Whole life insurance: How it works, explained simply

Life is full of uncertainty. While you can't prepare for everything that may happen, you can plan for how your loved ones would replace your income and pay your final expenses when you're gone. One solution is whole life insurance.

On top of paying out a death benefit, whole life insurance accumulates cash value that you can tap into while you're alive to help with a major expense—such as a home purchase, funding a child's college education or needing supplemental retirement income.

Whole life insurance is a form of permanent life insurance that is guaranteed to last your entire lifetime, as long as you pay the premiums. Your premiums are guaranteed to remain the same for the life of the contract, which means you don't have to worry about your costs increasing as you get older or if your health worsens.

With whole life insurance, part of your premium guarantees that you will build cash value that you can tap into during your lifetime. Your cash value will equal your death benefit when the contract matures (typically age 121).

Whole life insurance can be used as a tool to:

• Pay an income tax-free death benefit to your family when you die.¹ This money can be used for final arrangements, medical bills not covered by health insurance or other final expenses.
• Help replace the income you provided while living. Debts such as a mortgage, credit card balances or health expenses can be covered.
• Leave a tax-efficient legacy to your heirs or favorite charitable causes using its income tax advantages.
• Pay estate costs: Most contract types can be an efficient estate preservation tool when the death benefit is used to pay estate and inheritance taxes, probate costs and more.
• Provide funds for withdrawals or loans of the cash value for income in retirement, which also can help create generational wealth and more.

In addition, many whole life contracts are eligible to receive dividends, which can be used in multiple ways, including as a reinvestment in your contract. However, dividends are not guaranteed.

You can think of whole life insurance as a dual-function financial solution—it's a safety net and a way to help you build wealth over time.

Any earnings from the guaranteed cash value in your whole life insurance contract will grow tax-deferred. It's one way to achieve some tax diversification—a mix of tax now, tax later and tax never assets—depending on the other components of your financial plan.

You can withdraw or borrow your cash value in your lifetime to use for any purpose.^2,3,4 In some cases, it's less costly than getting a bank loan or cashing out an investment in the market. One of the most common ways people use cash value is as a backup source of funds in case of a sudden large cost. It also may be a smart resource for paying college expenses or supplementing your income in retirement if you no longer need the full amount of the death benefit.

Any unspent cash value when you pass away typically is forfeited to the insurance company unless you have a contract provision or rider that makes it part of the death benefit.

As the balance in your whole life contract grows, you typically can access the cash value in one of several ways:

• Make a withdrawal. This may be a good option if you face a large expense and need extra cash to minimize debt.
• Take out a loan. When you take out a life insurance loan, you're essentially borrowing money from yourself. You typically pay interest on the loan that goes back to your cash value, as well as a small amount that goes to the insurer.
• Pay premiums. You may be able to use your cash balance to pay the life insurance premiums. This gives you a way to keep your contract active if you experience a job loss or other strain on your budget.
• Surrender your life insurance. You can choose to surrender your contract and receive a lump-sum payout. Keep in mind that your coverage no longer will be in effect if you do this. Some companies also assess charges if you surrender within the first few years.

Note that any cash you take from your life insurance—including any loan amounts you don't repay—can reduce your death benefit, leading to a smaller payout for your loved ones when you die.^2,3,4

Whole life insurance offers a range of potential benefits, including guaranteed lifetime coverage, stable premiums and the ability to build cash value. Here's a closer look at six of the key features this popular life insurance product has to offer:

As a provider for your family, you put the financial well-being of your loved ones first. Whole life insurance can help you achieve that goal, giving your beneficiaries—whether that's a spouse, child, aging parent or someone else—a tax-free death benefit. When you're gone, the life insurance money can help them manage everyday expenses, pay off a mortgage or other loan, cover your funeral costs or go toward anything else they may need.

With a whole life insurance policy, your premiums never increase. As long as they are paid, the policy will remain active, even if your health worsens later in life. And the younger and healthier you are when you purchase a whole life insurance policy, the better those lifetime rates will be.

