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Whole life insurance: How it works

Read the Spanish version: Conceptos básicos del seguro de vida permanente

There are two main types of life insurance: term and permanent life insurance. Often, “whole” and “permanent” are incorrectly interchanged, when whole life insurance is actually a type of permanent life insurance. The most common types of permanent insurance are whole, universal and universal variable. This article focuses on whole life policies.

Visit Insure.com’s life insurance basics page to learn more about types of permanent policies.

What is whole life insurance?

Types of whole life insurance

Other types of permanent life insurance

Whole life insurance riders

What does whole life cover?

Which kind of insurance policy is right for me?

How much insurance coverage do I need?

What is the cost of a whole life policy?

What is whole life insurance?

A whole life policy provides a set amount of coverage for your entire life. As long as the premiums are paid, your beneficiary will receive the benefit amount upon your death. Whole life policies also build up "cash value" from part of the premium being invested. It’s possible to access that cash value as the funds grow.

The cash-value component of life insurance

Cash value is a crucial selling point for whole life insurance: It's an account within your policy that builds up over time, tax-deferred, Futurefueled by a portion of your premiums and interest paid by the insurance company. In fact, the whole life contract is designed for you to take advantage of that money because when you die, your beneficiaries receive the death benefit, but not the cash value that’s accumulated.

Look to universal life policies if you’d like the investment to potentially increase the death benefit.

Whole life policies build up cash value slowly at first, but then pick up the pace after several years, when your earnings start to grow faster than your "mortality cost” (the cost of insuring you). At some point, the cash value may eventually earn enough that it could be used to continue to pay for your premiums until you die. Your insurer should be able to provide you with a policy illustration to demonstrate the potential growth of your policy.

What is the difference between whole and term life insurance?

Unlike whole life, which covers you until your death, term life insurance provides coverage for a specified period of time, such as 10, 15 or 20 years. For term policies, the premiums increase over time unless you buy a "level term" policy, guaranteeing that premiums stay the same.

There is no cash value component to a term policy. In the event that you could outlive the term of your policy, your policy expires, and you would need to shop for another policy if you wish to still have coverage. Some companies allow you to convert your term policy into a whole policy.

With term insurance, you can get significantly higher coverage amounts for a much lower premium compared to permanent insurance. That’s because there’s a good change you outlive the term and get nothing for the premiums you’ve paid.

Types of whole life insurance

Ordinary whole life insurance Premiums are level as long as you live, and your policy builds cash value. The initial annual cost will be much higher than the same amount of term life insurance.
Limited payment whole life insurance This policy lets you pay premiums for only a specific period, such as 20 years or until age 65, but insures you for your whole life. As a result, premium payments will be higher than if payments were spread out through your lifetime.
Single premium whole life insurance This policy is paid up after one large initial payment.
Modified premium whole life insurance This policy has a moderate cash-value component and provides a lower premium during the early life of the policy. It still has the ability to accrue cash value that can be accessed tax-free by the policyholder.
Survivorship life insurance Also called “second-to-die” life insurance, this type of whole life policy insures two lives (typically spouses) and pays out upon the death of the second individual. This is good for people who need to provide for beneficiaries only after both have passed away. It is also less expensive than insuring two lives under separate policies.

Other types of permanent life insurance

If the features of permanent life insurance fit the bill for you, and you have a higher tolerance for financial risk, there are additional varieties of permanent insurance with more flexibility and greater investment opportunity.

Universal life (UL) insurance - This policy lets you vary your premium payments and adjust your death benefit as beneficiaries' needs change. You have to be aware of how much is in your account and whether you need to make payments in order to keep the policy in force. There are also UL policies that can provide level premiums. These policies may offer lower premiums in exchange for a slow accumulation of cash value, if any.

Variable universal life (VUL) insurance - Here your cash value and death benefit are tied to a particular investment account. Your cash value and death benefit increase if the underlying investments do well, or they may shrink considerably under poor investment performance. Read the prospectus for VUL carefully and never buy a policy that you don't understand. There may be an extra premium required to guarantee a minimum death benefit amount.

