By Dr. James M. Dahle, WCI Founder
It's no secret that I'm not a big fan of whole life insurance. I owned a policy for seven years before canceling it (for a minus-33% cumulative return). Very few physicians and other high-income professionals need a whole life policy. Once they understand how it works, even those who own one don't usually want it. However, let's step back today and take an objective look at the pros and cons of whole life insurance.
Pros of Whole Life Insurance
Yes, Virginia, there are some good things to say about whole life insurance and even some acceptable reasons to buy it.
#1 Life-Long Death Benefit
The main reason anyone should buy a whole life insurance policy is because they need, or at least want, a life-long death benefit. This is a death benefit that pays out whenever you die, whether at 32 or 102. Obviously, everyone is going to die, so a whole life policy held until death IS going to pay out eventually. That makes whole life significantly more costly (age dependent but can be 10X+ the cost of a term policy), but it is also far more likely to pay out rather than expire “worthless.” (With a term policy, you get insurance even if you didn't use it, and that has value, as well.)
#2 Can Surrender up to Basis Tax-Free
This little-known benefit of whole life insurance is actually what I consider to be the biggest tax benefit it provides. If you've owned a whole life insurance policy for many years and its cash value is now worth more than all of the premiums you paid, you can do a “partial surrender,” essentially pulling out an amount equal to all the premiums you paid tax-free. That lowers your death benefit and cash value, of course, but this is a significant benefit compared to other financial instruments. With a traditional investment, such as a mutual fund, you can sell your highest cost basis tax lots first, but within a tax lot, it all comes out pro-rata, gains and basis. With an annuity, all of the earnings come out first (and are taxed at ordinary income tax rates). The tax treatment of partial withdrawals from a whole life policy is better than both, at least up until you have withdrawn an amount equal to basis.
#3 Can Borrow Tax-Free (But Not Interest-Free)
A widely touted benefit of whole life insurance is that you can borrow against it tax-free. When insurance agents tell you it provides “tax-free retirement income,” this is usually what they are talking about. What they don't mention is that it is not interest-free. A whole life policy includes a loan provision that specifies how much interest you have to pay into the policy when you borrow against it. This might be a great option for you because they don't check your credit score or your debt-to-income ratio or because perhaps you are trying to borrow at a time of high-interest rates. It is possible that this is your best source of additional funds. However, most of the time, it isn't that great of a deal. For many years, people have borrowed against their house for 2%-4% or against their investment portfolio for 2% but had to pay 6%-8% to use their own money in a whole life policy.
This particular benefit is not unique to whole life insurance. You can borrow against any asset (your car, your house, or your portfolio) tax-free but not interest-free. Plus, the income tax-free death benefit isn't particularly unique. Thanks to the step up in basis at death, anything you leave to your heirs is inherited income tax-free.
#4 Paid-Up Additions Have Lower Commission Rates
You can improve the returns on a whole life policy by minimizing the size of the base policy and maximizing the size of “paid-up additions” that buy additional amounts of insurance. Paid-up additions pay lower commission rates to the agent than the base policy, improving your return. Unfortunately, some unethical (or ignorant) agents don't use these and end up maximizing their return on the policy instead of yours. If they did, you could break even on a policy much sooner than usual. Instead of breaking even in 10-15 years on a policy, you could break even in just 4-7 years by purchasing the maximum amount of paid-up additions.
#5 Can Be Designed with Wash Loans and Non-Direct Recognition
With direct recognition dividends, when you borrow against the policy, it no longer pays dividends on the amount you have “borrowed out.” With non-direct recognition dividends, it does. Imagine you have a cash value of $100,000, and you borrow $50,000 against it. The policy is paying a 5% dividend. If it is a direct recognition policy, that dividend will be $2,500. If it is a non-direct recognition policy, the dividend will be $5,000.
A wash loan is when the interest rate on the loan is equal to the dividend rate. If you're paying 5% to borrow the money and the dividend on a non-direct recognition policy is 5%, then the loan really costs you nothing. There's no magic there, of course. It's exactly the same as making a withdrawal from your savings account, but it is a cool feature.
