Companies like universal life insurance provide a very valuable product that is life insurance; whole life insurance, unlike term life insurance, is considered both an investment and family protection and is a favorite among financial planners for its benefits.
The customer and company
Whole life insurance companies and their customers benefit equally from their business together. The whole life insurance company makes money by collecting more in premiums and fees on average than it pays out in death benefits.
However, the customer benefits by paying only a very small annual premium for the protection of knowing that they will, at some time, need money to cover the costs of funeral and burial service, and to provide an income to their dependents should they pass away at a young age.
It has been the case for much of human existence that we live longer and longer with each passing year. New breakthroughs in medical treatments, new developments in fighting disease, and a generally better standard of living mean that whole life insurance companies have a natural advantage in issuing whole life insurance. If we continue to live longer, then we will pay more in premiums, even as the whole life company pays out less frequent death benefits.
Why buy whole life insurance
Unlike term life insurance, whole life insurance is commonly sold as an investment product. The premiums you pay to buy whole life insurance are separated into two pools: one for the insurance company, and one for your whole life policy. In many cases, whole life insurance policies accumulate what is known as a cash value, or an amount within the policy that is yours, should you ever seek to withdraw it.
This cash value is often invested in a collection of stocks, bonds, and index mutual funds which provide a return over the course of many years and build up to a final benefit. The cash value is, at any time, yours to withdraw, though it is often the case that whole-life policies are not redeemed until the end of life.
Instead, whole life cash values grow for many years, and ultimately investors may find that the cash value of the policy exceeds the actual value of insurance. As an example, a whole life policy with a cash value of $250,000 that provides only $100,000 of life insurance is over-capitalized, and the investor could withdraw $150,000 from the cash value without removing the available insurance.
Whole life insurance and taxation
Wealthier investors realize greater benefits from whole life insurance than the simple protection of their family and their income after death. Whole life insurance, thanks to a loophole in the tax code, is a financial product with serious potential tax benefits.
In going back to the example of the whole life policy with $250,000 in cash value, the investor can withdraw this money at any time. However, in withdrawing this money, the investor would have to pay capital gains taxes on the earnings and sometimes pay income taxes for bond payments. This doesn’t leave much room for making a profit.
Instead, investors would be wise to consult their financial planner on borrowing from a whole life policy. In such an arrangement, the cash value can be used as collateral. As you’re well aware, borrowing money is not taxed, and thus the income and capital gains taxes are avoided until death, where they are usually covered with any remaining amount of money. If you were to withdraw, say, $25,000 from accrued cash value each year for 10 years, you would incur $3,750 in capital gains taxation each year.
On the other hand, you could instead borrow $25,000 per year, and thus have no tax burden at the time of borrowing. Interest payments you pay on the loan are generally lower than the cost of taxes, and this example is one of many where you can minimize your tax burden and maximize your post-retirement standard of living with a very simple insurance policy.