How does Whole Life Insurance Work?

Thang Truong
Thang Truong
Updated on:

If you’re considering whole life insurance, you’ll need to know what you’re getting into with this major purchase. There’s a lot of information about whole life insurance out there. However, many whole life policies are surrendered or lapse because people either underestimate the expense or because they realize they would have better off with a term insurance policy. We’ll help you avoid this expensive mistake by answering some common questions about whole life insurance.

What Makes Whole Life Insurance Different?

Given that the point of life insurance policy is to replace your income if you die unexpectedly, why would you want life insurance that lasts forever? Some reasons are:

  • Whole life offers both guaranteed permanent death benefit and guaranteed cash value
  • You have special needs children who are unlikely to achieve financial independence
  • You want to leave your dependents a tax-free nest egg
  • Whole life is a good estate planning tool for wealthy families
  • Whole life insurance forces you to build a savings account
  • If you’re a high-income person who has maxed out all of your retirement accounts

If you’re a person who will fritter away money before you save anything, whole life insurance could help you build a nest egg. It’s also nice to leave your dependents money, so they can have that advantage. 

However, given such benefits, whole life is the most expensive life insurance policy. Is whole life insurance really worth it? Learn more from our case studies.

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Guaranteed vs. Non-Guaranteed Cash Value in Whole Life Insurance Policy

A portion of your premium goes to your cash value account. This is the guaranteed cash value. It usually increases at a fixed rate, generally about 2%. 

There is also a non-guaranteed cash value in the form of dividends. It is on top of guaranteed cash value. So at the minimum, you can always have access to guaranteed cash value of the policy. If the policy performs well, you will have access to non-guaranteed cash value account amount which is more than guaranteed cash value.

Non-guaranteed cash value works differently between mutual and stock life insurance companies.

  • If your whole life insurance policy is from a mutual insurance company, non-guaranteed cash value comes from the dividends. These dividends are not guaranteed, but if you research a company’s history and see that they have paid dividends for the past thirty years, you can assume they will continue to do so. Learn more about Dividend Paying Whole Life Insurance.
  • If you have whole life policy from stock companies, you won’t have dividend. However, if the cash value account in the policy earns a higher interest rates than the guaranteed rate, your cash value will grow more. It is non guaranteed, but in most cases it should be more than the guaranteed interest rate.

For more on whole life insurance cash value, see our article: Whole life insurance cash value: Everything you need to know.

Also see our guide to the Best Whole Life Insurance Companies

Guaranteed and Non-Guaranteed Death Benefit in Whole Life Insurance Policy

The face value of a whole life policy is also guaranteed assuming you keep paying your premiums as agreed in the policy. You are insured for your entire life, and when you die your beneficiaries will be guaranteed to receive a tax-free death benefit, which is at least equal to the face value of the policy.

In addition, as mentioned above, as non-guaranteed cash value grows, death benefit can grow as well. If insurance companies perform better than expected and either pay more dividend or has a higher interest rate for the cash value account, non-guaranteed death benefit may be more than face value of the policy.

What Can You Do with the Dividends on Your Whole Life Insurance Policy?

If you have whole life insurance with a mutual company, you get dividends. Not every whole life policy earns dividends, but if you do, you have some choices regarding what to do with them.

You can:

  • Take a cash payment
  • Add the dividends to the cash value of your policy
  • Use it to pay a portion of the premiums
  • Set up savings with the insurance company to earn additional interest

>>MORE: Understanding How Dividend Paying Whole Life Insurance Works

Does Whole Life Insurance Work Well As An Investment?

Not really. Whole life insurance traditionally offers a moderate rate of return, plus there are fees and inflation that eat into any gains. If you’re really risk averse and have already made the maximum contributions to your 401 (K) and IRA’s, you’re better off to invest the money you would be paying in premiums into mutual funds.

One advantage whole life insurance has over retirement accounts is that you can take a withdrawal, or a loan and you will not have to pay penalties, as is typical in retirement accounts. If you try to withdraw money from your IRA before you’re 59 and a half, there will be at least a 10% penalty, plus you’ll pay taxes on the money. 

However, such an advantage isn’t unique to whole life policy. You have the same benefits, even with more flexibilities, with indexed universal life insurance policy or variable universal life insurance policy. Yet better, these two universal life insurance policies often offer higher growth in cash value account because their growth are tied to the market indexes or other investment assets that you can choose from. In addition, they offer greater flexibilities if you want to increase or decrease to skip premiums and withdraw or take out a loan against the cash value account.

>>MORE: How to Use Life Insurance in Retirement Planning Through a Case Study?

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Who is Whole Life Insurance Good For?

If you have special needs children or other dependents and are worried about their financial futures, whole life insurance might work for you, as long as you can afford the high premiums. 

Lastly, if you are wealthy and need somewhere to park your money before it passes on to your heirs, whole life insurance could work for you.

Lastly and perhaps the most common use of whole life insurance policy is for people, especially seniors in their 70s or 80s and may have health issues, who want to have a small whole life policy of $5,000 to $25,000 for their final expense. This is probably the best use of whole life policy. You won’t be able to find another permanent life policy in this situation. Learn more about whole life insurance for seniors of 70 or 80 years old and whole life insurance for final expenses and no medical exam life insurance.

Are There Better Alternatives than Whole Life Insurance?

  • Buy a term life policy and invest the rest of the money
  • Indexed Universal Life Insurance
  • Variable Universal Life insurance
  • 529 plans (for college savings)

Say you purchase a whole life insurance policy when you’re 30 and you want $1,000,000 in coverage. Policygenius says you can get a 30-year term insurance policy for about $55 a month. You could also get a whole life insurance policy, for the same amount of coverage, for $827 a month. 

In ten years, you’ll have spent about $99,240 in premiums on that whole life policy ($827 x 12 months x 10 years).  If you invest that money in mutual funds, you will probably have more cash than your whole life insurance would have provided. The only difference is, you won’t have life insurance. But you could buy a term policy instead.

You could also purchase Universal Indexed life policy. UL is generally less expensive that whole life insurance, and it also offers cash value. It also has more flexibility in that you can adjust the premiums and the death benefit. On the other hand, if your investments perform poorly, you might not make any money. Indexed Universal life does the same thing, only instead of specific investments, the money you make is set by the performance of the market as a whole. 

If saving for college is a consideration, a 529 plan is a good option. 

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Last Thoughts

Whole life insurance is complex and difficult to understand. It’s probably best to talk to a financial advisor (not an insurance agent) to calculate the best options for you.

Thang Truong

Thang Truong covers small business insurance and small business success at BravoPolicy. He is a licensed P&C insurance agent. Previously, he held product leadership positions at, Capital One, NerdWallet, and Mulberry Technology. He holds a MBA degree from UC Berkeley - Haas School of Business.

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