What Is Whole Life Insurance?

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Dr. Jim Dahle:
Whole life insurance is a type of permanent or lifelong life insurance, meaning it's going to pay a benefit no matter when you die. So if you die at 35, it pays out the death benefit. If you die at 95, it pays out the death benefit.

The other main type of life insurance is called term life insurance, right? There's permanent life insurance and there's term life insurance. For term life insurance to pay out, you actually have to die during the term, right?

So if you buy a policy that basically matures or expires or whatever at age 60, and you die after 60 and you haven't renewed it and/or gotten another policy, it's not going to pay you. But if you die at 55, it's going to pay your estate, your heirs, whatever you've listed as the beneficiary.

So that's the difference between permanent life insurance and term life insurance. Because the permanent life insurance has to pay out to everybody that keeps it, it costs a lot more. A typical price difference, and it varies by age and health status and that sort of thing, but typically, it might cost you 10 times as much to buy a permanent life insurance policy as opposed to a term life insurance policy because it has to cover all those people that are going to die in their 60s and 80s and 90s, right?

But the issue is that's an expected event for you to die at 90, right? That is not like a financial catastrophe. I hope so. Most people don't actually need a lifelong or permanent life insurance policy. They need something that's going to pay their heirs if they die before they become financially independent, before they retire. And term life insurance works very well for that.

And so that leaves this product out there, whole life insurance, with not a very big market, right? Because almost everybody needs term life insurance. They've got a kid, or they've got a spouse, or somebody they're trying to take care of their needs if something happens to them at a young age. But not very many people have any sort of a need for a lifelong death benefit.

So that leaves all these agents who get paid commissions for selling permanent life insurance trying to come up with another use for permanent life insurance, another way to convince you to buy it, even though you don't need a lifelong death benefit.

They're trying to talk you into paying eight or 10 or 12 times as much for life insurance as you need to because then the commissions are eight or 10 or 12 times as large, and it can be a real tragedy if you end up being underinsured because of it, right?

If you buy a $100,000 whole life policy instead of the million-dollar term life policy that you should buy, you're maybe spending about the same amount of money, but your heirs get a whole lot less money if you die in the next few years when you really have a huge need for life insurance. So that can be kind of tragic.

But the bigger problem, if they talk you into buying this policy for some other reason other than the death benefit, is you probably have a better use for your money, right? I run into people who are putting 40% or 50% of their savings into whole life insurance, right? And that's just way too much for something like this.

I mean, the truth is 98%, 99% of doctors probably don't need whole life insurance. It's a very niche product and should only be bought by people in a specific niche where it makes sense to buy it.

So some of the ways that people try to talk you into buying these policies is they tell you, “Oh, well, this is another way you can save for retirement,” because a whole life policy actually acquires cash value.

Now, there's not two pots of money. It's one pot of money, right? The death benefit and the cash value that you can borrow out of the account, or that you get if you surrender the policy, is the same pot of money. There's not two pots of money.

There's not a million-dollar face value death benefit, and there's not this $100,000 in cash value that you've accumulated inside the policy. It's not $1.1 million. It's just a million. And whatever you borrow against the policy has to come out of the death benefit before the remaining death benefit is paid to your heirs.

But because it's acquiring this cash value, that does give you some other things you can do with this policy, like pay for retirement.

So, what can you do if you get to retirement and you have bought this whole life policy for some reason, and you actually want to use that money to spend in retirement, or you need to spend that money in retirement? How do you access that money?

Well, the first thing you can do is to just do a partial surrender of the policy. This is really the only unique tax benefit of whole life insurance, right? You basically can do a partial surrender up to your basis, meaning the total amount you paid in premiums over the years. You can take that money out tax-free, and you can take it out first, which is really cool.

You can't do that with a typical investment. You can't do that with an annuity. But with a life insurance policy, you take the basis out first.

So if you've got a policy that's now worth $1.5 million, and you've paid maybe $400,000 in premiums over the years, I don't know what you paid, that first $400,000 that comes out comes out tax-free, which is pretty cool. It's tax-free and it's interest-free.

But if you want more than that money out of the policy, you've got to do one of two things. You've got to either surrender it, in which case you now pay taxes on all the gains at ordinary income tax rates, not capital gains tax rates, or you borrow against it, just like you'd borrow against your house to spend money or you'd borrow against your investment portfolio to spend money. And that money comes out tax-free, like all loans, but not interest-free.

Now, there are some types of policies that can be designed so that it continues to pay dividends as though you hadn't borrowed that money out. That's called a non-direct recognition policy, and if you're planning to borrow against the policy, that's a good feature to have in your whole life insurance policy.

