People buy life insurance for various reasons, but its main purpose is to provide a financial benefit for loved ones after the policyholder passes away. Life insurance can also provide other benefits, including supplemental income during retirement or a temporary loan if a bank's interest rates are too high.
However, with a variety of life insurance options out there, it's critical to clear up any confusion and misconceptions you may have. Who should purchase life insurance? Are the proceeds taxable? And one of the biggest questions: What is the difference between term and whole life insurance?
Let's review how term and whole life insurance work, their differences and who may or may not be a good candidate for each.
What Is Term Life Insurance?
Term life insurance provides temporary coverage for a certain period of time. The most common terms are for 10, 20 or 30 years, although there are also plans for 15- and 35-year terms. The main goal of this type of insurance is to help your dependents with the financial burden of your unexpected passing. With a term life policy, your beneficiaries receive a tax-free death benefit if you pass away during the term period. In any other circumstance, this type of life insurance policy has no additional financial value and isn't considered an asset.
The best part about term life insurance is that the premiums remain the same throughout the agreement. However, term insurance policies with longer time periods typically cost more because of the obligation they can put on the insurance company, which may have to pay on a death claim.
When researching term life insurance plans, it's important to know how long you'd like to keep the policy in case you pass away prematurely. Benefits can be 10 to 20 times your yearly income, with some plans going as high as 20 to 40 times.
The need for term life insurance should technically end when you're in retirement or when your most expensive obligations, like your mortgage or college tuition, are already paid for. However, some people may still need insurance coverage during retirement. For this group, purchasing another policy later in life can be a good idea.
What Is Whole Life Insurance?
Whole life insurance is for — as expected — the policyholder's whole life. Its main purpose is to provide permanent coverage, and the premiums stay the same throughout the life of the policy.
Most whole life policies allocate a portion of the premium to the cost of insurance and deposit the remaining amount into a cash value account. This account typically earns interest and is not subject to taxes, meaning the cash value of the life insurance policy will increase over time.
If you have a whole life policy, your beneficiaries receive a tax-free death benefit, similar to a term life policy. Unlike a term policy, however, whole life insurance can be surrendered or terminated by the policyholder and paid based on the cash value. You can also borrow money from the policy tax-free, and your death benefit won't decrease as long as the loan is paid back.
Some whole life insurance plans may even pay dividends, which are a portion of a company's profits that are returned to policyholders. Dividend-paying policies tend to cost more than non-dividend-paying ones.
Be aware that dividends may be non-guaranteed. Either way, some of the ways they can be paid are:
- Cash: Policyholders can request a check for the annual dividend.
- Additional insurance: Policyholders can ask to purchase additional insurance or prepay their life insurance policy.
- Premium reduction: Policyholders can request to offset their future premium costs.
- Retained interest: Policyholders can keep the dividend within the insurance company and earn interest.
The dividend payment may or may not be taxable, depending on the option you choose. The IRS sees dividends as a return of premiums, so cash, additional insurance and premium reductions aren't typically taxed; however, retained interest is.
What Is the Difference Between Term and Whole Life Insurance?
The difference between term and whole life insurance comes down to costs and possible taxation. Depending on your needs, one may be a better fit than the other, so it's important to consider the following distinctions:
The costs of term life insurance and whole life insurance vary significantly. Depending on the insurance company, a whole life insurance policy can cost around 8 to 12 times more than a 20- to 30-year term life insurance plan. Term life insurance will always be the least expensive because it's temporary and not meant to last for a lifetime.
In addition, there's no cash value in the term life policy, whether you surrender or are still living at the end of the term.
Term life insurance has a plethora of benefits, including low costs, options for how long the term will be and the premium staying the same for the term length. However, whole life insurance has multiple benefits as well, including the premium payment staying the same throughout your lifetime, a permanent death benefit, an accumulating cash value and the ability to be surrendered for some value versus none.
The whole life policy itself may also be eligible for dividends, which can help with the purchase of additional insurance or lower your premium payments.
While the death benefits for both term and whole life insurance policies are tax-free, taxable events can occur, including when a whole life plan's cash value exceeds the premiums paid into the policy.
For instance, let's say you surrender a whole life insurance policy in 20 years with $20,000 worth of premiums and a cash value of $30,000. In this situation, you'd have to pay tax on the difference, which is $10,000 in this example.
Choosing the Best Option for You
Term and whole life insurance are sometimes explained as "renting versus owning." Term life insurance is temporary and should be looked at as a replacement for your income if premature death occurs. By contrast, whole life insurance is permanent and should be looked at as a possible solution to life's long-term obstacles, including retirement income needs and estate taxes.
Everyone is at a different point in their lives, and your financial goals are likely different than other people's. It's best to talk to an insurance specialist so you can make sure your life insurance policy is the right one for your financial needs and retirement plans.