On the surface, life insurance appears to be a straightforward concept: you pay a premium to an insurance company, and the insurer pays your beneficiaries when you die. However, whole life insurance has a cash value component, which might complicate matters.
These insurance generate interest in a tax-advantaged account and provide guaranteed returns, but they are costly and unsuitable for the majority of consumers.
How whole life insurance works as an investment
Whole life insurance offers permanent coverage with a monetary value.
When you pay your premium, the insurer invests a portion of it, giving your policy cash value. Your insurer guarantees that the cash value will grow over time at a specified rate. It is tax-deferred, which means that any interest earned is not taxed as long as the funds remain in the insurance.
Once you’ve earned enough cash value, you can start taking out loans against your policy. While you are not required to repay these loans because it is your money, your insurer will deduct any outstanding loans from your payout when you die. To avoid future problems, you should not borrow too much against your policy.
If you acquire a policy from a mutual life insurance company, which is owned by its policyholders, you may be eligible to receive dividends based on the business’s financial performance. You can cash them in, use them to pay premiums, or get additional coverage to increase the face value of your life insurance policy. If you choose that option, your cash value will also grow.
When is whole life insurance worth it?
Whole life insurance can be a good investment in certain scenarios.
You have maxed out your retirement accounts
If you are a high-net-worth individual who has made all of the permissible contributions to tax-advantaged accounts such as 401(k) plans or individual retirement accounts, you might supplement your tax-deferred savings by purchasing a whole life insurance policy.
Over time, the cash value will generate dividends or interest, and when your children are adults, your mortgage is paid off, or you no longer require life insurance for any reason, you can surrender your policy and receive the cash. If you surrender the policy, be aware that you will most likely be taxed on the increased value, and your beneficiaries will not receive a life insurance death benefit when you die.
You have a lifelong dependent, such as a child with a disability
Life insurance can provide financial security to anyone with dependents. If you are a parent caring for a disabled child, a whole life insurance policy may be appropriate for your case because it normally provides lifelong coverage, providing your family with financial security.
Avoid listing your child as a beneficiary to guarantee they remain eligible for government assistance such as Supplemental Security Income. Instead, consider establishing a special needs trust. An attorney can assist you in transferring your entire life insurance policy to the trust, and you can designate a trustee (such as a guardian) to manage the funds on behalf of your child.
You want to help your family pay estate taxes
Is your estate valued at $13.6 million or more? That is the federal tax exemption level for 2024, meaning the IRS may collect an estate tax on any assets that exceed the threshold when you die.
In addition, several states impose their own estate or inheritance taxes. For example, New York’s estate tax applies after $6.9 million.
Because of the cash value component, whole life insurance is a type of “forced savings.” Whether you keep the policy until you die or surrender it for cash when you retire, whole life insurance can provide your loved ones with the funds they need to pay estate taxes without having to delve into other accounts.
You want to diversify your investment portfolio
The cash value of whole life insurance grows at a defined rate, and the returns are consistent. They are not affected by market fluctuations, therefore you will not lose money if the market changes.
This is distinct from other permanent policies, such as variable life insurance and variable universal life insurance. With these policies, the cash value grows at a variable pace, which means that returns are market-dependent and not guaranteed.
The drawbacks of whole life insurance as an investment
While whole life insurance has some advantages, it is not the best coverage for most people. Before you buy a policy, consider these disadvantages.
The premiums are expensive
Whole life insurance is generally more expensive than term life insurance. For example, a healthy 40-year-old man may expect to pay an average yearly premium of $4,471 for a $500,000 policy, while a woman of the same age may spend $4,123, according to Quotacy, a life insurance agency. In comparison, a term life coverage for a healthy 40-year-old man would cost $340 and a woman $288 on average.
If you only want life insurance coverage, you could be better off purchasing a term life insurance policy and putting the proceeds into other investment vehicles.
The cash value is slow to grow
For the first few years, your insurer will deduct a portion of your premiums for fees, commissions, and other administrative expenses. Eventually, a larger portion of your premium will go toward your cash value. However, this takes time, so you may need to wait 10 to 15 years (or even longer) to accumulate enough cash value to borrow against.
If you prefer an investment that yields good returns rapidly, you should search elsewhere. And, if you’re interested in the relatively low but consistent profits offered by whole life insurance, attempt to purchase a policy when you’re young so you have plenty of time to harvest considerable cash value returns.
The cash value rate of return can be low
According to Quotacy, the average yearly rate of return on cash value for whole life insurance ranges between 1% and 3.5%. While whole life insurance provides set, guaranteed returns on cash value, other investments like equities, bonds, and real estate may yield larger returns. Consult a fee-only financial advisor to learn about tax-advantaged investing options that are appropriate for your risk level.
You can’t control your portfolio
Whole life insurance companies issue dividends or interest rates and professionally handle policyholders’ investments.
On the one hand, this renders whole life insurance a hands-off proposition. However, if you are an experienced investor, you may not be comfortable relying on your insurer’s investment managers to deliver results for you.In that situation, you could look into policies that allow you to choose investing sub accounts from a portfolio given by your insurer. These include indexed universal life insurance, variable life insurance, and variable universal life insurance, all of which offer the highest risk and potential returns for life insurance.
There can be tax implications if you withdraw cash from your policy
Generally, you only pay taxes on the cash value if you use it, and the IRS only taxes the amount that exceeds the insurance basis. This is the amount you’ve previously paid in premiums, less any dividends you’ve earned.
If you withdraw less money than the policy basis, those funds are yours, tax-free. However, any additional withdrawals are subject to income tax. You may also be required to pay taxes if you surrender your life insurance policy or borrow against it and fail to repay the loan. Speak with an accountant to learn more about how whole life insurance can affect you during tax season.