Participating or non-participating whole life insurance - Any type of permanent life policy listed above could be "participating" or "non-participating." You have a participating policy if your life insurance company pays dividends to policyholders when it has a good financial year. Dividends are not guaranteed and will vary year to year when they are paid, but if you have a participating policy you can take your dividends as cash, use them to pay your premiums or use them to purchase additional insurance to increase your policy's face value. Dividends are not taxable as long as they don't exceed the premiums you've paid in.

Whole life insurance riders

Life insurance companies offer a number of riders that can be added on to whole life policies. A rider is an add-on portion to a basic contract. Think of this as your opportunity to customize your policy to any specific needs you may have. All riders may not be offered by all companies, and many insurers offer other specialized riders not listed here, so it’s a good idea to check with your agent.

  • Accidental death benefit rider - Pays an additional benefit if you die in an accident.
  • Disability income rider - Provides regular income from the insurance company if you become totally and permanently disabled.
  • Level term rider - Adds a fixed amount of term insurance to the whole life policy for a specified period.
  • Living benefits rider, also known as accelerated death benefit - Pays a portion of your death benefit during your lifetime if you are diagnosed with a terminal illness and have a specified life expectancy (such as 12 months). You can add this rider after buying the policy.
  • Long term care (LTC) rider - Pays for LTC expenses if you meet certain criteria.
  • Policy purchase option - Gives you the contractual right to purchase additional insurance without evidence of insurability. For example, you may want to increase your life insurance coverage after the birth of a child.
  • Waiver of premium rider - Waives premiums if you become disabled or unemployed. (Terms vary by insurer.)

What does a whole life benefit cover?6 common uses

As with any type of life insurance, the death benefit amount you choose at the start of your policy does not have an assigned use. With whole life, these funds are usually used to cover funeral expenses, any remaining debts, inheritance. However, the funds could also be used for paying a remaining mortgage loan or to replace lost income of the insured party.

It’s important to note that the death benefit can be used by beneficiaries in any way they choose. Since there is no legal requirement for them to spend it on the items that you planned, it’s wise to choose your beneficiaries carefully. You can also choose multiple beneficiaries, allowing you to split up the money between family members the way you want. Any requirement for how the money should be spent, such as paying off a mortgage or college tuition for children or grandchildren, should be specified in a will.

What kind of insurance is right for me?

For many people, it’s helpful to review why you need life insurance in order to make the determination between term or permanent life insurance.

State Farm Insurance says that whole life can be an attractive option for any of these reasons:

  • Others are relying on you for long-term financial support.
  • You're worried about outliving a term life policy and being unable to buy further insurance due to age or deteriorating health.
  • You want to build up cash value in addition to protecting your beneficiaries.
  • You want to create an estate for your beneficiaries after your death.
  • Your beneficiaries need the benefit to pay estate taxes when you die.

"Whole life does two things for you: protects your family and allows you to save for the future," says Scott Berlin, senior vice president of the individual life department at New York Life.

Term

Permanent

Want a lower premium

Can afford a higher premium

Want a shorter commitment

Want no expiration date

Won’t have many expenses at the end of the term

Want money left to beneficiaries

Don’t care about building cash value

Want to build cash value

Want a high amount of coverage

Want a relatively conservative investment account

Berlin says whole life's advantages are that you don't have to worry about outliving your policy (as is possible with term life) and there is the "forced savings" component of the cash value account, which grows tax-deferred. Once your cash value is built up, you can access it for anything — retirement, your child's college tuition or the vacation you've always wanted. Whole life policies might be eligible to earn dividends (depending on the company and not guaranteed). These can be used in a variety of ways, such as providing paid-up additional life insurance, which increases both the life insurance benefit and cash value.Equity

"Buying term is like renting your insurance," says Berlin. "You don't build up any residual value. Whole life is like owning a home — you build up equity."

