Written by: Corey Janoff
The term vs. whole life insurance debate is a popular one, especially amongst higher income individuals, such as our physician and dentist clients. Today we will explain what is the difference between term and whole life insurance, how term life insurance works, how whole life insurance works, discuss other cash value life insurance alternatives to whole life, and identify scenarios where each type could be appropriate.
What is the Difference Between Term and Whole Life Insurance?
There are two main categories of life insurance: temporary and permanent.
Temporary life insurance is called term life insurance. It lasts for a defined term (number of years or age). If you pass away during that time span, your beneficiaries will receive the death benefit amount you signed up for.
With term insurance, the risk to the insurance company is if you will pass away. Odds are, you will outlive the term period. Therefore, it is rather inexpensive to purchase a policy, assuming you get approved for a policy at a favorable health rate.
All life insurance requires medical underwriting. Life insurance companies prefer to insure somewhat healthy people, who likely aren’t going to die anytime soon. The life insurance companies want to make sure they’re not teeing themselves up to pay out a large death claim on a new policyholder. Sure, there’s the rare freak accident, or person who is diagnosed with a terminal illness shortly after purchasing a policy. Most people though, who are in decent health today, will continue to remain in decent health for the foreseeable future.
Use your age and health to your advantage and lock in a policy when you are young and healthy. It’s easier to get when you are younger and healthier, and less expensive when you are younger and healthier. Rarely do people get younger and healthier over time.
Permanent life insurance is a policy that can last your entire life (hence the name, “whole life”). Because of this, the risk to the insurance company is when you will pass away. How many years of premiums can they collect from you before that day comes?
Whole life insurance is one of a handful of types of permanent life insurance (Universal life insurance, variable life insurance, adjustable life insurance, indexed life insurance, combinations of these, etc.).
In addition to providing a death benefit to your beneficiaries when you pass away, some permanent life insurance policies also can accumulate cash value within the policy that you can potentially withdraw or borrow against.
The main difference between term and whole life insurance is the duration – term life insurance is temporary, whole life insurance is permanent (until you die or let the policy lapse).
How Does Term Life Insurance Work?
As mentioned a few paragraphs ago, term life insurance lasts for a specified number of years. Once that time period is up, the policy goes away.
For example, you may purchase a life insurance policy with a 20-year level premium term period. You pay a flat rate for 20 years, or until you cancel the coverage, whichever is sooner. If you pass away while the policy is in force, your beneficiary will receive the death benefit amount you signed up for, tax-free (there could be applicable estate taxes on the total value of the decedent’s estate, but the life insurance check will be sent directly to the beneficiary, with no taxes owed by the beneficiary).
After the 20 years in this example, many life insurance companies will allow you to keep the term coverage in force, but at a significantly higher premium (and it will get exponentially more expensive each year). Due to the significantly higher cost, most people cancel the coverage at this point, or convert it to a permanent policy, if the insurance company allows for conversions.
Term life insurance is like most other insurances in the sense that you buy it hoping you will never need it and it will be a waste of money. You get it just in case. For those unlucky individuals who do end up cashing in on their term life insurance, you and your family will thank your lucky stars that you had the foresight to purchase a term life insurance policy.
Term life insurance is akin to renting life insurance coverage. Most people don’t need their life insurance to last forever. Once the kids are out of the house, the mortgage is paid off, and you’ve achieved financial independence, one could argue that you have enough money saved up, so if you pass away, nobody will be faced with a financial hardship.
Because term life insurance doesn’t last forever, it is the least expensive form of life insurance. Only around 1% of term life insurance policies result in a death claim, according to a 1993 Penn State University study (I know, a little outdated, but it was one I kept seeing referenced online). Most people either outlive the term length, or cancel their policy before the term is up, likely because they no longer need the protection.
How Does Whole Life Insurance Work?
Modern day whole life insurance policies can be designed in a number of ways. The primary objective though is life insurance protection guaranteed to last your entire life.
Almost every whole life insurance contract has a minimum guaranteed death benefit that will pay out to your beneficiaries when you pass away. As long as you pay your premiums each year, the coverage will stay in force and pay a death claim when you die.
The only risk is the insurance company going out of business. And even then, there are stopgaps in place to provide protection for policyholders. Each state has a backup reserve fund in place for that possibility. Other companies could buy out a struggling insurance company. In 2008, who did the government bail out? Not the big banks, but a big insurance company. We can’t bank on that happening again in the future, of course, so it’s wise to get a policy from a financially stable company, preferably with a long history.
Many whole life insurance policies also have more optimistic outcomes that are greater than the minimum guaranteed death benefit. Policies can be designed to gradually increase in value if things go well over time.
Whole life insurance policies can also accumulate cash value within the policy – sometimes guaranteed. This can be advantageous for people to create a supplemental savings vehicle.
We won’t get into the specific components and inner workings of whole life insurance policies today – that would be an entire post in itself. For today’s purpose, know that whole life insurance provides guaranteed insurance protection for life.
Cash Value Life Insurance
Whole life insurance is often the blanket term for all permanent life insurance policies. It’s easy to remember and makes sense (life insurance for your whole life, lasts as long as you do). However, there are numerous iterations of permanent life insurance policies, some designed for greater cash accumulation potential than whole life insurance.
Whole life insurance is all about the guarantees. Guaranteed death benefit. Guaranteed cash value at various stages.
