Some life insurance products like whole life insurance also double up as an investment tool. This is where things can become more complex.
But, don’t worry, we’ll demystify whole life insurance for you and help you get past all the confusing technical mumbo-jumbo, so that you can answer the only question that really counts — is whole life insurance worth it for me?
So, let’s dive right in.
How does whole life insurance work?
Whole life insurance has a dual purpose. It pays out a death benefit to your loved ones when you pass away and also builds cash value. Whole life insurance covers you for your entire life, assuming you pay monthly premiums on time. So, you can rest easy knowing your beneficiaries will get the payout they need.
Your policy’s cash value, however, is meant for you — not your beneficiaries. If you don’t use it while you’re still alive, it’ll be lost.
A part of your whole life premium goes toward covering the cost of insurance and fees. Another part funds an investment account inside your whole life policy. This investment component is called the cash value.
The cash value grows at a guaranteed rate set by the insurer. You can withdraw from or borrow against it and are free to use the funds however you like. The cash value withdrawals are not taxable up to the current sum of your policy. That means you won’t have to pay tax as long as the withdrawal amount doesn’t exceed the premium amount paid into the policy.
The cash value grows slowly at first but picks up pace over time. That’s because, for the first several years of your policy, a major portion of your premium goes toward funding death benefits and covering fees. For this reason, buying whole life insurance for investment purposes doesn’t make sense if you’re older. You’re not likely to live long enough to enjoy good returns.
Is whole life insurance considered a good investment?
The simple answer is: it depends on your situation and financial goals.
If you want a life insurance policy to secure your family’s wellbeing, a term life insurance policy coverage may be a better option. It’s affordable and provides coverage for a set number of years. The money you save on insurance premiums by signing up for term life insurance can be invested according to your risk tolerance.
Generally speaking, a whole life insurance policy is five to ten times costlier than a comparable term life policy. Even though you can access some of the premium you have paid, term life insurance is likely to offer you a better bang for your buck.
The rate of return for whole life insurance policies is lower than other traditional investment vehicles, and its fees much higher. For this reason, using such a policy as your primary investment vehicle is not a smart move. However, if you’re a high-net-worth individual and have maxed out other investment options, whole life insurance could make sense for you.
How can I access my whole life insurance policy’s investment gains?
Your beneficiaries don’t get to enjoy the fruits of your whole life insurance policy’s investment component. Instead, you must use the cash value while you’re still alive. Any remaining cash value at the time of your death will go back to the life insurance company itself.
You can access the policy’s investment gains by:
- Making a withdrawal
You can withdraw your cash value anytime. If the withdrawal amount is less than your contribution so far to the investment component of the policy, you won’t have to pay tax. However, if it is more than that, you’ll have to pay tax. Also, remember that a cash withdrawal chips away at the death benefit, and the insurer may charge a withdrawal fee.
- Taking out a loan
You can tap into the policy’s cash value by taking a loan against it. Insurers offer cash-value loans at interest rates lower than a bank.
Needless to say, you don’t need to pay the loan back because that is essentially your money. However, any outstanding balance (the loan amount, plus the interest) will get deducted from the death benefit if you pass away.
- Paying life insurance premiums
Once you have built up enough cash value, you can use it to cover premium payments.
- Surrendering the policy for its cash value
Surrendering a permanent life insurance policy is the same thing as cancelling it. When you surrender the policy, the insurer will pay you the cash surrender value, which equals the policy’s cash value, minus any outstanding loans or premiums and fees.
Should you buy whole life insurance or term life insurance?
Term life insurance is as basic and as affordable as it comes. In exchange for a set premium, the insurer covers you for a set period. If you die within the policy term, your beneficiaries receive the payout. If you outlive the term, nobody gets anything and your coverage expires. The monthly premiums can be as low as the cost of an extra-large pizza.
A whole life insurance policy, by contrast, lasts your entire life and builds cash value. As a tradeoff, premiums are significantly higher than those for a comparable term life policy.
Now coming back to the question of which one you should buy, the answer is: It depends on your financial goals and budget.
If you want to keep the cost of your life insurance as low as possible but still want to buy adequate coverage, term life insurance might be right for you.
It could also make sense when you know for how long you require the protection offered by life insurance. For instance, if you need a financial safety net until you retire or your children finish college, you can take a term life policy for that many years.
Lastly, term life insurance is a good option to cover your debts as well. Let’s say, you have a $2 million mortgage that you need to pay off in 20 years. If something were to happen to you during this time, your family would have to pay off the loan or risk losing the house. One way to secure your house is by buying a 20-year term life policy with a payout of $2 million.
A whole life insurance policy, on the other hand, maybe a better option if you have lifelong dependents. It may also be a good choice for a high-net-worth individual looking for an additional investment vehicle.
Buying whole life insurance vs universal life insurance
Here’re the key differences between them:
Universal life insurance offers more flexibility
Whole life insurance policies have a level premium and death benefit. By contrast, universal life insurance allows you to raise or lower the premium and the death benefit as per your needs.
Universal life insurance cash value doesn’t grow at a guaranteed rate
In the case of a whole life insurance policy, the cash value grows at a guaranteed rate set by the insurer. Also, you don’t get a say in how the cash value is invested.
However, the cash value of universal life insurance doesn’t grow at a steady rate. Plus, you can pick investment options according to your risk tolerance. If you invest wisely, there’s potential for bigger gains. But if things don’t go as planned, you can also lose money quickly.
Universal life insurance is more complex
Managing the cash value component of a universal life insurance policy requires both knowledge and time. If you are lacking in either, universal life insurance may not be for you.
To sum it up, if you are confident about your ability to invest money smartly and want the flexibility to adjust the premium and death benefit, universal life insurance could be a good option. Otherwise, consider buying a whole life policy.
Pros of whole life insurance
Whole life insurance provides an insurance cover that lasts as long as you do, assuming you pay the premiums. Ceaseless coverage can be reassuring for someone with a lifelong dependent or looking to cover the cost of their funeral.
Whole life insurance also includes an investment account that grows on a tax-deferred basis. This money can fund your retirement or come in handy when money is tight. The cash value feature can be appealing for very-high-income individuals who have maxed out other investment options.
Cons of whole life insurance
Without question, the biggest drawback is cost. As a general rule, expect a whole life insurance policy to cost five to ten times more than a term life insurance policy with the same death benefit amount.
While whole life insurance offers some tax advantages and in a way forces you to save money, you’re likely to get a better deal outside of insurance. Compared to other investment vehicles, whole life policies charge higher investment fees and have lower rates of growth. Getting coverage with a smaller insurance company (vs. a larger insurance company) can also save you some money.
Is whole life insurance worth it for you?
Whole life insurance isn’t for everyone. Its high cost can put off many life insurance buyers, while the low rate of return may not be a good fit for people looking for aggressive investment vehicles.
However, if you are a very-high-income individual and want to avoid taxes while accessing the policy’s cash value, it could be a good fit for your financial plan.
Whole life insurance may also make sense for people with lifelong dependents. Unlike a term life insurance policy, it pays the death benefit to your beneficiaries, regardless of when you pass away.
Lastly, it may be a good option for people who find it hard to save money. The investing component of a whole life insurance policy acts as “forced savings” once you sign up for it.
Whole life insurance is the closest thing to a fill-it-forget-it life insurance product. Once you sign up for a policy, you can rest easy knowing your loved ones will get the payout. It also doubles up as an investment tool.
But its high cost and low return rate make it an unsuitable option for most. Unless you have a lifelong dependent or are a very-high-income individual who has maxed out other investment vehicles, you’ll likely be better off with a term life insurance policy.