Definition
Whole life insurance is called permanent protection, meaning the coverage (and possibly the premiums) lasts for your entire (whole) life, as long as the premiums are paid. The death benefit is a guaranteed amount, and your premium is fixed. When you pay the premiums on a whole life policy, part of the money accumulates in a cash value account. Guarantees are based on the claims-paying ability of the issuing insurance company.
Prerequisites
You have a long-term need for insurance
You want insurance protection coupled with a cash value component
Key Strengths
Premiums are fixed
Policy pays minimum guaranteed death benefit (unpaid policy loans may reduce the death benefit below the guaranteed minimum)
Cash values grow tax deferred at guaranteed rate (cash values are held in the general account of the insurer and are subject to claims by creditors if the insurer faces insolvency)
Cash values are accessible during lifetime
Key Tradeoffs
Policy surrender in early years of policy can be costly
Because insurance company controls investment of cash value, you don't get the potential for higher returns that accompanies other types of investments
Guarantees are subject to the claims-paying ability of the issuing insurance company
Variations from State to State
No federal regulatory agency--insurance companies are regulated in each state by the department of insurance (or its local equivalent)
State laws govern ability of creditors to access cash values
How Is It Implemented?
Policy application may require physical exam
Can be difficult to compare policy features and benefits
Tax issues relating to policy loans and surrenders can be complex
Whole Life
What is it?
Permanent (cash value) life insurance
Whole life insurance is called permanent protection, meaning the coverage (and possibly the premiums) lasts for your entire (whole) life, as long as the premiums are paid. The death benefit is a guaranteed amount, and your premium is fixed. When you pay the premiums on a whole life policy, part of the money accumulates in a cash value account.
When can it be used?
You have a long-range insurance need
The purpose of whole life insurance is to protect against long-range or permanent needs. The coverage extends over your entire lifetime (generally up to age 95 or 100), protecting you even after you stop working. You can lock in a premium schedule, so you won't have to worry about the rising cost of insurance as you get older or your health deteriorates.
Strengths
Provides benefits common to all cash value insurance
Like all other permanent (cash value) policies, a whole life policy contains the following features:
Cash value grows tax deferred
Cash value can be borrowed against (however, unpaid policy loans will reduce the death benefit available to your survivors)
Caution: With a whole life insurance policy, you may be allowed to access your cash value by surrendering (canceling) the policy (you may be subject to surrender charges). However, once you cancel the policy, you will no longer have insurance protection. See Tradeoffs for more information.
Policy provides guaranteed minimum death benefit
Your whole life policy provides a minimum death benefit, which is usually equal to the face amount of the policy. This death benefit is guaranteed as long as you pay your premiums when due and your policy remains in force. See Tax Considerations for more information.
Caution: Unpaid policy loans will reduce your death benefit below the guaranteed minimum. See Tradeoffs.
Policy cash value receives guaranteed rate and predictable growth
With a whole life insurance policy, the insurance company manages your cash value and guarantees the return you will receive. The cash value that is part of your whole life policy is held in the general account of the insurance company. Even if the insurance company's investments perform poorly, you still receive the same rate of interest on your cash value. However, you should keep in mind that if the insurer faces insolvency, funds in the general account could be subject to claims by creditors of the insurer, including all other policyholders.
Your premiums are a fixed amount
When you buy a whole life policy, your premium payments are a set, level amount, making budgeting for your payments easy because the premium can't be increased. Even if the insurance company's general account (through which death benefits are paid) performs poorly or your health declines, you can never be required to pay a higher premium to maintain the guaranteed minimum death benefit.
Tip: If your policy pays dividends, you may choose to have the dividends applied toward your premium payment, reducing your out-of-pocket expense.
Choice of premium payment periods available
While whole life insurance coverage lasts your entire lifetime, your premium payments don't necessarily have to. Whole life insurance may offer a variety of premium payment options. For instance, if you want to pay a smaller premium over your lifetime, you may want to consider ordinary level premium whole life. Or, if you want to pay larger premiums for a shorter amount of time, you may want to consider limited pay whole life.
Can be cost-effective form of permanent insurance protection
If you expect your insurance need to last your entire life without diminishing, a whole life policy can be a cost-effective way to buy insurance protection. In the short term, whole life (or any type of permanent (cash value) life insurance, for that matter) is more expensive than term insurance. In the long term, however, whole life may be less expensive. With term insurance, you can count on your premiums increasing with each renewal. When you buy a whole life policy, however, your premiums are level and will not increase over time, an advantage if you keep the policy for many years.
Tradeoffs
Policy surrender in early years of policy can be costly
If you want all your cash value from a whole life policy but don't want to take a policy loan, you must surrender (cancel) your policy, and you may be subject to surrender charges. In addition, policy fees and expenses are usually charged against the policy in the first few years. As a result, policy surrenders during the first few years of the policy may provide little cash value.
Guarantees are subject to the claims-paying ability of the issuer
Guarantees relating to the policy are subject to the claims-paying ability of the issuing insurance company.
