What Is Whole Life Insurance and How Does It Work?

Whole life insurance is a type of permanent life insurance. As the name implies, permanent life insurance lasts your entire life. This means that whenever you die, the death benefit of your policy will be paid out to your beneficiary(s). This is different that term life insurance which only covers you for a set period of time such as 10, 15 or 20 years.

Your death benefit is the amount of money that your policy will pay out when you die and your beneficiary(s) are the person(s) who will receive this money when you die. For example, let's say that you bought a whole life policy with a death benefit of $250,000 and made your spouse your beneficiary.

When you pass away, your death benefit of $250,000 would be paid out to your spouse. This death benefit would pass tax free to your beneficiary meaning they would not owe taxes on the $250,000. Whole life insurance also has a few other features.

First, whole life insurance has level premiums. This means that your monthly cost (premium) to pay for the policy remains the same if you maintain the policy. If you are young and healthy, you can lock in a reasonable rate on a whole life insurance policy that will remain the same.

Secondly, whole life insurance offers a cash value component. When you pay your monthly premium to your insurance company each month, that money goes into three buckets. The first bucket goes towards covering the cost of your insurance (death benefit).

The second bucket goes towards covering the costs of fees and administrative expenses that the insurance company charges. The third bucket goes into the cash value component of the policy. Your cash value will earn a fixed rate of return from the insurance company and can be used in a variety of ways. Let us look at how cash value works below.

Your cash value will earn a return that is guaranteed to grow at a fixed rate by your insurer. The portion of your premium that goes into cash value is typically invested in conservative yield investments by your insurer which is how your cash value earns interest.

Your cash value also has the potential to earn higher returns than the guaranteed rate on your policy depending upon how the underlying investments perform. Keep in mind that these above average returns are not guaranteed by the insurer.

It is also important to understand that the cash value portion of your policy is a tax deferred vehicle. This means that you won't owe any taxes on the interest earned within the account as long as the money stays in the account.

Unlike cash that is deposited into a bank account that will show up almost immediately, the cash value portion of a whole life insurance policy takes time to build. The reason for this is that your insurer allocates more of your premium towards the cost of your insurance (death benefit) and administrative fees in the earlier years of your policy.

Over time, more of your premium will go towards cash value and your balance will start to grow. Depending upon how your policy is structured this can take anywhere from 5 to 7 years. However, you might be asking yourself a more pressing question. How can you use the cash value of a whole life insurance policy?

1) Borrow against the cash value - Whole life insurance policies are designed in a way in which you can borrow against the value of your cash value. For example, let's say you have had a whole life insurance policy for the last 10 years and have a cash value of $100,000.

If it makes sense for you to do so, you can borrow against your $100,000 of cash value. It is important to note that we say that you borrow "against" your cash value as whole life insurance loans are collateral loans. When you take out a loan against your cash value, the money does not leave that account.

Instead, the insurance company lends you their money and uses your death benefit as collateral. What does this mean exactly? Let's assume again that you have $100,000 of cash value in your policy and decide to borrow $20,000.

The $20,000 is not subtracted from your cash value. It is instead given to you by the insurance company. So, the entire $100,000 stays in your cash value account as opposed to $20,000 being taken out of the account which would leave you with an account balance of $80,000.

This means that as you borrow $20,000 from the insurance company, your entire $100,000 of cash value stays in your account and continues to earn interest and grow. However, the insurance company will charge you interest on the money they loan you.

They typically charge a slightly higher interest rate on the money you borrow than the interest that you are earning on your cash value. For example, let's say that your $100,000 cash value balance was earning interest at a 3% rate. If you borrow $20,000 you would likely be charged 4% or 5% to borrow that money.

So, what can you use a policy loan for? Anything you want. If you have sufficient funds in your cash value account, your insurance company is obligated to provide you with the funds that you desire. You could use the funds to finance a car, start a business, upgrade your home, etc.

As you have likely gathered, life insurance policy loans are not your typical loan. So, what are the requirements to pay back the loan? Unlike traditional bank loans, whole life insurance policy loans do not have a set schedule to pay the loan back.

For example, let's say that you were going to finance the purchase of a car. If you were to get traditional bank financing, you would be required to repay the loan on a set monthly basis. A life insurance policy loan does not require you to pay back the loan on a set schedule which gives you more flexibility to pay back the loan.

