Many people who purchase whole life insurance often do it because of its cash value component, which can act as an investment tool. Unlike term life insurance, which offers financial coverage in case of death, whole life insurance offers both financial coverage and a cash value component, the latter of which has several advantages.
Here we’ll discuss the concept of whole life insurance as an investment, the advantages and disadvantages, and whether it’s worthwhile or not.
Remember, life insurance is one of the most significant purchases you can make in your adult life, so it’s important to be informed and make the right decision!
What Kind of Life Insurance Can Act as an Investment?
Permanent life insurance is usually touted as the type of life insurance that can act as an investment, but permanent is a broad category that contains several types. The main definition of permanent life insurance is that it comes with a cash value component and lasts your entire lifetime (as opposed to term, which is only valid for a certain stretch of time, known as a “term” (i.e. 10, 20, or 30 years).
Whole and universal are the two main types of permanent life insurance. Both whole and universal include a death benefit and cash value component, but the latter is more flexible and your earnings are connected to market performance. Whole tends to be the more popular choice because it’s more straightforward, but any type of permanent life insurance can act as an investment.
Defining Whole Life Insurance
Since whole life insurance is the more simple and popular type of permanent life insurance, it’s often the first choice of those who are looking at life insurance as an investment.
The basic way it works is similar to any life insurance policy: You pay consistent premiums to an insurance company, and in return, the insurer commits to paying a predetermined death benefit to your beneficiaries should you die.
With term life insurance, the explanation would stop there. But whole life insurance also includes a cash value component. So the monthly premiums you pay are, first of all, much higher than those you would pay for term (more on that below). Secondly, the premiums you pay are generally divided three ways: a portion goes toward your death benefit, another portion toward your cash-value account (an investment component), and yet another toward administration fees.
This setup means that every time you make a premium payment, your cash value grows. However, it usually takes about 10 years before you can accumulate a significant amount. Once you get to a certain amount, you can use the funds in the account to pay your life insurance premiums, take out a policy loan, supplement your retirement income, or in other ways.
Features of whole life insurance include:
- A death benefit
- Guaranteed cash value accumulation
- Administration fees
- No expiration date
- Fixed premiums
- Guaranteed rate of return
- Tax-deferred growth
As long as you pay your monthly premiums, your policy will be valid. If you stop paying your premiums, you run the risk of your policy lapsing. If that happens, your beneficiaries will not be able to claim the death benefit upon your death.
Benefits of Using Whole Life Insurance as an Investment
Whole life insurance isn’t your typical investment, but that doesn’t mean you can’t benefit from it — if you know how to do it. In fact, there are many benefits of using whole life insurance as an investment.
Option to borrow against the cash value (also known as a policy loan)
Once the cash value of your account accumulates, you can borrow against it. Borrowing against your cash value is easier than taking out a regular loan because you don’t need to undergo a credit check or explain why you need the money. Moreover, when you borrow against your cash value, the money isn’t recognized by the IRS as income and is therefore tax-free. (Though you will still need to pay back the loan plus interest in a timely manner, but interest rates are typically lower than other types of loans).
This particular benefit makes it preferable over a 401(k) or other retirement plans, which can penalize you for withdrawing the funds ahead of time.
Tax-deferred and guaranteed growth
You don’t need to pay taxes on interest, dividends, or capital gains on the cash value component of your policy. The growth is also guaranteed, unlike a universal life insurance policy, in which the growth is tied to market conditions, and there is a chance that if the market performs badly, your earnings will suffer.
Taking dividends as cash
Many whole life insurance policies pay dividends, cash that insurance companies pay to policyholders when the companies earn excess profits after their projected operating costs and claims have been covered. Dividends are usually calculated annually, and you have several options of what to do with them. You can:
- Receive them as cash
- Deposit them in a side account that earns guaranteed interest based on the market
- Receive them as Paid-Up Additions, which means they are reinvested back into the policy. Essentially, this grows your death benefit and your cash-value account at a compounded rate
- Use them to pay your life insurance premiums
Can be used in estate/retirement planning
Many wealthy people use whole life insurance as a tool in their estate planning. In most cases, the death benefit of life insurance isn’t taxable, so it can be used as a way to avoid certain taxes and pass on a tax-free inheritance. Whole life insurance can also be used to supplement retirement income during your lifetime (in addition to standard retirement plans).
Some whole life insurance policies offer accelerated benefits, which allow you to withdraw between 25% to 100% of your death benefit before you die. This is an important benefit because it provides the option for financial assistance during your lifetime in case you have a serious health issue and require extra medical assistance and care.
Disadvantages of Using Whole Life Insurance as an Investment
If there were only benefits of using whole life insurance as an investment, then everyone would do it! But as with most financial tools, there are also some disadvantages, and it’s important to be aware of them before making a decision.
Some of the disadvantages of using whole life insurance as an investment include:
The high cost of monthly premiums
Whole life insurance is expensive, significantly more so than term. In a study conducted by Forbes, a 30-year non-smoking male would pay 5.8 times more for a $500,000 whole life policy than for a 40-year term policy. A non-smoking female would pay approximately 6.7 times more.
But whole life insurance isn’t only more expensive than term — it may also be more expensive than other investments vehicles. (See more below).
Whole life insurance is complicated, and if you aren’t financially savvy or don’t have a good insurance advisor, you won’t be able to maximize its potential. Other types of investments can be more straightforward.
Some benefits can be received through other investments
Due to the high cost of whole life insurance and the complexity, it shouldn’t necessarily be your first investment option, especially for retirement savings. CNN Money‘s Financial Advisors recommend focusing on 401(k)s and IRAs before whole life insurance due to the high investment and administration fees of the latter. In fact, whole life insurance is usually recommended as a retirement investment only if you’ve maxed out your contributions to your 401(k) and IRA.
Is Whole Life Insurance Worth It?
Whole life insurance can be worthwhile for certain people in certain financial and personal situations. It’s definitely not the right choice for everyone, but can be a valuable financial tool for people who fit certain criteria. In many cases, these are wealthy people or those who fall into high tax brackets.
So the question of being worth it is highly personal. If your financial and personal situations are such that you’ve maxed out your retirement plans or need an effective estate planning tool, whole life insurance can certainly be a good option.
When to Invest in Whole Life Insurance
For most people, the best time to buy any type of life insurance is at a young age. The reason for this is simple: age plays a significant role in determining the cost of life insurance. The younger you are, the lower your premiums. Therefore, whether purchasing term or whole life insurance, you’ll get a better rate if you purchase at a young age.
With whole life insurance in particular, the cash value component is crucial in getting the most out of the policy. This means it’s especially important to buy it at a young age, since you need to give the policy time to accumulate a significant cash value that you’ll eventually be able to use for a policy loan, to pay premiums, or for other purposes.
For example, if you purchase a policy at age 25, by age 35 and up you should have accumulated enough cash value to take out a significant loan to buy a house, pay for children’s college tuition, supplement retirement income, and more.
Of course, you can still buy whole life insurance at an older age, but you’ll need to be aware that the longer you have the policy in place, the more valuable it will be.