But the bottom line is, after partial surrenders of your basis, there's some complications with getting the money out of there to spend.

The bigger problem with whole life insurance is that cash value just doesn't grow very fast. It has a really low rate of return. And in fact, if you look at the entire premium you're paying as making an investment, not paying for insurance, which obviously some of it is, but if you look at the whole thing as paying for an investment, it has a negative return for quite a while.

The very best-designed policies, where you're doing all kinds of paid-up additions and it's designed for you to do this, you're still not going to break even for five or six years. Many policies don't break even for 15 or 20 years.

I mean, that's a terrible investment. You're better off in CDs or bonds or even just a money market fund than something that's going to take 20 years to break even. I mean, your money market fund, your money's probably doubling in 20 years, and so it's not a great investment from that perspective.

And that's why there's usually a better use for your money, right? If you are putting money into a whole life insurance policy and not even maxing out retirement accounts like Roth IRAs and 401(k)s and a second 401(k) for your side gig, and a 403(b) and a 457, everything that's available to you, you're probably making a mistake, right?

And you can even make a case, as long as you're investing the money aggressively into a stock index fund or into rental property or something like that, that you can invest outside of retirement accounts and still be better off, even adjusting for risk, than you are putting money into a whole life insurance policy.

The only time it even comes close to starting to compare is in the long term when you're buying very safe investments like CDs or bonds. Then it's more of a comparable return, but not for 10 or 15 or 20 years because during that time period the money has a negative return. Plus, it's hard to rebalance from a whole life insurance policy to your portfolio, etc., etc. It's just not a great strategy.

So, what are the things where it makes sense to have a whole life insurance policy? Well, there are a few of them, and perhaps one of the most significant ones is when you have a business purpose or an estate planning purpose for the long-term death benefit. You're still interested in the death benefit, but you've actually got a business purpose.

For example, let's say there's two partners. They're already 65 years old, and they want a buy-sell agreement for the business, right? They want to have enough money that if one of them dies, the other one will own the entire business, and that person that died's heirs will get cash from the life insurance policy.

But now term life insurance has become really expensive, so they decide, we're going to buy a whole life insurance policy that way. Even if we die at 83, it's going to pay out. Okay, very reasonable use.

Another reasonable use would be like a family where all their wealth is tied up in a farm, and maybe there's four heirs, right? And they don't want to have to split up the farm. They want one, say one son, to work the farm after they die, but they want everybody to get an equal amount.

So maybe they borrow against the farm and use the money to buy whole life insurance policies for the other three kids, and now everybody gets an equal amount of money, right? Estate planning purposes like that.

Some people really hate using banks for some reason and prefer to bank on themselves or do what's called infinite banking. And this is basically a way, in the long term, you can make a little more on your cash in exchange for dealing with the hassles of a whole life insurance policy.

So they're essentially borrowing frequently from the policy to buy things and then paying the policy back, and that can work out okay. It's not nearly as magical as its proponents would have you believe, but it's possible in the long term you can make a little bit more money on your cash.

So these are some of the reasonable uses of whole life insurance policies. But as you can see, they're pretty niche. Most people do not need these things, and whole life insurance agents need to send their kids to college. They need to make some money, and so they try to really push these things you can do with whole life insurance. You know, a great tax-efficient way to invest, and all these wonderful things you can do with it, and try to get you to buy these policies.

But the truth is, about 80% of white coat investors who have bought a policy regret it. About 80% of policies purchased are surrendered prior to death, so you can tell that most people buying these end up regretting it.

Treat it like a marriage, right? It is a lifelong commitment when you buy a lifelong insurance policy. And if you want to get out of it early, just like a marriage, it's going to cost you some hassle, and it's probably going to cost you some money.

So, hope that's helpful in making your decisions about what to do with whole life insurance.

Keep in mind, if you own a policy and you've already owned it for five or 10 or 15 years, maybe you're past a lot of the poor return years on that cash value because they tend to be heavily front-loaded. It might make sense to keep a policy you never should have bought in the first place.

And there's some other things you can do with cash value you already have, like exchanging it into another type of insurance, like a long-term care policy, or exchanging it into an annuity and using that for some retirement income. There's some other things you can do with it. So, more complicated question once you already own it.

But before you buy it, make sure you really want it. You really understand how it's going to work and that you don't have a better use for your money, right? It might be paying down your mortgage. It might be investing in real estate. It might be buying index funds in your taxable account. It might be saving for your kids with a 529 or UTMA or something like that.

But if you truly don't have a better use for your money, or you have one of these niche uses for a lifelong death benefit, go ahead and buy whole life insurance.

Hope that's helped you in understanding how whole life insurance works.

The White Coat Investor Podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.