Additionally, whole life insurance policy loans do not necessarily have to be paid back. Remember how we said that life insurance companies issue policy loans and use your death benefit as collateral? This allows your death benefit to cover any outstanding policy loans that you may have.

So, how does this work? Let's say that you bought a whole life insurance policy with a death benefit of $500,000. As you aged, you borrowed from your cash value to supplement your income or finance purchases. When you passed away, you had an outstanding policy loan balance of $200,000 that had accrued from loans and interest.

Your life insurance company would subtract this outstanding loan balance from your death benefit to "pay back" the loan. This means that your $200,000 loan balance would be taken away from your $500,000 death benefit and your beneficiaries would receive a death benefit of $300,000.

Keep in mind that you must be very careful with this concept. If your loan balance becomes greater then your death benefit, the policy can blow up and you can face all sorts of consequences. In general, whole life policy loans can be advantageous when used properly.

However, it is extremely important to understand the complexities of a whole life policy loan so that you do not get yourself in financial trouble. Working with an experienced life insurance agent can help you navigate life insurance policy loans.

2) Withdraw from the cash value - If you would rather pull money directly out of your cash value account as opposed to taking a loan, you are able to do so. A cash value account is a deferred tax vehicle which protects the interest you earn from taxes if you keep the money in the account.

However, as you take a withdraw the money inside is leaving your tax deferred savings vehicle which can trigger taxes. Taxes are typically only applied to the interest that you have earned in the account. For example, let's say that you have held onto a whole life insurance policy for 7 years and have built up $50,000 of cash value.

Let's assume that $40,000 of this came from the premiums that you paid into the policy and $10,000 came from interest you earned within the account. Only the $10,000 would be taxable as that is money that you earned. The rest of your account balance came from premium payments which had already been taxed.

It should also be noted that withdrawing money from your cash value account reduces the amount of death benefit coverage you have by the same amount. For example, let's say that you bought a whole life policy with $500,000 of death benefit and had built up your cash value to $100,000. If you were to take a withdrawal of $25,000 from your cash value, your death benefit payout would be reduced to $475,000.

3) Surrender the policy and take the cash value - It is possible to surrender the policy and take the cash value that you have built up. Essentially, you are deciding to not protect your life anymore and are giving up your death benefit coverage. In exchange, you get to keep your cash value.

If you decide to do this, you might be charged fees or a surrender charge by your insurer depending upon how long you have had the policy for. Additionally, you can owe taxes on any interest that your cash value earned if you surrender the policy.

4) Pay for your insurance costs - If you have sufficient cash value, you can use it to cover the cost of your insurance premiums. For example, let's say that your whole life policy costs you $500 per month. Let's also assume that you have about $20,000 worth of cash value.

If money gets tight from unexpected bills one month, you might be worried about whether you would be able to cover your $500 policy cost. However, since you have enough cash value, you can cover your policy cost from your cash value as you sort out your own personal finances.

Whole life insurance policies may also payout dividends. Life insurance dividends are similar to stock dividends but are officially declared to be a refund of excess premiums paid for tax purposes. When you pay your premium, your insurer will take that money and invest it.

If the investments do well and the insurer keeps costs down, a dividend will be declared and distributed to policy holders. These dividends are considered to be refunds from the insurer for overcharging you. Keep in mind that not all whole life policies pay dividends. Your policy must be a "participating" policy to receive dividends.

If your policy is "non-participating" it will not be eligible for dividends. It is also important to understand that dividends are not guaranteed and the amount you will receive can fluctuate based upon the performance of your insurer. With that being said, the dividends you might receive can be used in a variety of ways.

1) Receive cash payments - Your first option is to receive the dividends in cash. If you opt for this, your insurer will typically send you a check after every policy anniversary. Since the IRS views whole life insurance dividends as a refund of excess premiums, insurance dividends are not taxable when you receive them in cash.

2) Leave with insurer and earn interest - Your second option is to leave the dividends that your insurer distributes to you with your insurer. Your dividends would go into a separate account which would earn interest.

3) Reduce future premium payments - If you want to reduce your premiums, you can the dividends that you receive and apply them to reduce your premiums. Depending upon your dividend, your premiums can be reduced or covered by the dividend completely.

4) Buy additional coverage - Finally, you can use the dividends you receive to buy additional coverage. Your insurer will calculate the additional amount of coverage that your dividend would buy based upon your age. Your dividend will go towards purchasing this amount of coverage and be added onto your policy.  

