Whole Life Insurance: What Is It & How Does It Work?
Summary:
A whole life insurance policy is a type of permanent life insurance. This means the insured person pays a fixed premium and is covered for the duration of their life as long as they make their payments. Whole life insurance policies offer a cash value component as well as a death benefit for the insured person’s beneficiaries. It’s important to talk with an insurance agent to decide whether or not a whole life insurance policy is right for you.
Let’s face it, life insurance is intimidating. Not only is it uncomfortable to confront the reality of death, but it’s also a lot to learn all at once: premiums, death benefits, limits, and so on. Plus, you have to choose which plan is best for you: term or whole life?
Fortunately, all of this information can be broken down and understood with this user-friendly guide to the most common type of permanent life insurance.
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What is whole life insurance?
A whole life insurance policy is a type of life insurance coverage and is the most common of the permanent plans. This means that the insured person is covered for the duration of their life so long as their premiums are paid on time.
A permanent life insurance plan offers both a death benefit and a cash value. The death benefit is what your beneficiaries receive when you die, and the cash value is a separate fund that acts more like a savings account while you’re still alive. You can access the cash value component either with withdrawals or by taking out loans you can repay later.
Terms to know
Before we move on, let’s go over some key terms when it comes to any insurance policy:
- A premium is how much you pay your life insurance company to keep your coverage. You can pay premiums monthly, quarterly, every six months, or once per year. If you pay a higher premium, you have a higher insurance limit.
- A deductible is an amount of money you pay yourself before your insurance will contribute to a claim. How much your deductible cost depends on your plan and your insurer, as well as what kind of insurance you have. If you pay a higher premium, your deductible is lower, and vice versa.
- An insurance limit is the highest amount of money an insurance company will pay toward a claim. Basically, the amount of money on an insurance claim is split into a deductible (what you pay) and a limit (what your premium pays).
- A death benefit is how much the insured’s beneficiaries receive upon the policyholder’s death. The higher the premium on the policy, the higher the death benefit payout.
How is whole life insurance work compared to term life insurance?
There are two key differences between term life insurance coverage and whole life insurance coverage: the duration of the policy and the cash value component.
- Duration of the policy. Term life insurance only covers the insured person for a set amount of time, usually between 10 and 30 years. A whole life policy, on the other hand, covers the insured person for their entire life.
- Cash value. Whole life insurance has a savings component called a cash value. The cash value in your policy accumulates over time and allows you to access funds in your policy whenever you want. This feature is discussed more in detail below.
Related reading: For more information on term life insurance and how it differs from whole life insurance, take a look at our article on the topic.
How much does it cost?
The price of your policy depends on several factors, including how much coverage you buy and who the policyholder is. Generally speaking, whole life insurance is more expensive than term life insurance. Monthly whole life insurance premiums can be anywhere from hundreds to thousands of dollars per month, and the cost of your premium depends on factors like your age, health history, and gender.
Let’s say you take out a whole life insurance policy for $1,000,000. This may sound like a lot, but in terms of life insurance, it’s actually very reasonable. The amount on your policy is the amount that will be paid out to your beneficiaries as a death benefit.
To start, you need to justify your policy amount to your insurance company. The recommended policy amount is at least 10 to 12 times your yearly income. So, a $1,000,000 policy would be on the low end for someone who makes $100,000 per year.
The reason for the magnitude of a life insurance policy is that it will be used by your beneficiaries for any number of things. This could include mortgage payments, other living expenses, lost income, student loans, child support, funeral expenses, medical debt, and so on.
So, taking all of the above into consideration: how much does a $1,000,000 policy cost? Well, it might depend on your answers to the following situations.
Pro Tip
In addition, making payments more than once per year (i.e., breaking your premium down by months, quarters, or every six months) can incur additional fees, so check with your insurance provider before choosing a payment plan.
1. When you take your policy out
One consideration is when you take your policy out. Life insurance is significantly more expensive if you take your policy out later in life. On the other hand, premium payments are cheaper if you take out a life insurance policy when you’re younger and healthier. Another factor is the length of your policy; after all, term life insurance policies are much less expensive than whole life policies.
Some life insurance companies require a medical exam before approving you for certain policies. However, if you’re young and have a clean bill of health, you may not be required to complete a medical exam.
2. What you do in your spare time
Hobbies can play a part as well. If you’re an adrenaline junkie, your premium may be higher due to the risks of dangerous activities. Skydiving, hang gliding, bungee jumping, scuba diving, and others are a concern for life insurance companies.
