What is Whole Life Insurance? The Pros and Cons
Whole life insurance, by definition, provides coverage for the duration of your life as long as you continue to pay premiums. It is also known as "guaranteed whole life insurance" because insurers promise to keep premiums constant throughout the policy's term. If you die while the policy is still active, the beneficiaries will be paid.
Furthermore, whole life insurance provides tax advantages and has a cash value component that grows over time. It is appropriate for those who want the benefits of life insurance coverage as well as the use of the cash value as an investment vehicle.
How does whole life insurance work?
Because whole life insurance is a type of permanent life insurance, you will have coverage for the rest of your life as long as you pay your premiums. If you die, your policy beneficiaries file a claim with the insurer, who will investigate the circumstances surrounding your death and pay out the death benefit (also known as the policy's face value) if everything is in order.
Make certain that your family members are aware of your life insurance policy. If your spouse or child is unaware that they are the beneficiary, they may be unable to collect the payout if you die.
A whole life insurance policy is made up of a few key components:
Death benefit
This refers to the payment made to your beneficiaries upon your death. Death benefits are tax-free as long as you are below the federal and state estate exemption levels, which most households will be. Only 18 states impose estate or inheritance taxes, and the federal exemption level is approximately $5.5 million.
Policy face values start at $50,000 or $100,000 and can range up to several million dollars. In general, whole life insurance policies are more expensive than alternatives such as term life insurance. Because the death benefit has a direct impact on the cost, it is critical to assess your family's needs before making a purchase decision.
Death benefits for some products, such as final expense whole life insurance, can be as low as a few thousand dollars. These policies are less expensive because they have a low face value and are intended to cover end-of-life expenses. Given that the average funeral costs around $10,000, these policies can be extremely valuable if your family does not have an established emergency fund or would struggle to cover burial expenses.
Premium
This is the policy's cost, which can be paid annually, biannually, or monthly depending on your insurer. Premiums are typically paid for the duration of the policy, though some people choose to pay a higher premium for a shorter period of time, such as 20 years, to ensure that their policy does not lapse later.
This option is frequently useful for people with high incomes who want to lock in coverage for their family regardless of what happens to their income in the future. If you can afford it, this is a simple way to reduce the financial risk profile of your family.
Cash value
Whole life insurance, like other permanent life insurance policies, builds up a cash value over time. If you surrender the policy to the insurer, you will receive the cash surrender value. It is not added to the face value of the policy, which your beneficiaries will receive if you die.
In the case of whole life policies, the cash value grows tax-deferred over time and is guaranteed to grow at a specific rate. As a result, whole life insurance policies are frequently referred to as investment vehicles. While the guaranteed rate of return on cash value may be lower than that of other financial products, it can reduce overall portfolio volatility (though this benefit assumes you have a breadth of existing investments). The monetary value can be used to:
- Premiums must be paid
- Purchase additional insurance.
- Withdraw your funds (in certain cases)
- Make a tax-free loan available (for emergency expenses, a mortgage or other needs)
Keep in mind that if you borrow against your policy's cash value and die, the loan amount will be deducted from the policy's death benefit.
Dividends
Dividend-paying whole life insurance policies, also known as participating whole life insurance policies, pay a dividend if the insurer performs better than expected. After paying all death benefits and other business expenses, policyholders are entitled to a share of the company's profits.
Dividends are determined by the performance of your insurer, and there is no guarantee that they will be paid each year—though some insurers have consistently paid dividends for decades. If you're comparing whole life insurance policies from two insurers with the same features and premiums, dividends are unquestionably a plus.
Guaranteed acceptance and no-medical-exam whole life insurance
While a medical exam is not required as part of a life insurance policy, it is a fairly standard requirement that is used in conjunction with the underwriting process, both of which are used to evaluate your health and determine your premiums.
Some insurers do not require a medical exam, but they may charge significantly higher premiums because the insurer is taking on more risk. You must still answer health and medical history questions, but you are not evaluated in person. An exam is typically quite brief (about 30 minutes) and relatively painless because it can often be scheduled at your workplace or at home.
Similarly, guaranteed acceptance whole life insurance allows you to skip the medical exam and detailed health questions, but the premiums will be higher, and the death benefit will be limited — typically less than $100,000.
Furthermore, there is usually a time limit for the first few years of coverage, so if you die during that time, your beneficiaries will not receive the full payout. Unless you are concerned about your ability to obtain coverage, such as if you have been diagnosed with a life-threatening condition such as cancer, our analysis indicates that this is a poor choice for the majority of people.
The pros and cons of whole life insurance
Here's a rundown of the advantages of whole life insurance in a variety of financial situations:
Benefit | Overview |
Cash value accrual | A whole life insurance policy’s cash value has guaranteed, tax-deferred growth |
Tax-free policy loans | You can take out a policy loan using the cash value as collateral |
Dividends | If your policy provides dividends, these are free of income tax as they’re considered a return of premium |
Fixed premiums | Whether you pay over a shortened period or over your lifetime, premiums are guaranteed to stay flat |
Lifelong coverage | A benefit of all permanent life insurance policies, so long as premiums are paid |
No additional exams | If your health changes in the future, you’ll remain covered and aren’t required to take additional health assessments |
Option to surrender | If your financial situation changes, you can surrender the policy and receive its cash value back from the insurer |
Similarly, there are a number of drawbacks to whole life insurance that, depending on your coverage objectives, can often outweigh the benefits:
Downside | Overview |
Complex product | Whole life insurance is a complex product with many features and potential benefits, but these can be challenging to take full advantage of without a professional |
High premiums | The cost of whole life insurance is significantly higher than term, and means it may not be a good choice unless you take advantage of all the potential benefits |
Growth rate and fees | While the policy’s cash value is guaranteed to grow at a certain rate, this can be lower than other investment vehicles and you need to determine what fees are applied |
Should I buy whole life insurance?
Your financial goals will determine whether or not whole life insurance makes sense for you. Given the cost of whole life insurance, other products are likely a better fit if your primary goal is to have a death benefit in place to cover your family's expenses if you die.
If you want the benefits of having coverage but also want to use the cash value as an investment vehicle, whole life insurance is worth considering. For example, if you're a young parent with a high income, you might be okay with the higher costs and the ability to lock in a lower annual premium by purchasing early in life. Furthermore, it could take decades for the policy's cash value to consistently grow into a sizable asset.
Whole life insurance is not a good investment on its own and should be considered as part of a diversified portfolio. If you're just getting started with retirement savings and investments, whole life is probably not the best place to start. If you already have a healthy emergency fund, have maxed out your IRA and 401(k), and are looking for new tax-advantaged accounts for retirement or estate planning, whole life insurance should be seriously considered.
If you're not sure whether whole life insurance is right for you, consider the following scenarios in which a different life insurance product would be more appropriate:
- You have significant outstanding loans or upcoming expenses, such as a mortgage or sending your child to college, that you want to ensure are covered. A term life insurance policy would probably be better suited for these types of situations.
- You want coverage for the rest of your life so your family isn't in a financial bind covering your final expenses, or simply to ensure they have money to fall back on if something bad happens. In these cases, you should look into final expense whole life insurance and guaranteed universal life insurance as alternatives, as they have lower long-term premiums.