Those guarantees are expensive. In order to provide those guarantees, the insurance company needs to charge more than they cost, and/or invest the incoming premiums to receive a greater rate of return (with high certainty) than the guarantees they are offering policyholders.
As a result, the growth of the cash value in whole life insurance policies is less than exciting.
If you are looking for a life insurance policy that is potentially better at accumulating cash value, it’s typically best to avoid the guarantees and take on some risk. That reduces the internal costs of the policy, therefore giving you more potential for investment growth, albeit not guaranteed.
For example, a variable life insurance policy allows you to invest your cash value into sub-accounts (mutual funds, more-or-less) of stocks & bonds. If they increase in value, your cash value grows. If they decrease in value, your cash value shrinks and you could be at risk of seeing the policy lapse, unless you pay a higher premium to keep it in force. You ride the wave of the market, like you do with your other investments.
Another option is an Indexed Universal Life (IUL) insurance policy that enables you to tie your cash value to a stock market index, such as the S&P 500. The insurance company uses some of your premiums to buy stock options contracts on the S&P 500, in this example. If the S&P 500 increases in value, they cash in the options and credit your account. If the S&P 500 goes down, they let the options expire and you get no credit that period.
IUL’s are nice in that the cash value within your life insurance policy will increase if the stock market goes up, but won’t decrease due to market performance. The worst it can do is stay flat. There are costs of insurance that could eat away at the cash value, but it can’t go down due to market performance.
IUL’s, however, typically lack the guarantees that whole life insurance contracts offer. As a result, if things don’t go well, or if they’re not utilized correctly, you may be required to increase premiums in later years to keep the life insurance in force.
Any time you are considering life insurance for the cash value accumulation aspect, proceed slowly. Ask a lot of questions. For most people, it’s not appropriate. In order for a life insurance policy to be a worthwhile “investment,” you need to structure the policy so you are contributing a significantly higher premium than the actual cost of insurance (so the excess can get invested) and you really have to stick with it for about 15-20 years, or more.
If structured and utilized correctly and for the right reasons, it can be a nice compliment to your other investments and possibly be tax-favorable for your circumstances, as the cash value grows tax-deferred within the policy and you can borrow against the cash value tax-free.
Is Whole Life Insurance Worth It?
If you scour the internet and read the blogs, you’ll mostly find negative opinions on whole life insurance (and permanent life insurance in general). I have to agree that whole life insurance is inappropriate for most people.
Whole life insurance is expensive. Unless you have a high income, it is difficult to secure an adequate amount of death benefit for an affordable cost. For the majority of Americans, it simply isn’t practical.
However, there are scenarios where it is very appropriate. There is a reason it exists as a product and has for hundreds of years. Some people want their life insurance to last for their whole life.
You may want to have a whole life policy to provide a guaranteed death benefit and influx of cash for your heirs when you eventually pass away. It will provide them a safety net. It creates liquidity so your heirs don’t have to sell off investments or other assets to cover expenses or pay off debts.
It can be used a tool to cover anticipated estate taxes. If you are worth over a certain amount, the government taxes you when you die! Depending on the state you live in, you could owe state taxes when you die as well.
Some people prefer to pass their assets onto their heirs, rather than a tax bill. Whole life insurance can be a great tool to cover that expected estate tax bill, so your heirs can inherit your assets tax free.
If you are intentional with how you use a whole life insurance policy, and have purchased it for a specific purpose, then it can be well worth it. If utilized correctly, it can be looked at as purchasing money at a discount. The catch is, you have to die to get the money, so it’s really for your beneficiaries, not you.
Hypothetically, say you purchase a policy with a $1 million death benefit and a $20,000 annual premium. We’ll assume the policy is designed so it’s guaranteed to increase in value over time. After 40 years you pass away, and the death benefit at that time is $1.7M. You have paid $800,000 over that time and your beneficiaries received $1.7M. Not too shabby.
Sure, over 40 years in a more traditional investment, that $20k/year would likely grow to a sum larger than $1.7M, but it’s not guaranteed to. A whole life policy can have those guarantees built in.
Risk is free. Guarantees cost money. But to some people who hate risk, the guaranteed option is well worth it.
What is the difference between term and whole life insurance? Term is temporary, whole life can last indefinitely. As long as you keep paying the premiums on a whole life insurance policy, the coverage will stay in force and your beneficiaries will receive a check when you die.
How does term life insurance work? You sign up for a policy that lasts a finite number of years (maybe 20 or 30 years). There is a defined age or number of years when the policy expires. As long as you pay your premiums, if you die before the policy expiration date, your beneficiaries will receive the money when you pass away.
How does whole life insurance work? Whole life is designed to last your entire life and can have guaranteed death benefits and even cash accumulation built into the life insurance policy contract. While it is considerably more expensive than term life insurance, it can be appropriate if you are looking for coverage to last your whole life.
Term vs. whole life insurance: which one is right for you? Maybe it’s a combination of the two.
- Physician Life Insurance
- How Much Life Insurance Do I Need?
- How Much Money Does A Doctor Need to Retire?
- Kiddie Policies
- The Importance of Life Insurance
- Financial Clarity for Doctors podcast: Estate Planning Essentials
- Financial Clarity for Doctors podcast: Permanent Life Insurance – The Thing We Love to Hate
- Financial Clarity for Doctors podcast: Life Insurance Considerations for Doctors
Consult with an estate planning attorney to understand estate laws in your state. Consult with a tax professional to understand the specific tax implications for your circumstances. Investments involve the risk of loss, including total loss of principal.