but this can be quite low or 0%. (While 0% is not a bad annual minimum, it does ensure that gains from previous years are not impacted by poor results.) Similarly, in good years, the insurer will set a maximum annual gain limit.
Variable universal life insurance is even riskier because the cash value can actually decrease and administrative fees are higher. Furthermore, your investment options frequently have higher expense ratios than comparable mutual funds.
However, one significant advantage of universal life insurance policies is that you can contribute more to the cash value in years when you can afford to. By doing so, you shorten the time it takes to accumulate enough cash value to pay for the majority of the premiums. A similar effect can be obtained by purchasing a whole life insurance policy that is paid for over a shorter period of time, such as 20 years. However, with a universal life insurance policy, you are not required to pay more in years when you do not have the money.