1) Guaranteed death benefit - Whole life insurance guarantees that your beneficiary(s) will receive a death benefit pay out when you die. It does not matter if you owned the policy for 1 year or 50 years. Keep in mind that there are some instances in which the insurer would not pay out.

For example, your life insurance company may deny coverage if your death happened as a result of you committing a crime or if you were to commit suicide within the first 2 years of owning the policy. Natural and accidental deaths are guaranteed to be covered.  

2) Cash value - The cash value of a whole life insurance policy is a safe place to store your money and provides you with the ability to use your life insurance policy when you are still alive. Your cash value earns a guaranteed interest rate and is a tax-deferred savings vehicle.

3) Policy loans - Whole life insurance allows you to borrow against the value of your cash value and use your death benefit as collateral. Throughout the course of your life you can find yourself in situations in which you need access to capital. The ability to leverage your life insurance policy for capital can be beneficial if used properly.

4) Dividends - Whole life insurance dividends are considered to be a refund of overcharged premium by the IRS. Dividends are an additional benefit of whole life insurance as you can take a cash check, build interest, reduce your cost of future premiums, and buy more coverage with them.  

1) More expensive than term life insurance - Whole life insurance policies are more expensive than term life insurance policies. Reason being is that you have a guaranteed death benefit and will build cash value. For some this extra cost is worth it, and for others it is not.  

2) Slow cash value growth - The cash value in most whole life insurance policies takes time to build. The insurer allocates a higher percentage of your premium towards their fees and the cost of your insurance in the early years of the policy. If you plan to use a whole life policy, it is important to understand that it will take some time to build up your cash value.

The average cost for a whole life insurance policy with a $500,000 death benefit is around $408 per month for a healthy 30 year old female and $472 for a healthy 30 year old male. However, the exact amount of money you will pay will vary. Life insurance companies tend to use the following factors to assess how much a whole life insurance policy will cost for you.

1) Age - The younger you are, the cheaper your premiums tend to be as you are less likely to die. A healthy 20 year old has much longer to live than a healthy 60 year old. If you want a whole life insurance policy, it is best to buy one when you are young to lock in an affordable premium.

2) Gender - Life insurance is cheaper for women than it is for men.

3) Health - Your health plays a huge factor in the price of your life insurance as better health will get you into a better risk class rating. Life insurance companies will look at your height and weight, and any pre-existing medical conditions that you have or previously had. The healthier you are, the less you pay.

4) Family medical history - In addition to your own health, life insurance companies will also look at the medical history of your family. If you have had family members that have died from cancer or heart disease, you could end up paying a higher premium.

5) Smoking/tobacco use - If you smoke, chew tobacco, use a pipe, vape, or use e-cigarettes, you will pay a higher premium for coverage. Life expectancy is 10 years shorter for smokers than it is for non-smokers. Life insurance companies charge more to take on the risk of insuring you if you smoke or use tobacco.

6) Coverage amount - The more coverage you have, the higher your premiums will be. $1 million of coverage will obviously cost more than $500,000 of coverage.

7) Hobbies - Dangerous hobbies can cause the price of your premiums to increase. Any activity than a life insurance company believes will increase your chance of death is more of a risk to them and you will be charged more for coverage. Think of things like scuba diving, car racing, hang gliding, etc.

8) Occupation - If your work increases the chance of death, you will be charged more for coverage. An office job won't affect this, but industries such as construction, roofing, certain types of police work, firefighting and others can cause your premiums to increase.

9) Driving and criminal record - If you have a reckless driving record with DUIs, a suspended license or frequent traffic violations, you are seen as a higher risk and will pay more for coverage. If you have a criminal record, you will pay a higher premium or not be eligible for coverage at all.

In addition to these general factors, the amount you will pay for a whole life insurance policy can also be impacted by a few other factors since it is a permanent life insurance policy.

1) Pay period - Your insurer might offer what is called a "limited pay" option. This can allow you to pay for the cost of your policy over a set number of years or until you reach a certain age. For example, a 10 year or 15 year limited pay whole life insurance policy allows you to pay for the cost of your policy over 10 or 15 years respectively. If you pay over a shorter amount of time, your premiums will be higher.

