There is a lot of misinformation and half truths out there when it comes to comparing whole life against term life insurance. We want to set the record straight. There are benefits and downsides to both kinds of life insurance and the “best” kind for you could be either type, it all depends on your personal situation.
What many people don’t realize is that while both types of policies provide insurance against the financial harm associated with death, term and whole life are really fundamentally different products. with different purposes. It behooves any buyer to understand why one would choose term or whole life so that the right policy is chosen. It may seem confusing at first, but we want to make it as simple as possible. Here are the risks, benefits, and other considerations when it comes to choosing between the two.
Length of Insurance Coverage
This is the most obvious difference between the two types of life insurance. A term policy only provides coverage for a specified “term” hence the name. Options for policy length are numerous but the most popular durations of term insurance are 5, 10, 15, 20, 25, and year policy lengths. Another type of term policy is “till age -“, the age is different for different providers but is typically about 80 years old today which means regardless of your current age, the policy will be in force until you reach the specified age.
A whole life insurance policy on the other hand is meant to provide coverage for your entire life regardless of how long you live. As long as you make your scheduled premium payment the insurance company is bound by the terms of the contract to keep your policy in force forever. They can’t cancel the policy on you even if your health changes or if you live to be over 100, it doesn’t matter the coverage is yours.
That doesn’t mean that you can’t cancel either policy type. A term policy can be cancelled (or you can just stop making payments), and a whole life policy can be surrendered for the cash value. Keep in mind that during the early years of the contract a whole life policy may have surrender charges so be mindful of the schedule for those.
You can apply for and be approved for the same death benefit whether it is term or whole life insurance that you use for coverage. The minimum policy size is typically the same or very similar, and whatever the maximum that you qualify for (yes compliance does put a cap on your policy based on your financial situation) is the same with either type of insurance.
Whole life insurance does give the policy owner the option of using dividend payments to purchase additional paid up insurance, so hypothetically a whole life policy can have an increasing death benefit over time if this dividend option is chosen.
The death benefit can be paid to a beneficiary of the owner’s choosing with either policy type, and is generally paid out tax free. Claims are paid in the same time frame, they have to be paid quickly by law. If a life insurance claim is paid out, it doesn’t really matter if the policy was a term or whole life contract, the death benefit is equal to the face value of the contract. The only adjustments can happen if there is a loan outstanding on a whole life policy or partial surrenders were made, or additional insurance was purchased. Riders can also increase the death benefit in certain circumstances for either policy type.
Here is where we start getting into slightly more nuanced differences of the two types of insurance. A term policy has no cash value. It is a rather straightforward contract that specifies insurance coverage of the face amount of the policy in exchange for scheduled premium payments. If you fail to pay the premium the policy will go into a short grace period, and then the coverage will be cancelled if no payment is made.
A whole life policy is a bit more complex, because in addition to providing the face amount of coverage, the policy also builds cash value. The cash value is yours, and can be withdrawn, taken as a loan, or used to pay premiums. The cash value can actually become quite substantial, and the policy is in fact designed so that your cash value will eventually become equivalent to the face amount of the policy! Typically this is occurs around age 95 or 100, and at this point the policy is deemed to be “mature”, and the face amount can be paid out. This isn’t always ideal since some people may prefer their beneficiaries to receive the death claim tax free rather than being passed down through the estate.
If you withdraw your tax value through a partial surrender or a loan, you can use the money for anything. People often pay student debt, use the money for a down payment on a home or vacation home, or fund a vacation. Loans do not necessarily need to be paid back, but they do accumulate interest at a low rate, and the death benefit will typically be reduced by the amount of the outstanding loan.
Tax Free Earnings
Whole life insurance is considered to be investment grade insurance. It will actually produce a positive return after a few policy years (in other words your cash value will be greater than the money you’ve paid into the policy). The real advantage of these gains is the tax treatment that these earnings enjoy from the IRS. There are ways to access the money made on a whole life insurance policy tax free, and the earnings grow tax deferred in the policy cash value.