Whole life insurance allows you to build cash value that you can use during your lifetime. Cash value interest or earnings is guaranteed to accumulate on a income tax-deferred basis even if interest rates change or markets decline. Plus, you can withdraw your money tax-free, up to the total amount of the premiums you've paid into your contract.^2,3,4

The longer you have your life insurance, the more your cash value may grow. In addition to funding that cash balance with your premium payments, the insurer credits your account based on prevailing interest rates. In time, you could use your life insurance cash value to support things like a family wedding, a home renovation, or day-to-day needs if you lose your job.

Whole life insurance can be a valuable estate planning tool. Since your death benefit is generally income tax–free¹, it can be used to cover the estate taxes of other assets you’ve left to loved ones or to equalize inheritances across multiple beneficiaries. This helps to preserve and create generational wealth.

Read more about creating generational wealth

Whole life insurance often earns dividends, or money an insurance company distributes to eligible contract holders based on company performance. Not every insurer or contract offers dividends. You can receive dividends in cash or use them to pay premiums, purchase additional insurance, add to your contract's cash value or minimize loan payments borrowed against the contract.

Learn more about Thrivent's dividend performance

You can tailor your whole life insurance contract based on your unique financial situation. In addition to choosing the amount of your death benefit, you may be able to select different payment lengths. You also can purchase riders that ensure you have the coverage you need when you need it.

The living benefits of life insurance

The primary purpose of life insurance is death benefit protection, but there are other ways permanent insurance can be used. The lifetime death benefit and cash value provide a number of opportunities to help with your financial plan.

See 7 ways to use life insurance

There's no such thing as a one-size-fits-all solution to life insurance needs. While whole life offers a range of potential benefits, it also potentially has three drawbacks compared to other life insurance products.

When you first purchase a whole life contract, your premiums can be significantly higher than a term contract with the same death benefit. While whole life can be a good long-term solution if you can afford the payments, it may not be the best solution for more budget-conscious families. If you can't pay your premiums and you don't have enough cash value to cover them, your contract could lapse. In this case, term insurance may be a better option for you.

While your whole life insurance policy offers cash value accumulation, the growth rate may be lower than other traditional investments like stocks, bonds, mutual funds and real estate. For individuals with a disciplined savings and investment approach, a whole life insurance policy may represent an opportunity cost.

If you surrender your contract early, you may only receive a portion of the premiums you've paid. Before canceling your policy, make sure to read the contract carefully so you understand the potential consequences.

Whole life insurance can benefit anyone looking for lifetime coverage and cash value, but it can be a particularly good option for families, business partners or children.

Because the contract is active as long as you pay the premiums, whole life insurance may be a good fit for families seeking coverage that lasts longer than term life insurance. It also can serve as a wealth-building asset for investors—either those seeking insulation from market volatility or others who simply want a lower-risk asset to balance out their traditional investment accounts. Whole life insurance also can benefit families who want to transfer wealth to the next generation.

Whole life insurance for couples can help cover lost income, debts, final expenses and maintain the quality of life you want for your children. It also can help you leave behind the legacy you intend for the people or causes you care about.

Whole life insurance isn't solely for families. If you own a small business, a whole life contract can insure you or other key employees who are vital to the organization's long-term success. When you die, the payout from company-owned whole life insurance can help your team keep the business running while they decide what to do going forward.

You may decide to purchase whole life insurance for your children at a young age to take advantage of attractive pricing. Because whole life has level premiums, you'll be paying the same low premiums years from now. In addition, those who have pre-existing conditions or get sick may find it more challenging to get coverage later in life. So, a juvenile whole life policy can ensure your child will have some form of life insurance regardless of their health in the future.

Whole life insurance purchased by seniors (typically those who are retired or are about to retire) allows you to pay predictable premiums throughout your retirement years while growing the cash value of the contract. Over that time, you can use your whole life insurance in a variety of ways—as a source of cash emergency funds, as a part of your long-term care plan, or to pay for final expenses with a death benefit.

Suppose you purchased a whole life insurance policy that, by age 50, has accumulated $150,000 in cash value based on guaranteed and non-guaranteed (i.e., dividend) returns.

If you were to lose your job and have to search for other work, you may not have the ability to pay all your bills—especially if you don't have other assets you can easily tap into. The whole life policy you own offers potential solutions.

For example, you can take a withdrawal or a contract loan up to the $150,000 balance in your contract. Or you can use the cash value and dividends to cover your future premiums, freeing up your cash flow.