3. What you do for a living
If you work a high-risk job — like working on an oil rig or in the military — your whole life premiums could also go up. Your driving record is also a consideration for most life insurance companies, and they’re likely to inquire about any collisions you may have had in the last two to three years.
When you consider all of these factors together, your premium for a $1,000,000 whole life insurance policy could range anywhere from $180 to $1,500 per month. Contrast that with a term life insurance policy, which could start as low as $27 per month.
To get a better idea of what a whole life insurance policy may cost you, take a look at our comparison tool below.
What are the pros and cons of whole life insurance?
The decision to buy life insurance is extremely personal and should be made based on your unique circumstances. Below are the pros and cons of whole life insurance to help you make the best choice.
Pros
With whole life insurance, your fixed premium will never go up. Unlike universal life insurance policies, which may offer the option to adjust premiums or death benefits over time, a whole life insurance policy sets your premium once and never changes it. This means you pay the same amount monthly or yearly (depending on what payment program you choose) no matter what the external market conditions look like.
With whole life insurance, you can withdraw funds or take out a loan from your account with the cash value component. As mentioned above, whole life insurance policies include a cash value fund, which can work like an emergency savings fund. A portion of each of your monthly contributions (your whole life premium) is funneled into the cash value savings fund.
As you build your cash value fund, you can make partial withdrawals or take out a loan from it. Rules on this vary by the insurance company and the details of your policy, but your insurer will offer guidelines on how to use your cash value funds.
Another beneficial feature of whole life insurance is if you cancel your policy, you can collect the accrued cash value. The amount you save also has a guaranteed, fixed interest rate, meaning you will earn a minimum amount of interest on each contribution you make no matter what.
Cons
As mentioned above, whole life insurance is much more expensive than term life insurance. Since it’s cheaper to take out a whole life policy when you’re younger, your coverage needs may change as you get older. Since whole life insurance has the added feature of a cash value fund, you may also need to pay taxes on the money you withdraw from that fund.
Another drawback regarding the cash value component of a whole life insurance policy is how long it can take to accrue, says Pete Chatfield, founder and CEO of Household Money Saving.
“One of the main drawbacks of a whole life insurance policy is that the cash value of the policy may not be realized for many years,” he explains. “Most of your payment in the first few years will go toward the insurer’s fees and commissions, with only a little portion going toward building your cash value. This could mean waiting as long as 15 years before you can borrow against your policy’s cash worth.”
Lastly, whole life insurance policy premiums are not tax deductible. If your beneficiaries receive the benefits from your policy, they will likely not have to pay federal income taxes on the benefits. However, any interest earned on top of the death benefit is most likely taxable income.
Be sure to check with your tax advisor to calculate the correct taxes on your potential death benefits.
One of the main drawbacks of a whole life insurance policy is that the cash value of the policy may not be realized for many years. — Pete Chatfield, founder and CEO of Household Money SavingClick to Tweet
Other types of permanent life insurance
In addition to whole life insurance, there are a few other types of permanent life insurance policies that you might want to know about to help you find the right one.
Universal life insurance
This type of permanent life insurance policy is different than whole life insurance because it allows you to adjust the death benefit payout or reduce your premium payments after you accrue enough cash value in your policy.
However, this type of policy carries a risk that whole life insurance does not. If you spend your cash value on premium payments, your policy could lapse and you could lose your coverage.
Indexed universal life insurance
This policy differs from a universal life insurance policy because it has no fixed interest rate on the cash value you accrue. Having no fixed interest rate means less stability when it comes to potential gains or losses from your investments.
In other words, you could stand to gain or lose much more than you would with a regular universal life insurance policy.
Variable universal life insurance
This type of policy offers multiple investment options that could increase your cash value, plus adjustable premiums and death benefits. The risk with this type of policy is that if you make a bad investment, those losses can reduce your cash value. A reduction in your cash value can reduce your death benefit, so think carefully about choosing this policy.
Key Takeaways
- Whole life insurance is a type of permanent life insurance with the additional benefits of a cash value fund, lifetime duration, and fixed premium payment.
- Beneficiaries of a whole life insurance policy have a guaranteed death benefit.
- A whole life insurance policy is more expensive than a term life insurance policy.
- It’s cheaper to get a whole life insurance policy when you’re younger and healthier, but you may need additional coverage as you get older.
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