Berlin cautions against buying term life insurance just because it's low-cost life insurance option.

"When you're 35, you think that 20 years is a long time, but life doesn't always work out like you think," he says. "People who buy permanent insurance understand the value of what they're providing to their family."

A whole life policy might be right for you, but what if you’re unable to afford the premiums for the face value you desire? Berlin recommends buying as much whole life as you can afford and filling in the rest of your face amount with term life. Later, you may be able to convert your term life policy to whole life.

For the wealthy with large estates, putting a whole life policy into a trust is a way to avoid paying hefty estate taxes when they die.

How much insurance coverage do I need?

Here are common situations that you can review to help determine your coverage need.

Covering debts and expenses

One strategy is to choose a larger term life policy during higher-debt years (e.g. mortgage, student loans, child expenses) and also purchase a smaller whole life policy, anticipating far fewer debts to pay as you age (e.g. mortgage has been paid off, children are grown)

The next step is to determine your amount of coverage. Insure.com has created a Life Insurance Calculator to help determine a suggested coverage amount.

Here are the major factors that are considered:

  • Funeral costs
  • Outstanding debt
  • College-bound children
  • Income replacement

Leaving money to beneficiaries

If you are not concerned about income replacement for a spouse, then the policy amount may come without any obligation to your beneficiaries. If you have no debts to pay and final funeral expenses have been arranged, then this is a way to leave a tax-free monetary gift to your beneficiaries. The amount of the policy will be simply decided by how much you would like to bequeath. A beneficiary can be a family member, but it does not have to be. It could be a friend or an organization. It’s not uncommon for people to leave their policies to charitable organizations or a college alma mater.

Be sure to clearly name and inform your beneficiary. And if the beneficiary is an organization, notify the person in charge of charitable planning/donations. Keeping the beneficiary a secret can create legal complications that could derail your wishes.

Final expenses

If you won’t have any debts to be paid, and you do not have a need for leaving a gift of money to a beneficiary, a small policy in order to cover your final funeral expenses may be all you need. With just a little thought and effort, you can pre-plan your funeral and final expenses.

Arrangements should be made directly with the funeral home, and the funeral home is made the beneficiary (as allowed in your state). If there are any funds left over, they would be given to your secondary beneficiary.

What is the cost of a whole life policy?

The price of a whole life policy varies greatly depending on your age, health and behavior. Due to the guaranteed payout, the premiums are substantially more than term coverage. However, don’t assume that a policy is out of reach because of cost. Eighty percent of consumers misjudge the cost of term life insurance, according to LIMRA. And the perceived cost prevents over 60 percent of millennial and Gen Xers from purchasing any life insurance at all.

In order to get a closer idea of what the costs could look like, review the whole life insurance sample premium comparison chart from AAA of Southern California.

Whole life insurance

Monthly rates (Standard Non-Nicotine)2

$25,000 coverage

 

$50,000 coverage

Female

Male

Age

Female

Male

$23

$27

30

$38

$47

$26

$31

35

$46

$55

$31

$38

40

$56

$68

$38

$47

45

$69

$83

$46

$59

50

$85

$106

Advice from the experts

James Hunt of the Consumer Federation of America, a life insurance actuary and former insurance commissioner of Vermont, says that because of the high fees associated with whole life, you want to look for ways to maximize your premium dollar within the policy. He suggests these strategies:

  • Decline riders unless absolutely necessary, because they'll eat into your cash value potential.
  • When you look at the policy illustration -- a document that details what could happen with your policy -- make sure your first year's cash surrender value is a significant portion of your first year's premium outlay. (A good number would be 50 percent or higher.)
  • If you are looking at cash-value life insurance to possibly supplement retirement income, Hunt advises that you may be better off buying term life and maximizing other tax-advantaged retirement plans first, such as your 401(k), 403(b), IRA or Roth IRA.

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