Let's say you decide to take a $25,000 loan from your contract to help pay your bills, including a mortgage and car payments. When you take out the loan, your cash balance—and the death benefit available for your beneficiary—both will be reduced by $25,000. However, if you repay the entire loan, that $25,000 will be added back to the death benefit of the contract.

You don't have to pay back the loans on a whole life contract. But you will accrue interest charges that can decrease your cash value over time. If those fees eventually exceed your remaining cash balance, your contract could lapse. When taking out a loan, you can ask the insurer for a contract illustration that projects your cash value based on whether or not you plan to repay the amount.

The cost of whole life insurance depends on how much life insurance you need. The more coverage you take out, the more your premiums will be.

Several personal factors affect how much you'll pay. These include:

• Age. The younger you are when you buy your contract, the more affordable your premiums will be.
• Gender. Women live longer than men on average, which means they typically pay premiums for a longer time. Because of this, women pay slightly less than men of the same age and health status.
• Health. If you're in good health, you'll likely pay less than someone with high risk factors, including smoking, weight issues and chronic conditions like high blood pressure.
• Income. Higher income earners and those with consistent employment generally receive lower premiums.
• Hobbies. You'll generally pay more if you have dangerous hobbies, such as skydiving or mountain climbing, or if you work in a high-risk occupation.

Premiums for whole life insurance can be several times higher than term life insurance at the outset. However, the difference in cost allows you to receive guaranteed lifetime coverage and cash value—features you don't receive from term coverage. In the long run, it may be less expensive to buy a whole life contract that you don't have to renew.

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How much life insurance do you need? Enter your current assets, expenses and income. You also can adjust the inflation rate and your expected rate of return to see how these variables could impact your insurance needs.

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There's a basic rule to life insurance: Generally, the younger you are when you buy it, the less expensive it will be. In the case of whole life insurance, an early start also allows you to start building cash value that you can rely on for unexpected costs or a sudden loss of income.

When you get married or have children, it's usually an opportune time to buy a life insurance contract. It can give you confidence your loved ones will be financially protected no matter what life has in store. However, you don't have to wait until you have dependents to get coverage.

You're also never too old to buy whole life insurance. Even when your children are grown, getting whole life coverage can be a smart way to care for the people you love. Your family may not need the same amount of income replacement they once did, but they still may need a source of funds to pay for final expenses or outstanding bills when you die. By tailoring your coverage to your needs as an older adult, it's still possible to get valuable coverage you can afford.

For whole life insurance to stay in force, you have to pay premiums. While many people opt to spread out the payments over a lifetime, you may find it more beneficial for your situation to break it into even payments across a specific time period or even pay it all at once. Here are three ways to pay premiums for whole life insurance:

With this common payment method, the insurer offers a fixed schedule for your premiums where you submit them monthly, quarterly, twice a year or annually. This allows you to spread the cost of the insurance over a lifetime with the drawback that if you miss a payment, you risk your coverage lapsing. Because the payments are incremental, your cash value also may have less growth potential.

Some insurers offer limited payment life insurance. In this arrangement, your premiums are completely paid up after a certain period of time (such as 10, 15 or 20 years) or when you reach a certain age (often 70). Once you hit that milestone, your premiums stop, but your coverage remains active for the rest of your life.

One of the benefits of a limited payment schedule is that your cash value grows at a faster rate than it would in a standard whole life contract. But because you're not paying into the contract for as long, the premiums are higher than contracts where you make lifetime payments.

Single premium whole life insurance allows you to pay for your life insurance contract all at once and right away, giving you immediate full coverage. Paying a single premium isn't affordable for a lot of people, but it has the advantage of giving your cash value the most growth potential since you're funding it all upfront.

One thing to consider is that all life insurance policies of this type are automatically classified as modified endowment contracts (MECs), which occur any time you've cumulatively funded a life insurance contract across the first seven years with an amount that's more than the cost of the whole contract divided by seven. The main effect of this is that it changes the taxability of loans and withdrawals from your cash value, as money taken out will count as coming out of your earnings first rather than from your paid-in contributions, making it subject to ordinary income tax.⁴

Most contracts allow you to purchase optional add-on features, or riders, that give you and the people you love extra protection. These riders can help provide the financial freedom you need during life's inevitable changes. Among the more common whole life insurance riders are:

• Waiver of premium. Should you become disabled, the waiver of premium rider eliminates the requirement to pay your contract's premiums. Your coverage will remain in force, ensuring your loved ones still are protected.

