Whole life insurance, specifically dividend paying whole life insurance, offered through a mutual insurance company, is a great tool for building a solid financial foundation.
You see, whole life insurance has very unique qualities that set it apart as a excellent vehicle for escaping the rat race and helping you on your way to financial freedom, despite what the financial pundits would have you believe.
Whole Life Insurance Advantages and Disadvantages
The following article covering whole life insurance pros and cons is separated into two sections.
Section one covers the different benefits of whole life. Section two covers the disadvantages of whole life. Since this article is so encompassing, we broke it down into a table of contents for easier navigation.
Whole life insurance advantages and disadvantages snapshot:
- Forced Savings
- Tax Favored
- Creditor Protection
- Guaranteed Death Benefit
- Guaranteed Fixed Premiums
- Guaranteed Cash Value Growth
- Living Benefits
- Waiver of Premium
- More Expensive than Term
- Agent Commissions
- Fees & Expenses
- Death benefit does not include the cash value
- Limited contribution limits
- Opportunity Costs
When you buy a participating whole life insurance policy from a mutual insurance company you become a partial owner in the company.
You now share in the profits and growth of the insurance company. You have voting rights. And you have the right to dividends paid out by the insurance company to your participating whole life policy.
A very important benefit of whole life is that it is permanent life insurance coverage.
So, no matter how old you live to, your life will always be insured.
Why might that matter?
With participating whole life structured for cash value growth, you get a leveraged death benefit, that continues to grow as you age, and passes to your beneficiary free from income taxation.
Another reason permanent coverage is necessary might be a a child who has special needs. Special needs planning with life insurance is a great way to provide for your child when you are no longer able to.
Business owners can fund a buy-sell agreement with life insurance to provide an additional source of income if an owner dies. The death benefit is a great liquidity injection that can be used to keep the business afloat, rather than the alternative of closing the business due to the death of an owner.
Whole life insurance is a forced savings plan. Now you might say, “I don’t need to be forced to save money.” OKAY, that might be true for you.
But consider that only 39% of Americans have enough savings to cover a $1,000 emergency.
Financial entertainer, Suze Orman, recommends you have at least 8-12 months of living expense put away. And Dave Ramsey recommends putting aside $1,000 as the first “baby step” to take.
You can look at your monthly or annual whole life insurance rates as your savings “bill”. You make sure to pay your other bills, so pay this one as well.
But unlike most bills, the bonus here is that the money you are paying into your policy will be available to you down the road.
Benefits such as being able to use the money in your policy for whatever you choose and you can access it anytime without being penalized.
Whole life insurance is considered cash value life insurance and is tax favored under the IRC. Among the tax incentives for cash value life insurance are:
Typically, the life insurance death benefit is not taxed.
Rather, it goes to your life insurance beneficiaries income tax free, but may be subject to estate tax if your estate is above the current federal estate exemption limit.
Life insurance loans are tax free, and many of the best whole life insurance companies offer low interest loans that are comparable to the current policy’s return, making it a wash or close to it.
You can borrow against your life insurance, using your cash value as collateral.
Life insurance loans do not need to be repaid. However, loans lower your death benefit until repaid.
Life insurance operates under the FIFO (first-in first-out) accounting method. So, the money you withdraw is from your cost basis, not from any gains.
The benefit is you can withdraw premiums paid into your policy up to your basis without a taxable event. Your basis represents how much whole life premiums you have paid into your policy.
Your cash value grows tax deferred, allowing true compound interest growth, free from taxes, which greatly diminish returns over the long term.
Cash value life insurance has certain state specific exemptions in regards to cash value and the policy’s death benefit.
Life insurance creditor protection varies by state. Some states allow maximum protection for cash value and death benefits, which means creditors cannot touch your cash surrender value in your life insurance policy.
Your whole life death benefit is guaranteed, as long as your premiums are paid.
With a properly designed dividend paying whole life policy, your death benefit grows the older you get.
Think about it, the older you get, the bigger your death benefit grows. It is built in inflation protection.
Your whole life policy’s premiums are fixed. You can choose whole life to age 100, or choose limited pay whole life, which allows you to pay premiums for a shorter period of time and still enjoy the benefits of life insurance coverage for your whole life.
Guaranteed fixed premiums provide peace of mind knowing that you can budget for your whole life premiums, without the concern that the insurance company will ask for more premium down the road.
Your cash value accumulates inside your policy at a rate guaranteed by the life insurance company.
Further cash value growth can (and typically does) occur beyond the guaranteed cash values of a whole life insurance illustration.
The non-guaranteed cash value on whole life insurance can be even greater due to return of premium paid to policyholders in the form of dividends.
The best whole life insurance policies are ones that pay a dividend.
Life insurance dividends are actually a return of premium and are not subject to income taxation.
You have various options on how you decide the dividend should be used.
Paid-up additions allow you to use your dividend to purchase additional paid-up life insurance. The additional coverage increases your death benefit and cash value.
You can choose to take the dividend in the form of cash for whatever you want you to do with the money.
You can use your dividend to buy annual renewable term insurance, adding to your death benefit.
If you have an outstanding policy loan, your dividend can be used to pay down all or a portion of your loan.
You can use your dividend to pay your whole life insurance premiums.
Another dividend payment option is to leave the money with the life insurance company, earning interest at a rate set by the insurer.
Whole life insurance living benefits provide another level of security as the policy acts as buffer in a worst case scenario where you are diagnosed as terminally or chronically ill.
An accelerated death benefit typically is included in your policy at no additional cost. If you are diagnosed as terminally ill with 12 months to live, the rider will allow you to access your death benefit payout in advance.
If you are diagnosed as chronically ill, typically requiring that you be unable to perform 2 of 6 activities of daily living, you can access a portion of your death benefit in advance.
