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Understanding Whole Life Insurance
Whole life insurance provides lifelong coverage and accumulates a cash value over time—presenting an option for high net worth individuals or parents with lifelong financial dependents. However, the low rates of return might not offset the higher premiums, depending on your budget.
At its core, life insurance is straightforward: you pay premiums, and the insurer pays a death benefit to your beneficiaries. Whole life insurance, however, has a cash value component—making things more complex.
Essentially, these policies accrue interest in a tax-advantaged account, offering guaranteed returns, though at a higher cost, and may not be the right choice for everyone.
How Whole Life Insurance Works as an Investment
Whole life insurance offers permanent coverage and builds cash value. A portion of your premium goes towards investments, accumulating a cash value that grows at a fixed rate guaranteed by the insurer. This growth is tax-deferred, which means interest earned isn’t taxed, as long as the funds remain within the policy.
Once sufficient cash value is accumulated, you can take out loans against the policy. While these loans don’t need to be repaid directly (it’s your money), the insurer subtracts any outstanding loan balance from the death benefit. It’s crucial not to over-borrow to avoid future issues.
If the policy is from a mutual life insurance company (owned by policyholders), dividends based on the company’s financial performance might be received. These can be cashed out, applied to premiums, or used to purchase additional insurance, which further increases the policy’s face value and cash value.
When Whole Life Insurance Might Be a Good Investment
Whole life insurance may be suitable in specific situations:
Maxed-Out Retirement Accounts
For high net worth individuals who have maximized their retirement accounts, a whole life insurance policy can supplement tax-deferred savings. The cash value grows over time through dividends or interest, and the policy can be surrendered to collect the cash when children are adults, the mortgage is paid off, or the need for life insurance diminishes. Surrendering the policy will most likely result in income tax on the gained value.
Lifelong Dependents
Life insurance offers peace of mind for those with financial dependents. A whole life insurance policy can be beneficial for parents caring for a child with a disability, providing lifelong coverage and a sense of financial security. To maintain eligibility for government benefits, such as Supplemental Security Income, it’s critical to avoid naming the child as your beneficiary and to consider setting up a special needs trust instead.
Estate Tax Planning
Whole life insurance can also help families manage potential estate taxes if the estate’s worth exceeds the federal tax exemption limit. The cash value component provides funds for estate taxes without impacting other assets, and you want the insurance funds to go directly to your beneficiaries without being taxed.
Portfolio Diversification
The cash value in a whole life insurance policy grows at a set rate, and returns are consistent. They are protected from market fluctuations. For those seeking hands-off investment options, whole life insurance may be ideal. However, should you be a more seasoned investor, you should examine other options that allow you to determine your own investment strategy for possibly greater returns, yet higher risks.
Potential Drawbacks to Consider
Although there are benefits to whole life insurance, it isn’t the right choice for everyone. You should be aware of these drawbacks before deciding.
High Premiums
The cost of whole life insurance is much higher than term life insurance. For instance, a healthy 40-year-old man might anticipate an average annual premium of $6,408 for a $500,000 policy, whereas a woman of the same age might pay $5,654. However, according to Covr Financial Technologies, a term life policy for a healthy 40-year-old male would cost about $334, and for a woman, about $282. If your primary goal is life insurance coverage, a term life policy might be the right choice, with the savings used to invest in other vehicles.
Cash Value Accumulation
Administrative fees, including commissions, account for a part of your payments early on. Over time, a higher percentage of your payment applies to your cash value. However, this process can take time. You may have to wait 10 to 15 years to have ample cash value to borrow against it. If you seek quicker returns, you might consider other investments. If whole life insurance holds relevance for you, purchase a policy early in life for meaningful returns.
Low Rate of Return
The annual rate of return on the cash value averages about 1% to 3.5%. While whole life insurance guarantees fixed returns, you may be able to earn more with other investments like bonds, stocks, and real estate. You should consult with a fee-only financial advisor regarding tax-advantaged investment options that match your risk tolerance.
Limited Investment Control
With whole life insurance, the insurer manages investments and declares the dividend or interest rate. This can make the product hands-off, but a seasoned investor may prefer control over their investments. Alternatives include policies like indexed universal, variable life, or variable universal life insurance, allowing policyholders to choose investment subaccounts from a portfolio offered by the insurer. These come with high returns but also higher risk.
Tax Implications
Generally, taxes are paid on the cash value only when it is accessed, and the IRS only taxes the amount that exceeds the policy basis. This is equal to premiums paid already, less dividends received. If you withdraw less than the policy basis, this is tax-free. Any withdrawals over that, however, are subject to income tax. Likewise, if you borrow from your policy, or surrender it, taxes can be relevant. Speak to an accountant for further guidance on your whole life insurance.