• Accelerated death benefits. If you're diagnosed with a terminal illness, you may be able to access some or all of your death benefit while you're still alive. An accidental death benefits rider can help you hire caregivers and pay for ongoing medical bills that might otherwise create a financial challenge.

• Guaranteed insurability. A guaranteed insurability rider gives you the right to purchase additional coverage at certain dates without having to undergo additional medical underwriting. The premium you pay on the new coverage amount is based on your age and health status when you first bought the contract. Depending on the insurer, these riders may be restricted to younger policyholders—for example, those ages 0 to 17.

• Paid-up additions. This optional benefit allows you to buy additional coverage for your contract. These paid-up additions accumulate their own cash value, which you can access through loans or by surrendering them.

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For information on this rating, visit www.forbes.com/lists/best-insurance-firms/

Whole life insurance has a few variations to consider, depending on your needs: joint, survivorship and juvenile.

A joint life insurance policy insures two lives—typically, spouses or business partners—under one policy and pays one death benefit. In the case of "first-to-die" joint life insurance, the insurer pays a benefit after the death of the first insured. People often choose this when it's most important to have the death benefit available to help the remaining person temporarily cover income lost. It's also usually cheaper than buying two policies that pay out the same death benefit.

Survivorship whole life, also called "second-to-die" life insurance, similarly insures two lives with one premium. Instead of paying one death benefit after the first person dies, it pays one death benefit after both people die. These premiums also can be lower than two individual policies, which could help you get more coverage for your money.

Whole life insurance for children, also called juvenile life insurance, is purchased for a child younger than 18. It offers a death benefit that parents can use for expenses if the child dies while living at home, but most people use it to establish permanent coverage for their child early so they can carry it into adulthood. This can be a wise move because life insurance rates typically increase with age and as potential health issues arise. Locking in premiums while young and healthy can help ensure long-term affordable coverage.

Safeguarding the people in your life isn't just about buying enough life insurance—it also requires getting the right type of coverage for their needs and yours. Here's a quick look at how whole life contracts compare to three other popular types of life insurance:

Unlike permanent life insurance, including whole life, term contracts are only in force for a specific period of time—typically 10 to 30 years. Term coverage is sometimes referred to as "pure" life insurance because while it provides a death benefit to your loved ones, it doesn't have a savings component.

These contracts are usually considerably cheaper than whole life when you first buy coverage, making them a popular choice for budget-minded consumers. However, your premiums likely will go up if your contract expires and you want to buy a new term contract.

Universal life insurance is a form of permanent coverage that allows you to build cash value, just like whole life. But with universal life, you have the ability to vary your premium payments. You also can adjust the face amount of your contract. However, increasing your coverage usually will require proof that you qualify for the new amount.

Cash value from universal life contracts typically earns a fixed rate of interest that changes over time with shifts in market conditions. Most contracts guarantee a minimum interest rate that your cash value will earn even if market rates drop.

Universal life may be appealing if you're uncertain about your future income or just want the flexibility to adjust your coverage as your financial picture evolves.

With variable universal life insurance, the death benefit and cash value depend on the performance of one or more investment subaccounts—similar to mutual funds—that you select. Some contracts limit your investment return when your investments do particularly well and limit your loss in down years. As with traditional universal life contracts, you can adjust your premiums and coverage amount as your needs change.

In the long run, variable universal life contracts offer greater growth potential than whole life, but there's also a possibility your death benefit and cash value could go down in a given year. Because these products are more complicated than whole life, you should understand the potential advantages and drawbacks when choosing a variable insurance contract.

Explore blended life insurance

Blended term life insurance acts like a combination of term and whole life insurance. It can offer financial flexibility between what you need now and what you may want later in a single contract.

Learn about this mix of coverage

The decision to buy permanent life insurance or term coverage depends on the specific needs of your family or business. Because whole life is a form of permanent insurance, not term, you can expect the premiums to be higher than what you might pay for term coverage. But with the benefits it offers, it can be a valuable part of your financial plan.