#6 Can Be Used to Earn More on Cash in the Long Run
The magic, such as it is, occurs when you combine paid-up additions, wash loans, and non-direct recognition dividends. This technique is sometimes called “Bank on Yourself,” “Infinite Banking,” or “LEAP.” You put as much cash into the policy as possible using paid-up additions to get past the early, crummy return years on a whole life policy as soon as you can. Then, you borrow against the policy using wash loans and non-direct recognition dividends instead of separately saving up for purchases or withdrawing from a bank account. Then, you pay back the policy. Or you don't, depending on how you feel.
Once you cut through all of the marketing, hype, smoke, and mirrors, what you are left with is something that, in exchange for crummy returns for a few years, provides a higher long-term return on your cash than your savings account would. Instead of earning 2%-3%, maybe you get 5%. Cool trick, so long as you are insurable, are willing to deal with the upfront and ongoing hassles of getting a policy, are getting an appropriate policy to do this with, and are not worried about those crummy early returns.
#7 Can Provide Asset Protection in Some States
Many states protect some or all of the cash value in a whole life policy from your creditors if you have to declare bankruptcy. While this is exceedingly rare among high-income professionals (despite their fear of an above policy limits judgment), it does happen. If your state has weak IRA protection or homestead protection and doesn't offer an asset protection trust, you might consider a whole life policy primarily for asset protection reasons. I wouldn't, but you might. If I were you, I'd read The White Coat Investor's Guide to Asset Protection before buying a whole life policy for this reason.
#8 Can Provide Liquidity at Death
One reason that people need or want a lifelong death benefit is to provide liquidity at death. Imagine you own a small business or a farm, but you need to split an inheritance among multiple children. You can leave the farm to one and make it up to the other one with the death benefit of a life insurance policy funded with some of the income from the farm. Whether you die next year or in 30 years, the two heirs will be fine.
Liquidity is also helpful to pay estate taxes. Imagine you have a $40 million small business you will leave to your heir. However, there will be an estate tax bill of several million dollars due. The heir does not have the cash to pay that. If you don't leave them the cash, they will have to fire sale part or all of the small business. A whole life insurance policy can provide that cash.
This is also a reason why many partnerships have a buy-sell agreement that involves a first-to-die whole life insurance policy on the partners. If one partner dies, the other gets the business while the heirs get bought out with the death benefit.
#9 Avoids Trust Taxes in an ILIT
An irrevocable trust is a great way to avoid estate taxes. By placing an asset into an irrevocable trust, any appreciation after that point occurs outside of the estate. However, trust tax rates are notoriously high, and trust tax returns can be complicated and expensive. What if you could put an asset into the trust that grows in a tax-deferred way until death and then provides an income tax-free lump sum? Voila, a whole life policy can do that.
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Cons of Whole Life Insurance
Enough with the pros. I made it sound so awesome you want to run out and buy a policy, right? Not so fast. Better read this section first.
#1 Sold Inappropriately
The biggest problem I have with whole life insurance is that it is sold inappropriately by ignorant (and probably a few unscrupulous) insurance agents. If I had $100 for every physician who had ever been sold an unneeded and unwanted crummy whole life insurance policy, this website would not need to have any ads on it. It's actually far rarer to find a physician who has never been pitched a whole life policy than it is to find one who owns one and regrets buying it. Whole life is a product that is sold, not bought. The agents make it sound so good, but the truth is that there is a better financial product for almost every financial need. Most purchases of whole life insurance qualify for financial malpractice in my book.
#2 Most Policies Are Poorly Designed for Their Use
To make matters worse, the policies that get sold are designed poorly for the use they were originally pitched to the doc. Instead, they seem to be designed to maximize the commissions paid to the agent or, at best, to maximize the death benefit. If the goal is to maximize the return on the policy, it would be a “7-pay” policy where premiums would only have to be paid for seven years, and as much as possible of the premiums paid would come from paid-up additions. If the goal is to “Bank on Yourself” with the policy, it would have wash loans and non-direct recognition dividends. However, these are not the policies being sold to the readers of this site.
