When purchasing life insurance, you may be tempted to buy a permanent life insurance policy. A permanent policy differs radically from a term life policy. Make sure you understand the differences between these policy types before you buy one. Whole life is a popular choice, but cash value policies are not always whole life insurance.
Whole life insurance refers to a particular type of cash value life insurance. Whole life insurance charges premiums for a death benefit. The policy also builds a cash reserve in addition to the death benefit. The cash reserve is a savings that accumulates with the death benefit, effectively replacing it over time. When the cash value and the death benefit equal each other, at age 100, the policy is said to be "matured"; the policy is then payable to you at your age 100. You may keep the policy with the insurer and invest the death benefit or you may simply take the money in cash.
Cash Value Insurance
Cash value life insurance is a type of policy that builds a cash reserve. Whole life is one type of cash value insurance. Universal life insurance is another. Universal life insurance builds cash value is two ways. First, you may elect an increasing death benefit in the policy. This option provides a level death benefit for your life and the cash value accumulates on top of the death benefit. The other option for you to choose is a death benefit that stays level. Under this option, cash value builds up in the policy similar to how a whole life builds cash value.
With whole life, you may take policy loans only, unless the policy also pays dividends. If the policy is a dividend-paying policy, then you may withdraw dividends from the policy. A universal life insurance policy allows for withdrawals and policy loans. You may withdraw or borrow money from your policy up to the total amount in the policy.
In both cases, policy loans are tax-free as long as the policy remains in force and do not need to be repaid until your death. Withdrawals are tax-free up to your cost basis -- the total amount of premium you've paid into the policy. Cash value may be used at any time and for any purpose.
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The benefit of a cash value policy is that it gives you a savings when you need it without any restrictions on its use. A cash value policy may also be used as a source of funds when you need money to buy a new car, do repairs on your home or send your child to college. There is no loan application and no approval process with a policy loan as there is with other loans.
The disadvantage to whole life and cash value policies is that the premiums are higher than for term life insurance. Also, the policy takes many years to realize a gain. You may be required to wait 10 years or more before you recover your cost basis in the policy. Cash value policies are long-term, so if you need money in the near term, these policies will not be ideal for you.
- "Life Insurance"; Kenneth Black, Jr., et al.; 1994
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, et al.; 2007