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Life insurance is an indispensable part of legacy planning. But do you find it difficult to rationalize paying for something that is unlikely to ever be used? After all, a 30-year insurance policy bought at 25 years old only lasts until 55 years old at its locked in premium rate. Wouldn’t it be better to lock in an insurance policy rate that doesn’t expire? This question defines the difference of whether a term or a whole life policy gives the most bang for your buck.

While term policies are by far the most popular type of life insurance, is there ever a rationale for purchasing the permanent option of whole life?

To thoroughly explore the answer to this question, let’s identify the unique qualities of each type.

Benefits of Term Life Insurance

Term life insurance is most popular because of its affordability. You decide how long you want to lock in a monthly or yearly rate, and you pay that over the course of the agreed period.

Technically, the policy doesn’t expire at the end of the set period; it is the agreed rate which expires. Generally, the owner will choose to drop the policy at this time, because the cost skyrockets far higher than is usually worth its continuation. A rare exception might be if the policy rate expired at a time when the owner was terminally ill or otherwise likely to pass away in the near future. Under these circumstances, they may choose to continue the policy by paying the much higher premium until they either pass away or recover.

This also fits most people’s financial plan that, when the agreed term is over, they aim to have built enough net worth to provide for the beneficiary’s needs without it.

Term life insurance acts as a bridge to ensure the beneficiar(ies) receive needed support in the unlikely event of one’s passing away sooner than they can build up the necessary assets.

Pros

• Cheap insurance
• Simple to understand

Cons

• No cash amount to draw from
• Premium rate comes to an end

Benefits of Whole Life Insurance

A whole life policy, on the other hand, doesn’t expire. It lasts throughout your entire life.

In addition to having no expiration date on the policy rate, it also builds up a cash value within it that can be accessed in case of an emergency.

The reason for the cash value is so that the interest earned on that cash can help to pay for the higher premium costs in your later years, allowing your locked in, out-of-pocket premium to remain the same.

Think about it this way: imagine you have a premium locked in at $300/month from age 30 on a $500,000 policy. An equivalent term life policy might only cost 1/10 of that number, but what you’re doing with whole life is saving up a nest egg to assist you in the future. When you’re in your 60’s, 70’s and beyond, that premium cost should theoretically be astronomical.

Why can you keep paying just the $300/month? Because you built up cash value in the early years which pay for the higher required premiums in the later years. You pay upfront and reap the benefits on the back end.

Even though you can technically access the cash value through a withdrawal or a loan, this will likely reduce the death benefit; therefore, this option should only be a last resort in case of an emergency.

Pros

• Coverage lasts a lifetime
• Cash value can be accessed in an emergency
• A missed payment might be payable from the cash balance (depending on the terms of the agreement), but could also reduce the death benefit

Cons

• Far more expensive than term insurance
• Cash value earns interest but will probably not grow as fast as equities over the long-term
• Doesn’t allow much flexibility around premium payments

Why I Don’t Like Whole Life Insurance (My Personal Opinion)

Take this with a grain of salt, because whole life insurance has its (rare) place. But I believe that anyone who trusts the power of statistics and is willing to take on the additional risk can do better than what a whole life insurance policy offers.

Allow me to illustrate.

Investopedia offers an excellent article which shows the average costs of whole life vs term life insurance policies among both men and women of different ages.

Let’s use the example of the 30-year-old female who is given a choice to purchase a 30-year term policy for $25/month or a whole policy for $247/month. Let’s also assume that she lives to the average female life expectancy of 80.

Under the term life policy, she will have paid a total of $9,000 over 30 years, after which she will let it drop unused. This is $9,000 she will never see again.

Under the whole life policy, she will have paid a total of $148,200 over 50 complete years ($247 monthly premium x 12 months per year x 50 years).

But crunching the numbers shows that gaining a $500,000 death benefit on a $247/month premium after 50 years only equates to around a 4% rate of return!

What if she had invested the difference instead?

She could have purchased a term life insurance policy for 30 years, paid the $25/month, and invested the difference of $222/month into a retirement account or even a taxable account. A 50-year time horizon could easily support an all-stock, or mostly stock, portfolio, provided that she was willing to stomach the ups and downs that come along with that.

The average annual return of the S&P 500, for reference, has ranged between about 9% and 10% since its inception. Let’s assume that she could have made at least 7% of this on average over 50 years.

That difference of $222 invested monthly for 50 years at a 7% return on investment has an ending value at 80 years old of over $1 million. That means she’s potentially giving up half a million dollars because she wants to be guaranteed this death benefit for her beneficiaries. That’s an expensive guarantee!

One Word About Taxes

I will also say that, in this scenario of investing the difference, it does matter to her beneficiaries whether she chooses to invest that difference in a retirement account or a taxable account. A retirement account that is tax-deferred will be charged income tax whenever it is withdrawn, whether during her life or for her beneficiaries.

Alternatively, a taxable account will receive a stepped-up basis when inherited by her beneficiaries. If she were to sell shares during her lifetime that had accumulated in value, she would owe capital gains tax on the growth. But her beneficiaries would receive a clean slate, and would likely owe very little, if any, capital gains tax if they sold it soon after receiving it as an inheritance.

A whole life insurance policy is not subject to income or capital gains taxes, so will pass tax-free to the beneficiaries in this regard. But it is considered as part of the estate, so could potentially be subject to estate taxes. The closest thing she could do to mirror her whole life policy is to save the difference into a taxable account, which receives the stepped-up cost basis at her passing away.

Conclusion

The whole life versus term life insurance subject could be debated, as there are some instances in which a whole life policy might make sense. One instance might be someone who is very risk averse and is perfectly comfortable with a bond-like return on investment over 50 years. But this comes down to a person’s preference. I, for one, prefer more risk for the much higher potential benefit. I like to encourage others to see the massive benefits that might be sacrificed at the expense of being safe. In the end, this is a decision that each person will have to make for themselves.

Whichever path you end up choosing, life insurance as a concept is an unmatched strategy for leveraging your wealth to leave a legacy no matter what circumstances may come your way. The wealth potential to leave for your loved ones will echo throughout time to the next generation and beyond.

To calculate how much insurance is appropriate for your situation, you’re welcome to follow up this article with How to Calculate My Life Insurance Needs.