Whole life insurance: What it is and how it works

Whole life insurance is a type of permanent life insurance that offers lifelong coverage, combining a death benefit with a cash value component. Unlike term life insurance, which provides protection for a specific period, whole life insurance remains in force for your entire life as long as premiums are paid. This makes it a popular choice for those seeking guaranteed lifetime coverage and the ability to build financial value over time.

One of the defining features of whole life insurance is its cash value, which grows at a fixed rate and accumulates on a tax-deferred basis. This means that the cash value can serve as a financial resource that policyholders can borrow against or withdraw from, providing additional flexibility beyond the standard death benefit. Many people use whole life insurance not just for the security of lifelong coverage, but also as a tool for long-term financial planning, such as supplementing retirement income or funding large expenses.

Understanding how whole life insurance works and how it can fit into your financial strategy is essential before making a decision. This type of policy offers stability and guarantees, but it also comes with higher premiums compared to term life insurance. By weighing the benefits and potential drawbacks, you can determine whether whole life insurance aligns with your long-term financial goals and protection needs.

How the cash value of whole life insurance works 

The cash value of whole life insurance is a unique feature that sets it apart from term life insurance. As you pay your premiums, a portion of each payment goes towards building cash value, which grows at a guaranteed rate set by the insurance company. This growth is tax-deferred, meaning you won’t owe taxes on the accumulated amount as long as it remains within the policy. Over time, this cash value can become a significant financial asset, providing a source of funds that can be accessed through loans or withdrawals.

Policyholders can borrow against the cash value of their whole life insurance policy, using it as collateral for a loan with generally low interest rates. This can be a valuable resource for covering unexpected expenses, supplementing retirement income, or funding other financial needs. However, it’s important to note that borrowing from the cash value reduces the death benefit if the loan isn’t repaid, and any outstanding balance, plus interest, will be deducted from the payout to your beneficiaries.

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 for your entire life, term life insurance provides coverage for a specified period of time, such as 10-, 20- or 30-years. This is because term life insurance is designed to offer financial protection during key years when your beneficiaries would need it most, such as when paying off a mortgage or supporting children until they become financially independent. Term policies are generally no frills and typically have lower premiums, making them an affordable option for those seeking straightforward protection without the long-term commitment.

In contrast, whole life insurance offers lifelong coverage as long as premiums are paid. It not only provides a guaranteed death benefit but also includes a cash value component that grows over time. This cash value can be borrowed against or withdrawn, offering a financial resource for policyholders while they’re still alive. However, the comprehensive benefits and lifelong protection of whole life insurance come with higher premiums compared to term life. Choosing between the two depends on your financial goals, budget, and whether you want a policy that only offers temporary coverage or one that also serves as a long-term financial asset.

What does whole life insurance cover?

The death benefit of whole life insurance is a guaranteed payout to your beneficiaries when you pass away, providing financial support during a difficult time. This lump sum payment can be used to cover a variety of expenses, including funeral and burial costs, which can quickly add up. It also helps pay off outstanding debts, such as mortgages, car loans, or credit card balances, ensuring that your loved ones are not left with financial burdens.

Beyond immediate expenses, the death benefit can also be used to support long-term financial goals. For example, it can provide income replacement for your family, helping them maintain their standard of living. It can also fund future needs like a child’s education or serve as an inheritance to help secure your family’s financial future. The versatility of the death benefit makes whole life insurance a valuable tool for protecting your loved ones from financial hardship.

It’s important to remember that beneficiaries have the freedom to use the death benefit however they see fit. Since there’s no legal obligation for them to spend it according to your wishes, it’s essential to select your beneficiaries thoughtfully.

Types of whole life insurance

There are many types of whole life insurance, and the policy you should get depends on your life insurance needs: 

• Burial insurance: Offers low coverage amounts with relatively high premiums, designed to cover final expenses such as funeral costs and outstanding medical bills.
• Ordinary whole life insurance: Provides level premiums for life and builds cash value over time. While the initial cost is higher compared to term life insurance for the same coverage amount, it offers lifelong protection and savings growth.
• Limited payment whole life insurance: Allows you to pay premiums for a specific period, such as 20 years or until age 65, while maintaining lifetime coverage. Premiums are higher than spreading payments over a lifetime, but the policy is paid up after the chosen period.
• Single premium whole life insurance: Requires a single, substantial upfront payment, after which the policy is fully paid and remains in force for your entire life.
• Modified premium whole life insurance: Features lower premiums in the initial years, with a moderate cash value component that grows over time. Premiums increase later, but the policy still builds cash value that can be accessed tax-free.
• Survivorship life insurance: Also known as second-to-die life insurance, this policy covers two individuals, typically spouses, and pays out only after both have passed away. It’s a cost-effective option for providing for beneficiaries while avoiding the expense of separate policies.

Who should get whole life insurance?

For many people, term life insurance is the better option. It’s more affordable and does what it’s supposed to — protects your beneficiaries from financial hardship if you die. By the time your beneficiaries are financially independent, the policy expires. 

Whole life insurance, on the other hand, is more expensive — but it also lasts your entire life and provides a cash value. People who need this type of permanent life insurance usually have very specific needs that validate the high cost. This includes people with lifelong dependents and individuals with a high net worth who want to use life insurance as a wealth management tool or to pay estate taxes. 

You may consider whole life insurance for the following reasons:

• You plan to provide long-term financial support.
• You want to build up cash value as an additional retirement fund.
• You want to create an estate for your beneficiaries after your death.
• Your beneficiaries need the benefit to pay estate taxes when you die.
• You have a large estate and putting a whole life policy into a trust will protect your beneficiaries from paying hefty estate taxes when they die.

“Buying term is like renting your insurance,” says Scott Berlin, senior vice president at New York Life. “You don’t build up any residual value. Whole life is like owning a home — you build up equity.”

Given the complexity of whole life insurance and its suitability for specific financial profiles, it’s advisable to work with a financial advisor when purchasing a policy.

How much does a whole life insurance policy cost?

The exact cost of whole life insurance depends on several factors, including your age, health, coverage amount, and the specific features of the policy. Because it lasts your entire life and has a cash value component, it costs significantly more than term life insurance. 

How to make the most of your whole life insurance policy

James Hunt of the Consumer Federation of America, a retired 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:

• Avoid 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% 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.

Is whole life insurance worth it?

Whole life insurance is a good option for people with specific life insurance needs, such as coverage for a lifelong dependent or an additional estate planning tool. But for most people, term life insurance will be the better choice because of its affordability and simplicity. Usually, traditional investment accounts, such as 401(k), will also yield higher returns.

If your financial needs are complicated, talk to a certified financial planner (CFP) to figure out what strategy is best for you. When you’re ready to shop for coverage, check out our guide to the best life insurance companies. 

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