If the policy is surrendered or withdrawals are taken, only cash value made in excess of the premiums paid (minus any dividend payments paid out) is considered taxable. However, life insurance withdrawals are on a first in first out (FIFO) basis, so partial withdrawals are tax free until you’ve withdrawn more than you’ve paid (check out this great resource to learn more about the FIFO accounting method). In addition, loans are not taxable unless the policy is later surrendered with the outstanding loan. So if you take earnings out of the policy through loans and withdrawals up to the amount of premium paid, you have tax free earnings and you still have your life insurance.
For both term and whole life, the death benefit is tax free to the beneficiary in most instances.
Whole Life Pays Dividends, Term Does Not
Dividends are another difference between the two types of life insurance. Whole life insurance pays the owners an annual dividend payment, but term life insurance does not give owners the right to dividend payouts. As a purchaser of whole life, some people are entitled to dividends because they are considered to be part owners in the case of a mutual company, or dividends are paid by life insurance companies with other equity structures so that the product is competitive. Either way, the dividend is useful to you.
It may sound trivial, but the value of the dividend payments can become quite substantial over time. Dividends can be used to pay premiums, they can be used to purchase more paid up insurance (increasing dividends even more in future years), or they can be taken and used by the policy owner however they want as a cash payout.
A life insurance company takes in a certain amount of cash every year, they then have to pay their employees and fund their operating expenses, pay out all their death claims, and fund their reserves for future claims. The surplus that is left over after all these obligations are funded is paid out as the dividend.
Because life insurance companies have massive reserves which are invested in fixed income products, they actually make a substantial amount of money from their bond holdings each year. As interest rates change, so does their rate of return on these holdings. Typically higher interest rate environments lend themselves to the life insurance company paying higher dividends, all else being equal. The dividend rate is projected on the life insurance illustration, but the actual rate is announced each year before it is paid out and is never known for sure. While life insurance companies are not legally obligated to pay dividends, most large well respected companies have not failed to pay dividends in over 100 years including through the great depression. Always ask about the dividend payout history before you purchase a policy if you are not familiar with the company.
Price is a major consideration when anyone buys insurance, and there is a big price discrepancy between these two types of life insurance. Term life insurance is much less expensive than whole life, but for good reason.
As outlined above, whole life insurance comes with many additional benefits and features compared to term, over the long run. In fact, they are priced very differently because they are very different products. It isn’t the most intuitive concept to wrap your mind around, but bear with us while we try to explain why these are fundamentally completely different types of life insurance.
Term is very simple and straightforward. The insurance company knows your age and health, and the length of time that you are buying protection for. They understand that X percentage of people will cancel their policy every year, and they know that everyone at a certain age, grouped by risk class, has a certain odds of dying every year. Term life is a very statistically informed bet by the insurance company that with a large enough group of clients, enough people will either outlive or cancel their policy before dying so that the insurance company overall makes money, even if they need to pay out a low percentage of claims. Policy owners are expected to outlive the expiration of term coverage to put it simply.
Whole life insurance is different because the insurance company is banking on the fact that they eventually will need to pay out a death claim because the policy never really expires (maturity date aside). While they do account for a certain amount of people cancelling their policies every year, fundamentally the product is priced so that even if no one cancels, the company will still be able to make money. How do they do this? They are holding your cash, but they aren’t holding the money in cash, they are investing it. Usually most of the life insurance companies cash and reserves are held in a conservative portfolio of treasury securities, but they still earn a certain interest rate. Even though they eventually will need to pay out a death benefit, in the meantime they made money on the cash that you paid in.
