How Does Whole Life Insurance Work?

Sean McGinn is an assistant director of Product Positioning in the Insurance Solutions department at Northwestern Mutual.

The financial world can feel like it’s full of uncertainties. And it can be hard to know what you can count on, no matter what. But some financial tools can provide stability, like whole life insurance. Here we’ll describe what whole life insurance is and how it works. We’ll also suggest times when you might want to review your coverage and make sure it’s still right for you.

What is whole life insurance?

Whole life insurance is a type of permanent life insurance, which means it doesn’t have an end date—it covers you for your entire lifetime. In contrast, term life insurance expires after a certain number of years.

With whole life insurance, as you pay premiums, your policy builds equity, which is your accumulated cash value. This money can be used any time and for any reason—to pay for a child’s wedding, to remodel your home, to start a business or to supplement retirement income. Term life insurance does not accrue cash value. You pay your premiums, and when the term of your policy ends, you walk away from the policy. You’ll need to purchase a new policy if you’d like to continue your coverage.

How does whole life insurance work?

Whole life insurance is a flexible, tax-advantaged financial product that can help you reach many financial goals throughout your life. Here’s how whole life insurance works.

Your coverage never expires. 

Whole life insurance doesn’t last only for a term. Instead, it covers your entire life. That’s one of the biggest differences in term life insurance vs. whole life insurance. As long as you pay your premiums, your death benefit is guaranteed for life, generally tax-free, regardless of when you die.

Your premiums remain level. 

With whole life insurance, your premiums will stay the same until you have finished paying for your policy, either when you get to a certain age or after a set number of years. When you finish paying premiums on a whole life insurance policy, your coverage will remain in place, and you won’t owe any more. It’s sort of like paying off your mortgage.

Your policy is eligible to earn dividends.

At Northwestern Mutual, the cost of our insurance is based on certain assumptions, like how many death claims we expect to pay in a year. Whenever the company performs better than we assumed, we may pay a dividend to our policyholders. While a dividend isn’t guaranteed, we’re proud that we’ve paid one every year since 1872.

With whole life insurance, you get to decide how your dividends will be used. Here are some of the choices:

• Purchase additional insurance, which can increase your death benefit and accumulated cash value more quickly than your policy’s original guarantees. When you use your dividend to purchase additional insurance, it sets a new level of guarantee below which the policy’s values cannot fall from one year to the next.

• Reduce the amount of premium you owe each year.¹

• Take it in cash to use for anything you want.¹

Your financial advisor can help you figure out the best option for you.

You will accumulate cash value. 

Your policy will accumulate cash value that’s guaranteed to grow over time and is not tied to the stock market—meaning it won’t decrease after a drop in stock prices. And if you choose to use dividends to buy additional insurance, your accumulated cash value and death benefit can increase even faster, compounding over time.

You can access this cash value at any time for any purpose, and you’re typically able to get the money in a matter of a few days. When accessing your cash value, you have a few options to consider.

• Take a loan against your policy. You can take a loan against your policy from the insurance company. Repayment of the loan is flexible, but interest will accrue. If you die while there is a loan against the policy, your death benefit will be reduced by the amount of the loan. Another option is to use your policy as collateral for a loan from your bank. This is generally a good option in the event of an emergency or for larger, infrequent needs, such as remodeling a home.

• Surrender a portion of your policy. When you surrender your policy, you will no longer have your insurance. In many cases, when people need to access their cash value and no longer need their full death benefit, they surrender a portion of their policy. They keep some life insurance death benefit in place. This can also be helpful from a tax perspective. That’s because when you surrender a policy, you’ll owe ordinary income tax on any cash value above money that you’ve paid (or “basis”). 

• Surrender your entire policy. In this case, you can take all the cash value in your policy, but you also surrender all your life insurance. If your cash value is worth more than what you paid in, you will owe ordinary income tax on that amount. 

If you’re thinking about using your cash value, your financial advisor can help you think through the best options for your situation. One thing to keep in mind: It does take time to grow your policy’s cash value, so giving it time to grow can give you more to work with down the road.

The insurance company may pay your premiums if you become disabled. 

If you have the optional waiver of premium benefit on your policy, the company will pay your premiums if you ever become disabled. During this time your cash value will continue to grow without you owing any money for your policy.

You may be able to purchase more insurance without a health exam. 

If you have the optional additional purchase benefit on your policy, you will be able to purchase additional insurance without having to take a health exam when you reach certain ages (which vary by company—examples are ages 22, 25, 28, 31, 34, 37 and 40). This benefit means that changes in your health won’t affect your ability to get more insurance.

It can lead to better financial outcomes as you build retirement savings.

It can work alongside other financial tools like investments and deferred income annuities in a multifaceted approach to retirement savings. In fact, a study by EY found that retirement strategies involving permanent life insurance and deferred income annuities excelled overall against investment-only approaches.

You could use it in retirement. 

You’ve worked hard your entire life and have sacrificed to save money for your retirement. But investments in 401(k)s, IRAs or other accounts are subject to the rise and fall of the market, which means your balance could also rise or fall. Because your whole life insurance is guaranteed to grow, your accumulated cash value can be a supplement to your retirement income, particularly during down markets. Using cash value during a downturn allows your other assets time to rebound. Otherwise, if you access those accounts while they are down, you would essentially be selling at a loss.

When to review your whole life insurance policy

It’s a good idea to check in regularly with your financial advisor. Most of the time, you won’t need to make changes to your whole life insurance policy. But there are a few reasons that you may want to revisit your insurance coverage.

• Changes in your family. When you have a change in your family, like a divorce or the birth of a child, review your policy. Make sure the beneficiaries that you listed are still correct and that your policy provides the right amount of death benefit.

• Changes at work. Your company could change benefits, such as the life insurance they provide, or you might get a big raise. You may want to increase your whole life insurance coverage.

• As your financial plan changes. When you first get insurance, you may have little savings and a large mortgage. Eventually, your savings will grow, and your mortgage will shrink. As this happens, you may want to update your life insurance coverage.

• When you update your estate plan. Life insurance beneficiary designations supersede what’s in a last will and testament. That means any time you’re updating your will, it’s a good idea to also look at your insurance beneficiaries. Make sure they accurately reflect your wishes.

With its guaranteed death benefit and guaranteed growth, whole life insurance can help you reach several financial goals. Your Northwestern Mutual financial advisor can also show you how your insurance can work with your investments to more efficiently reach your savings goals. Your advisor can listen closely to your goals and partner with you every step of the way—helping to co-pilot your financial plan. They can even reveal blind spots and opportunities that can otherwise be overlooked.