2) Dividends - You can use your dividends that you receive to help reduce the costs of your premiums if you choose to do so. Keep in mind that your policy must be a participating policy and that dividends are not guaranteed.

Whole life insurance is among the most complex financial products to use and understand so there is no straightforward answer. With that being said, a whole life policy might be right for you if you want a financial product that can do two things.

First, whole life insurance has a guaranteed death benefit. If you want a way to guarantee that your loved ones will be left with a sum of tax free money whole life insurance is a good way to make sure that will happen.

Secondly, whole life insurance builds cash value which you can use in a variety of ways when you are alive. You might have heard some say that "whole life insurance is an investment." This is not exactly the right way to think about it.

You put money in a whole life insurance policy so that you have access to capital when investment opportunities arise or when you need access to capital to fund other financial obligations. For example, let's say that you needed to buy a car, but interest rates were currently at 7%.

If you had a whole life insurance policy, you might be able to take a loan out at 4% and pay your policy back. Many of the individuals who are against whole life insurance will say that you could take the same money that you put into a cash value life insurance policy and invest it into the stock market and earn a higher return.

This is true. However, as previously stated whole life insurance should not be thought of as an investment itself. It should be thought of as a safe place to store capital that you can leverage when investment opportunities prevent themselves.

Whole life insurance is not the end all be all of financial products. If you opt to use a whole life insurance policy it is important that you learn how to use it in tandem with other investments or accounts such as a 401k or Roth IRA.

With all that being said, whole life insurance is a very complex financial product. It is important that you work with an experienced competent insurance agent and/or financial advisor to understand the product to see if it is what is best for you.

1) Know how much coverage you need

The exact amount of coverage that you need will vary. In order to estimate how much coverage you need; you can speak with an experienced life insurance professional or complete a LIFE needs analysis. Each letter of a LIFE needs analysis represents a different area of your life that you could want covered if you were to pass away. Once you have determined how much coverage you need for each letter, you add up the total.

a) Liabilities - You want to list out all of the items that you owe money on that you would want to be covered in the even that you die unexpectedly. This can include a mortgage, auto loans, car loans, credit cards, and others.

b) Income - You want to estimate how many years your family would be dependent upon your income if you were to pass away and add that to your coverage. For example, if you make $100,000 per year and estimate your family would be reliant upon that for 15 years, you would add $1.5 million in coverage.

c) Final expenses - If you pass away unexpectedly, your family will have to cover the final expense associated with that including your funeral and burial costs. You want to estimate what this would cost and add this to your coverage.  

d) Education - If you have children and plan on paying for their education, whether that be college or trade school, you want to estimate these costs and add them into your coverage.

2) Compare quotes

Once you have an idea of your desired coverage amount and policy type you can compare quotes from different life insurance companies. You can get quotes directly from a provider online or via the phone or use third party comparison sites.

Make sure to get quotes from life insurance companies with strong reputations and a history of strong financial performance. Also keep in mind that the prices you receive from quotes can change once you fill out an application.

3) Fill out an application

After you find a quote you like, simply fill out an application. These applications will gather information about your health, family health history, lifestyle, hobbies, occupation and more. Life insurance companies make sure to due their due diligence before issuing policies so expect to answer a lot of questions.

It is also important that you are honest about every question when filling out your application. Life insurance companies use third party sources to verify your application. They will be able to see medical records, prescription drug history, driving records and public records. There is a good chance you will be caught if you lie on your application.

4) Submit your premium to lock in coverage

Once your application is submitted, you can typically submit your first premium to bind coverage during the underwriting process. Underwriting is the process in which life insurance companies review your application before issuing the policy. If for whatever reason you are denied coverage, you will be refunded your premium.

5) Take a medical exam if necessary

During the underwriting process, you may be asked to complete a medical exam in addition to your application. This is standard practice for some companies. The life insurance company will typically send a medical professional to measure your height, weight, and conduct a blood and urine sample. The insurance company pays for this, and you will get a copy of your results.

The bottom line is whole life insurance is a type of permanent life insurance that has a guaranteed death benefit that will be paid out to your beneficiary(s) when you die. In addition to the insurance coverage, whole life insurance allows you to build cash value and you may receive dividends from your insurer if your policy is a participating policy.

Whole life insurance is a complex financial product, but can be part of a well rounded financial plan when understood and used properly. It is important to work with an experienced competent insurance agent if you decide to buy and use a whole life insurance policy.