Whole life insurance: What is it & how does it work?

What is whole life insurance?

Whole life insurance is a type of permanent life insurance that provides coverage for an individual's entire life. Like all life insurance products, whole life pays a tax-free death benefit to the insured's beneficiaries upon their death. It also has a cash value that can accumulate value over time.

How does whole life insurance work?

With whole life insurance policies, the policyholder pays a premium, usually monthly or yearly, in exchange for permanent life insurance coverage. As long as they continue to pay premiums and keep their policy active, they'll have coverage for their whole life and their beneficiaries will receive a death benefit when they die. 

Typically, a portion of the premium goes toward the cost of maintaining the insurance policy and the rest goes toward a cash value account, which gains interest. How the cash value grows depends on the type of whole life insurance policy the insured has.

Death benefit

The death benefit amount, also called the coverage amount, is the money that goes to the policyholder

beneficiaries when you die. The death benefit is essentially how much coverage you purchase, for instance, $250,000 or $500,000. The minimum amount of traditional whole life you can buy is typically around $50,000, but it depends on the company. Certain policy types, like guaranteed issue whole life, can offer as little as $2,000 in coverage.

When looking at whole life insurance quotes, the higher the death benefit is, the higher the premium will be.

Cash value

The cash value of a whole life policy builds interest over time – and offers a guaranteed rate of return that grows at a fixed rate. Unlike a death benefit, the policyholder can access their cash value while they're still alive. 

How the cash value grows and how they can use it depend on the type of whole life insurance policy they have. With traditional whole life insurance policies, the interest rate is set by the insurer. With other types of whole life, the cash value can be invested into mutual funds or tied to a specific market index.

What are the benefits of whole life insurance?

Whole life insurance lasts an insured's whole life, so they don’t have to worry about their coverage expiring. This can be especially helpful if they have a need for coverage that will last longer than 30 years, the maximum length of many term policies.

The policy also earns interest through the cash value, which can make it another tax-deferred investment option if the insured already maxes out their other retirement accounts.

What are the disadvantages of whole life insurance?

Whole life is five to 15 times more expensive than term life insurance. If an insured takes out a whole life policy and then finds they can’t afford to keep it, they risk leaving their family without protection. With whole life, penalties can apply if they cancel coverage (there is no penalty to cancel term life insurance). As an investment vehicle, one disadvantage of whole life is that other investment options offer higher rates of return.

How long does the insured pay for whole life insurance?

For most whole life insurance policies, the insured will pay premiums for the rest of their life. There are some policies — called 10 Pay or 20 Pay — that have a payment plan that is structured so that the insured only pays for 10 or 20 years, but those premiums will be much higher. Other policies can be structured so they’re fully paid up at a specific age, like 65. 

What happens with an insured's whole life insurance policy when they die?

After the insured dies, their beneficiaries will file a claim with the insurance company so they can get the death benefit. Most commonly, they’ll receive a lump-sum of money tax-free, but it’s possible to set up alternative payment plans, too.

With whole life insurance specifically, it’s important to note that if the insured happens to have a loan against their cash value at that time, their death benefit will be reduced by the amount of the outstanding loan, so their beneficiaries will receive less than they would otherwise.

What are the options for surrendering whole life insurance?

Surrendering your life insurance means that the insured effectively cancels the policy and will no longer have coverage. In this case, they'd receive the surrender value, which consists of their cash value minus any surrender fees charged by the insurance company.

Since it can take years for cash value to build up, they'd likely want to check with their insurance agent if they need to surrender the policy in the first 10 years, since they may need to pay fees.

Questions or want to learn more?

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