#3 You Get the Cash Value or the Death Benefit but Not Both
Amazingly, many purchasers of whole life policies don't do an appropriate amount of due diligence on this expensive purchase that, like marriage, requires you to hold it until death or suffer severe financial consequences. They do not even understand that there are not two pots of money in a whole life policy. There is not a death benefit AND a cash value; there is a death benefit OR a cash value. Any dollar “borrowed out” of a policy is one dollar less that is paid as a death benefit. Have a million-dollar death benefit but have borrowed out $800,000? You now have a $200,000 death benefit. Sorry, that's the way it works. I know the agent spun it as a combination of an investment (although they never actually said that because it's illegal) and an insurance policy, but you really don't get both. You just get a choice between them.
#4 Low Returns
Perhaps the most disappointing aspect of a whole life policy is that it pays really low returns for an investment (I can say that, even if the agents can't) that requires you to hold it for decades. In fact, in the early years, the return on your premiums is negative. It might take 10 or even 15 years for the cash value to equal the total premiums paid, and that's without borrowing any money against the policy or skipping any payments. However, even if you make all of the premiums for decades, you are likely to end up with a return somewhere between the guaranteed scale (about 2% a year) and the projected scale (about 5% a year); 3%-4% a year is probably about right for a policy bought these days. It gets confusing, though, because the “dividend rate” is usually higher than that—in the 5%-7% range.
However, dividends are only applied to the cash value you already have, NOT the total premium paid. Some of that premium goes toward commissions, costs of insurance, administrative costs, and profit for the company. If you mistake the dividend rate for your rate of return (as many purchasers and, surprisingly, many agents often do), you're going to be disappointed. If you are really going to tie up your money for decades, you probably ought to consider something paying a higher rate of return, such as stock index funds, well-managed real estate, or perhaps even TIPS if you can buy them with a good real interest rate.
Consider the difference between earning 4% on $100,000 instead of 10% over the course of 40 years.
=FV(10%,40,0,-100000 = $4,525,926
=FV(4%,40,0,-100000) = $480,102
Yes, there is one digit less in that lower number. It is $4,025,823 less, just 11% of what you could have had with something that paid a higher return. Even after you adjust for taxes, interest, and risk, there's still a dramatic difference here.
#5 Provides Unnecessary Insurance
On average, insurance is worth less than it costs. It has to be or the insurance companies would go out of business. I'm not saying don't buy insurance, but I am saying don't buy insurance you don't need. For most people, insurance that provides a death benefit after retirement is not a need. If the decedent was single, nobody else is likely depending on their income, so there's no financial catastrophe when they die. If they are partnered, the survivor can live just fine the rest of their life on the money that was going to sustain both of them for the rest of their lives. Again, no financial catastrophe. So, no need for insurance. If you buy whole life insurance when you should have bought term life insurance, you're going to buy a whole lot of (expensive) insurance that you don't need.
#6 Difficult to Commoditize
One reason whole life insurance is so expensive is that it isn't commoditized. When you think of a commodity, think of gasoline. It's (mostly) all the same, so you buy it based on price and convenience. Term life insurance is that way. There are dozens of companies selling it, all competing with one another. Thus, the price gets bid down, and there isn't a whole lot of profit left in it by the time you buy it. You can easily compare the same $1 million, 30-year level term policy across a dozen companies and select the one offering it at the best price. Whole life doesn't work that way. Every policy is unique. You are comparing apples to oranges. This makes shopping harder, but it also makes the product more expensive for you to buy than it would be if it were commoditized.
#7 Guarantees Cost Too Much
The nice thing about whole life insurance is that it provides guarantees. There is a guaranteed rate of return on the policy. There is a guaranteed death benefit. There is a guaranteed ability to borrow against the cash value. However, you are giving up way too much in return to get those guarantees (see Con #4 above to understand just how much those guarantees are costing you.)
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Whole life insurance is a financial product that most white coat investors shouldn't buy. Once they understand the pros and the cons, that won't be a problem.
Have more questions about life insurance and what kind of policies would be the best for you? Hire a WCI-vetted professional to help you sort it out.
What do you think? Did I miss any pros or cons? Which of these matters most to you? Comment below!