What is whole life insurance?

Whole life insurance is a type of permanent life insurance, which is one of the two categories of life insurance.

The biggest difference between the categories of permanent life insurance and term life insurance is that term life insurance ends after a set number of years; it offers a death benefit and nothing more. Permanent policies like whole life, on the other hand, cost more because they include an extra savings component, which is referred to as the “cash value.”

How does the life insurance part work?

There are three major parts of a whole life policy:

  1. The death benefit is a tax-free chunk of cash paid out by the life insurance company if you die. For example, let’s say you buy a whole life insurance policy with $500,000 in coverage. That $500,000 is the death benefit.
  2. A beneficiary is the person or people that receive the death benefit. Beneficiaries can be your spouse, your kids, a trust, a business partner, a friend, a non-profit organization and other legal relationships and organizations.
  3. Your premiums are how you pay for your life insurance policy. You usually pay monthly or annually.

Whole life insurance lasts for your whole life — as long as you keep paying the insurance premiums. That means if you buy it when you’re 30 and keep paying your premiums until you die at 85, your family will receive the death benefit.

How does the cash value part work?

When you pay your premium, a certain percentage goes into a tax-deferred savings component, known as the cash value of the policy.

The cash value of your policy earns interest and grows tax-deferred over time, at a rate determined by your individual policy. The growth rate is generally on the low end compared to other investments because life insurance companies have additional expenses (like policy administration expenses, underwriting costs, and death benefit payouts) that a pure asset manager does not.

However, life insurance companies often guarantee a certain amount of growth every year, which is one reason whole life insurance products attracted many people following the 2008 recession.

Here’s where whole life insurance (and permanent life insurance in general) can get confusing:

You can access the cash value of your policy in a few different ways, but each comes with certain risks.

  • You can withdraw money tax-free from the cash value of your policy. However, if you completely surrender your policy or your policy lapses, any money you’ve withdrawn over your basis (that is, the portion of the cash value that’s drawn from your premiums) will be taxed as income.

  • You can take out a low-interest loan. In this case, you’re borrowing against your policy. As with other loans, a cash value loan accrues interest until you pay it back. And if you die before you pay your cash value loan back, the amount you owe (including interest) will be deducted from your death benefit.

  • You can collect the cash value by surrendering your policy. But keep in mind that most of the growth in your cash value happens when you’ve held the policy for two or three decades, so if you surrender within the first ten years, it’s unlikely that your cash value will be greater than the total premiums you have paid. Some life insurance companies also charge a surrender fee, so you should check with your carrier before terminating your policy.

Note that the cash value of your whole life policy is separate from the death benefit. While your beneficiaries are guaranteed to receive the death benefit when you die (provided you’ve paid your premiums), the cash value component can only be utilized while you are living.

This can be confusing to shoppers who believe that in the event of their death, their beneficiaries will receive both the death benefit and the accrued cash value. However, anything that remains of your policy’s cash value when you die will be retained by the insurance company.