Adding a bit more complexity, many life insurance companies are organized as mutual companies. This means that the company is owned by the clients, the policy owners. This entitles them to a portion of the company profits, paid out as a dividend payment. However, only whole life policy owners are usually considered to be owners. Some life insurance companies are not organized as mutual companies, but still pay dividends so that their whole life product is competitive with mutual companies. Owners of term usually do not receive any kind of dividend. Dividend payments are typically large enough that whole life owners actually can expect to have a positive rate of return on their life insurance during the life of the owner, meaning after a certain amount of time the cash value of the policy will be larger than the amount of money paid in.
So to summarize, term is inexpensive because it expires before the vast majority of insureds are expected to have a death claim, and it is a simple product with no cash value or dividend payments. Whole life policies are expected to eventually require a death claim because they last the entire life of the insured person, they accrue cash value, and they pay out dividends. Whole life policies actually give a positive rate of return to the owner during the life of the insured person. This makes whole life require a significantly higher premium payment than term, but the structures of the products are completely different.
Riders and Other Policy Features
The riders available on term and whole life are generally very similar but there can be differences. The most popular riders such as waiver of premium, accidental death and dismemberment, and accelerated death benefit rider are generally available on both policy types.
Some riders are specific to whole life, such as the guaranteed insurability rider (which allows you to purchase more life insurance without underwriting), and the disability income rider (which actually pays you in addition to waiving premiums if you are disabled). Typically a disability income rider has an age when it stops, such as 65.
Specific to term, the term conversion rider allows you to turn a term policy into a whole life policy. This rider may automatically come with the purchase of a term policy, or it may be available at time of issue for an additional premium charge. This is a more valuable rider than you may think.
The biggest incentive to convert your term policy to whole life happens if you think that your health has declined enough so that you can not purchase additional term insurance after your policy expires. This is called negative selection for the insurance company. If during your ownership of term you become worried about your health and you think you may need life insurance coverage longer, this gives you the option of turning your term policy into lifelong coverage without new underwriting.
A term conversion may be available before a certain policy year, during a certain range of policy years, or after a given policy year. Make sure that you understand the rules of your conversion rider when you purchase your policy because it may be a very useful rider to you.
What About Buy Term and Invest the Difference?
A common refrain among pop financial pundits is to “buy term and invest the difference“. This means that instead of buying a whole life policy, people are better off purchasing term life insurance and investing the difference between the cost of term and whole life into the stock market. The thinking goes that after a long enough period of time, this investment will add up to a higher value than the cash value on a whole life policy, and over a really long time will grow to be larger than the death benefit. This is not necessarily wrong, but here are some considerations.
The stock market is volatile. While it might be true that historically if you invested your money this way you would realize a higher rate of return than purchasing whole life, the investor needs to actually stomach the downturns in the market and keep the money invested. Studies have proven time and time again that most people are not capable of keeping their money invested well and make very poor timing decisions, leading to extremely low or negative returns in stocks. People tend to buy high and sell low.
The cash value of whole life policy is not volatile, it accumulates cash value year after year after year, and only goes up in value as long as there are no withdrawals or loans taken by the owner. Whole life insurance has also consistently performed at a higher rate of return than highly rated bonds, but it historically has been an extremely secure investment just like a highly rated fixed income product.
Some people also need whole life insurance because it passes down money tax free to the beneficiary. It allows money to bypass estate taxes, no matter how large the policy is.
Some people also need coverage their entire lives. Keep in mind that for the “buy term invest the difference” to accrue enough money in an investment account to equal the face amount of a policy, it will take many years. It only really works if you are purchasing a 20 to 30 year term policy in other words, otherwise there may be a gap in financial protection.
So Which Kind of Insurance is Best?
As you may be able to tell, there is not a one size fits all solution when it comes to life insurance. Whole life certainly has its place for the right buyer, as does term. If you need inexpensive protection for 20 years, say while your children are growing up, term is probably right for you. If you are interested in whole life insurance either as a source of protection for your entire life, the investment aspect of the product, or both, whole life may be the product for you.
If you need more information or have questions, please feel free to reach out to our experts at Life Ant.