Except for undertakers and teenagers with all-black wardrobes, death isn't a subject most people like to think about. Unfortunately it's one of life's few certainties, so life insurance is a vital part of any properly thought-out financial plan. Term life policies are a cost-effective way to protect your loved ones, but in some circumstances whole life policies can also be advantageous. To know whether they're right for you, it's important to understand how they work.
The Philosophical Difference
The purpose of any life insurance policy is to pay a lump sum, called the "death benefit," if you should pass away while the policy is in force. Term policies will pay out this money, but you never own it. With a whole life policy, the death benefit is treated as a tangible asset that you buy over a period of time. This is a fundamental philosophical difference you'll need to bear in mind. With a whole life policy, you eventually own a sizeable quantity of cash, yours to use as necessary. The question is whether your circumstances make it worth the cost.
Cost of Premiums
Term life policies are in force for a limited number of years, and charge a premium based on the likelihood of your dying during that time. The younger and healthier you are, the cheaper it is. Whole life policies remain in force for your entire lifetime, as long as you make the payments, and must account for your total life expectancy. They're much more costly when you're young, but cheaper when you're older. Just as with your mortgage, most of the monthly payment goes to cover costs in the early years. After roughly 20 years, the policy's costs are paid and equity builds rapidly. This makes whole life a long-term purchase.
Your insurer deducts its costs from the monthly premium, and then puts the rest into its internal investment portfolio. This pool of funds must cover the company's insurance obligations and is invested conservatively to minimize risk. That means your investment grows more slowly than it would in more conventional investments, hence the financial adviser's mantra of buying term coverage and investing the savings yourself. However, investment growth within a whole life policy is tax-sheltered, so if you've maxed out your IRA or 401(k), whole life can be a useful option.
Every policy names a beneficiary, a person or organization -- or even pet -- you designate to receive the policy's benefits when you die. With term insurance, that's the face value of the policy. With whole life it's the face value plus the cash values accumulated by the policy's investment component. These funds are paid soon after death by the insurance company, tax-free and without going through probate. This provides your beneficiary with funds to clear up your estate and cover funeral costs, and can also be a useful wealth-preservation measure.
It's important to remember that whole life policies are a long-term product. They build equity slowly, and it will typically take 15 to 20 years until a policy contains enough cash to be useful. During the early years, when your insurer is using the premiums to cover its costs, you'll pay heavy penalties for cashing out or surrendering your policy. If you close a policy and withdraw cash from it, those funds become taxable income during that year. If you're experiencing temporary financial hardship, it's often better to leave the policy in place and ask your insurer to take its premiums from your cash values until you're able to resume making monthly payments.
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