Long-term care riders can be attached to permanent life insurance policies, such as IUL and Whole Life. The rider allows you to receive long-term care benefit payments to help you pay for long-term care services.
A benefit of long-term care riders vs traditional long-term care insurance is that a hybrid life insurance long-term care policy’s premiums are fixed.
Waiver of premium provides protection if you are totally disabled. The rider kicks in after an elimination period and the insurance company will waive all premiums due. This may, or may not, extend to all benefits in the policy, including paid-up additions.
Wrapping up our list of whole life insurance advantages is perhaps the most important benefit of whole life. With whole life you retain control of your money. And you can access your money at anytime, for any reason.
Your cash value is available anytime either through a loan or withdrawal.
Other assets, such as your home equity, are not as liquid.
Some assets will even charge you a penalty or fee for early withdrawals, such as a 401k withdrawal.
You can borrow from your policy and purchase other income producing assets.
By keeping your money moving you benefit from the velocity of money, since your cash value is still in your policy earning interest.
At the same time, your loan is at work in your newly purchased asset creating cash flow.
You will pay interest when you borrow from the insurer, using your cash value as collateral.
However, as mentioned above, your money is still at work in the policy and also in any asset you choose to invest in, creating the potential for positive arbitrage.
Whole life insurance is an asset that is not connected to the stock market, providing peace of mind to policyholders when the stock market tanks.
The main knock to whole life you always hear, particularly from certain financial pundits like Dave Ramsey, are that whole life is more expensive than term. He also advises to buy term and invest the difference.
Just as an aside, the phrase buy term and invest the difference was not originated by Dave or Suze Orman. Rather, the saying was originated by Primerica founder Arthur Williams Jr., net worth 1.4 billion as of 2008. That is some pretty successful marketing!
What the pundits don’t talk about is that whole life has a savings component and death benefit component.
Basically, whole life is both a savings account with a leveraged death benefit, and decreasing term insurance. As your cash surrender value grows, your reserves against the death benefit increases, while the net amount at risk goes down.
And another thing the pundits don’t address is that…
The major hang up with this line is reasoning of buy term and invest the difference is that no one ever “invests the difference.”
But what we will point out is that term insurance gets more expensive the older you get.
In contrast, whole life provides fixed premiums for the entire duration of the policy.
If price is the number one objection, in close second is that a whole life insurance salesman makes bank on these life insurance policy types.
In reality, a properly designed whole life policy, blended with term insurance and paid-up additions, carries a very low commission for the agent in comparison to ordinary life insurance. An agent may only make about 30% of the annual premium for first year commissions, and then 5-6% roughly for the next 9 years.
Over the life of the policy, total fees and costs associated with a properly designed whole life policy focused on high cash value growth are well below a typical managed account investors pay to an investment advisor, which ranges from 1% to 3%, each and every year, regardless of portfolio performance.
Consider the commissions for a Real Estate agent, who makes 3-6% commission on the full value of a home’s sale price. On a $1,000,000 home, a real estate agent can make between $30,000 to $60,000.
In contrast, a life agent selling a $1,000,000 death benefit may make only 1% of the total commission vs the total death benefit over the life of the policy.
The initial fees and expenses make it difficult to get ahead in the early years of your policy. Most of the fees and expenses are front loaded into your whole life policy.
As a result, over time your policy gets more and more efficient, paying you a higher internal rate of return the longer you have the policy.
And if you consider the fees as a total percentage of the death benefit, the fees and costs are relatively low when compared to other savings vehicles.
Consider 401k plans or mutual funds, where the fees paid are calculated based on the total account value. Under this model, the fees will probably increase each year as your 401k or mutual fund account grows.
Another knock on whole life and permanent life insurance in general is your beneficiary does not get your cash value and death benefit. But this is to confuse how life insurance works. It is analogous to selling your home and expecting the sales price and the equity in return.
With a properly designed whole life insurance policy, the death benefit can be larger than the total of the original death benefit purchased and cash value combined.
So, you don’t get the cash value and death benefit. But you do get a death benefit, which can grow year over year as you age and be much higher than the original death benefit you began with.
It used to be you could load up a life insurance policy to the max. Prior to some law changes, this was a great tax shelter. Of course, the IRS is not a friend of tax shelters so that changed.
Today, there is a 7-pay test that sets the criteria for what is considered cash value life insurance vs a modified endowment contract (MEC).
However, you can still fund your policy with limits set by your face amount, and you can overfund your life insurance with the appropriate riders.
Contrast this with a ROTH IRA, where contributions are limited, or even non-existent for individuals who make too much money, which is why whole life insurance is the rich persons Roth.
Finally, to end our whole life insurance disadvantages list, we have to consider opportunity costs.
What is the opportunity cost of paying a whole life insurance premium vs other opportunities available to you?
We would argue that if you are using the policy for infinite banking, there are no opportunity costs.
Consider the following two points which help clarify our position.
One, there is a huge benefit to starting a whole life policy while you are young.
As mentioned above, the policy becomes more and more efficient as time goes by. (Parents and grandparents, this is why life insurance for children should be considered).
Two, you can always borrow against your cash value and purchase a cash flow investment and use your cash flow income towards your whole life insurance premium, as we outlined in our article on real estate wealth building.
That way, your investment is increasing in value and your policy is growing its cash value. And over time, you will have two income producing assets, that can then be leveraged into creating even more income producing assets, which is the foundation of infinite banking.
At I&E, we are huge fans of whole life insurance due to its utility. More specifically, we are huge fans of whole life because it is a great asset for building wealth and leaving a legacy and should be part of anyone’s financial blueprint.
Give us a call today for a complimentary strategy session and see just how powerful this asset can be for you.