Whole life insurance offers coverage for the rest of your life and includes a cash value component that lets you tap into it while you’re alive. Whole life insurance is more expensive than term life insurance because people with a whole life policy are guaranteed to have a death benefit when they die. On the other hand, term life insurance offers level rates for a specific period, such as 10, 20, or 30 years. Term life policies are cheaper than whole life insurance because they provide only coverage and no cash value.
Cash value accumulation in whole life insurance
Part of the premium payments for whole life insurance will accumulate in a cash-value account, which grows over time and can be accessed with a policy loan or withdrawal. The money in the cash value account grows tax-free. However, if you take out cash value that includes investment gains through a policy withdrawal or loan, that portion will be taxable. Cash value accumulation is the primary differentiator between whole life and term life insurance. While actual growth varies by policy, some take decades before the accumulated cash value exceeds the amount of premiums paid. This is because the entire premium does not go to the cash value—only a small portion. The rest goes to paying for the insurance itself and expense charges. Most whole life policies have a guaranteed return rate at a low percentage, but it’s impossible to know how much your cash value will actually grow. Most insurance companies that sell whole life also offer a “non-guaranteed” rate of return based on dividends. You can choose to apply your dividends to cash value every year, but you can’t know how much that will amount to. It may take decades for a policyholder’s cash value to exceed what’s paid in premiums.
Using the cash value in whole life insurance
You can tap into cash value with a withdrawal or a loan or surrendering the policy. If you take a loan, it’s tax-free, and you can pay it back, with interest. There are no taxes as long as your withdrawal is less than the portion of your cash value that’s attributable to the premiums you’ve paid. If your withdrawal is greater, you’ll owe taxes on the difference because those are investment gains. Outstanding loans and withdrawals will both reduce the amount of death benefit paid out if you pass away. That’s not necessarily a bad thing. After all, one of the reasons to buy a whole life insurance policy is to get cash value, so why let the money sit there without ever using it? You want to be sure that you know all the ramifications of accessing cash value prior to making any decisions.
Death benefit and picking beneficiaries
When you buy a policy, you’ll choose a life insurance beneficiary to receive the death benefit. You don’t have to split the payout equally among beneficiaries. You can designate the percentage for each, such as 75% for Mary and 25% for John. It’s also a good idea to designate one or more contingent beneficiaries. These folks are like your backup plan if all the primary beneficiaries are deceased when you pass away. Designating beneficiaries is an important task to keep your designation up to date with your wishes. The life insurance company is contractually obligated to pay the beneficiaries named on the policy, regardless of what your will says. It’s wise to check once a year to verify your beneficiaries still reflect your wishes.
What happens when you die
A central selling point of whole life insurance is that it will be in force until your death, as long as you’ve paid the required premiums. But here’s a kicker: For most policies, the policy pays out only the death benefit, no matter how much cash value you’ve accumulated. At your death, the cash value reverts to the insurance company. And remember that outstanding loans and past withdrawals from cash value will reduce the payout to your beneficiaries. Some policies allow you to purchase a rider that gives your beneficiaries both the death benefit and the accumulated cash value. This provision also means you’ll pay higher annual premiums, as the insurance company is on the hook for a larger payout.
Options for Surrendering Whole Life Insurance
If you no longer need insurance with term life insurance, you can stop paying. Once you stop, the policy lapses and the insurance company will no longer pay any benefit if you pass away. Whole life insurance isn’t that simple. If you stop paying, the cash value will be used to pay any premiums until the cash value runs out and the policy lapses. But there are alternatives to simply stopping payments. Options vary depending on your plan but can include the following tactics.
Take the cash surrender value
You can simply ask for the cash surrender value to be paid to you. This is the cash value minus any surrender charge. This action ends the insurance policy, so you should only do this if you no longer need insurance or have new insurance in place. By taking the surrender value, you’ll have to pay income taxes on any investment gains that were part of the cash value.
Ask about reduced paid-up life insurance
The life insurance company takes what you’ve already paid in, calculates how large of a death benefit that would permanently provide, and gives you a policy with the lower death benefit amount. This avoids any taxes and leaves you with some life insurance, but it may not be the full amount of coverage you need.
Extended-term life insurance
The life insurance company takes what you’ve already paid in and converts the policy into a term life policy for the same death benefit. How long the policy lasts depends on how much you’ve paid, how old you are, and the company’s current rates for a policy of that size and duration. This is helpful for someone who wants to preserve some life insurance for a short period of time, but no longer has a need for whole life insurance.
1035 exchange
You can exchange your policy for a different life insurance policy or for an annuity. This can make sense to avoid taxes on the surrender value or if you realize another whole life policy has substantially better features and you’d prefer to have that policy instead.
When Does Whole Life Make Sense?
Given the expense of whole life insurance and that many people do not need insurance for their entire lives, it is often not the ideal product to purchase. However, there are some specific situations where a form of permanent life insurance makes sense.
Funding a trust: Permanent life insurance can be used to fund a trust that will support children after you die. Paying estate taxes: For those with estates larger than the current estate tax exemption, which is $12.06 million in 2022, permanent life insurance may make sense to help heirs pay any estate taxes after you pass away. Some states have lower estate tax limits, so it may make sense for folks living in those states as well.
Funding a buy-sell agreement: If you’re an owner of a business with a partner, you might consider whole life insurance to fund the purchase of each other’s shares in the business at death.
Is Whole Life Insurance Worth It?
Here are questions to help you decide if whole life insurance is right for you.
Whole life insurance is a product that has some uses, but it’s not for everybody. The additional benefits offered by whole life can often be found by using your retirement and investment accounts for gains, in combination with a term life insurance policy. Before purchasing any insurance policy, be sure to fully understand the options available, and the policies’ various provisions.
Use our offline life insurance calculator to help determine a good starting point.
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Investment advisory services are made available through NFI Advisors, Inc., a Registered Investment Advisor.
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