How to do it
Determine your life insurance need and overall financial goals
Before you buy life insurance, you need to know how much insurance you need. Insurance need is based on numerous factors, including your current age and income, marital status, number of incomes in the household, number of dependents, long-term financial goals, level of outstanding debt, and existing insurance and other assets. Your overall financial, estate, and tax planning goals and your planning time horizon should be considered as part of your insurance need evaluation.
Tip: Consult your financial advisor concerning your need for insurance. Some of the analysis can be complicated.
Complete the insurance application and name your beneficiary
Before the insurance company can issue your policy, it must receive a completed application form. The application includes general health questions, and the process may include a physical examination, which is usually paid for by the insurance company. A critical part of the application is the beneficiary designation--the naming of the person or persons to receive the policy proceeds when you die. You must name a primary beneficiary (this can be your estate) to receive the proceeds of your insurance policy. Your beneficiary may be a person, corporation, or other legal entity. You may name multiple beneficiaries and specify what percentage of the net death benefit each is to receive. If you name your minor child as beneficiary, be sure to designate an adult as the child's guardian in your will.
Generally, you can change your beneficiary at any time. Changing your beneficiary usually requires nothing more than signing a new designation form and sending it to your insurance company. If you have named someone as an irrevocable (permanent) beneficiary, however, you will need that person's permission to adjust any of the policy's provisions.
Caution: Naming your estate as beneficiary will subject the policy proceeds to claims by creditors of the estate.
Buy the policy and pay your premium
Once your life insurance application has been approved and you pay your initial premium, you'll be issued a policy. However, because an insurance policy is a legal contract, make sure you thoroughly understand all of its provisions before signing it or paying your premiums. Ask an insurance agent or financial professional for help, if necessary.
Review your insurance need periodically
The amount of life insurance you need may change over time, so you should periodically review your life insurance coverage. It's especially important to review your coverage when a major life event occurs (such as the purchase of a home, birth or adoption of a child, or change in marital status).
Tax considerations
Income Tax
Premium payments not deductible
Life insurance premium payments are generally not tax-deductible expenses.
Policy loan proceeds generally not taxable
When you take out a loan against your life insurance policy (except a policy classified as a modified endowment contract (MEC)), the amount you receive is not considered taxable income. This rule applies even when the loan is larger than the amount of premiums you have paid in (except in the case of a policy classified as a MEC).
Example(s): You own a life insurance policy (non-MEC) with a cash value of $20,000. Your basis in the policy is $14,000. You decide to take a policy loan to pay your daughter's college tuition. Under the terms of your policy, you are allowed to take a loan for an amount up to 90 percent of the policy cash value--in this case, $18,000 ($20,000 x 0.90). You are not currently subject to tax on the amount of the loan, even though the loan is larger than your basis in the policy.
Caution: If you cancel your policy while there is a loan balance outstanding, you may be subject to income tax on the amount of the loan.
Policy loan interest not deductible
Interest you pay on a policy loan is not a tax-deductible expense when the loan is for purposes other than business or investments (plus any accrued but unpaid interest).
Policy cancellation may be taxable
If you cancel (surrender) your policy for cash, the gain on the policy is subject to federal income tax. The gain on a canceled policy is the difference between the net cash value and loan forgiveness amounts and your policy basis.
Caution: You may be subject to surrender charges. Check your policy.
Caution: Policy fees and expenses are usually charged against the policy in the first few years. As a result, policy surrenders during the first few years of the policy may provide little cash value.
Caution: If you surrender your policy while there is a loan balance outstanding, you could be subject to income tax on the amount of the loan (plus any accrued but unpaid interest).
Policy lapse may be taxable
If you allow your policy to lapse, you could be subject to income tax even if you don't receive any cash from the policy. A policy lapse can occur when you stop paying premiums and don't have cash values available that can be used to pay the premiums. If you have an outstanding policy loan, it is possible you could be subject to tax on the amount of the loan plus any accrued but unpaid interest.
Death benefits generally not subject to federal income tax
Policy death benefits are generally not subject to federal income tax. One notable exception is when the policy has been sold or otherwise transferred for valuable consideration by one policy owner to another, subjecting it to the transfer-for-value rule.
Gift and Estate Tax
Policy proceeds not considered gift to beneficiary
When the proceeds of your life insurance policy are paid to a beneficiary, they are not treated as a gift for federal gift and estate tax purposes.
Policy premium payments generally not subject to federal gift and estate tax
When you are the owner of a policy on your own life, with another party as the beneficiary, premium payments made by you are not considered a gift to the beneficiary for federal gift and estate tax purposes. If, however, someone else pays the premiums on a policy you own, the premium payments are considered a gift to you and may be subject to the tax. Policy premiums paid by another on your behalf generally qualify for the annual gift tax exclusion.
Policy proceeds included in estate value in some cases
The proceeds of a life insurance policy are included in the value of your estate if you held any incidents of ownership at any time during the three years before your death or if the proceeds are payable to you or your estate or executor. Incidents of ownership include (among other things) the right to change the beneficiary, take out policy loans, or surrender the policy for cash.
Policy proceeds often exempt from state inheritance tax
In many states, life insurance proceeds are exempt from state inheritance taxes. For more information, please contact me at 502.271.8452