Whole life insurance, as the name implies, is a contract designed to provide protection over the insured’s entire lifetime. There are many types of whole life policies, but the oldest and still the most common type of whole life policy is ordinary level premium whole life insurance, or simply ordinary life. This form of insurance is also known as “straight life,” “traditional whole life,” or “continuous premium whole life.” If the term “whole life” is used alone, it is generally accepted that the reference is to ordinary level premium whole life as opposed to any other type of lifelong policy.
This type of contract features level or fixed periodic premiums computed on the assumption that the policyowner can retain the policy for the life of the insured. The death benefit remains level throughout the lifetime of the contract. Insurers invented the level premium concept to make the whole life contract affordable for as long as the policyowner decided to keep it.
As an outgrowth and natural byproduct of the fixed and level premium, the whole life contract develops cash values. These values reflect the reserve the insurer needs to accumulate in the early years of the policy’s life so that they will have sufficient money (together with interest earned on the reserve) in later years to pay the promised death benefit while keeping premiums level. Absent this reserve, the level premium would be insufficient to pay the increasing mortality costs as the insured ages. The policy contains a fixed and guaranteed schedule of the cash values that the policyowner may borrow for any reason (such as an emergency or opportunity) at any time, or take upon surrendering the contract.
See also: The value of cash value life insurance
The policyowner agrees to pay a fixed or level premium at regular intervals for the rest of the insured’s life (generally only up to age 100, if the insured lives that long, or in some cases, to age 95). In return, the insurance company agrees to pay a fixed death benefit when the insured dies if the policyowner has continued to pay the premiums. Policyowners who discontinue paying premiums and terminate their policies are entitled to the scheduled cash surrender value.
1. Who needs whole life insurance?
In general, some type of life insurance is indicated when a person needs or wants to provide an immediate estate upon his or her death. This need or desire typically stems from one or more of the following reasons:
a. To provide income for dependent family members after the head of household dies until they become self-supporting.
b. To liquidate consumer or business debts or mortgages, or to create a fund that would enable the surviving family members to service the debts.
c. To provide large amounts of cash at death for children’s college expenses or other capital needs.
d. To provide cash for federal estate and state inheritance taxes, funeral expenses, and administration costs.
e. To provide funds for the continuation of a business through a “buy-sell” agreement.
f. To indemnify a business for the loss of a key employee.
g. To help recruit, retain, retire, or reward one or more key employees through a salary continuation plan and to finance the company’s obligations under that plan to the dependents of a deceased key employee.
h. To fund bequests of capital to children, grandchildren, or others without the erosion often caused by probate costs, inheritance taxes, income taxes, federal estate taxes, transfer fees, or the generation-skipping transfer tax.
i. To fund charitable bequests.
j. To preserve confidentiality of financial affairs. Life insurance proceeds payable to someone other than the deceased’s estate are not part of the probate estate and are not a matter of public record. It is not unusual for a beneficiary to be a lover, illegitimate child, or to have some other relationship to the insured that the insured may not want to publicly acknowledge. Likewise, the insured may not want the amount payable to the beneficiary to become a matter of public record.
k. To assure nearly instant access to cash for surviving dependents. Insurers generally pay life insurance proceeds to beneficiaries within days of the claim. Because insurance benefits do not need to pass through probate court and are not taxable, there is no delay in distributing the assets to the beneficiaries.
l. To direct family assets to family members in a way that minimizes state, local, and federal taxes.
m. Level premium whole life, in particular, is the preferred type of policy when the need is long-term and there is a desire to maintain a relatively fixed annual premium cost. For many families, it is the most “affordable” form of long-term coverage on the principal breadwinners.
n. Level premium whole life may satisfy various business related life insurance needs (e.g., financing vehicles for buy-sell agreements, key person insurance and nonqualified deferred compensation arrangements). It is especially suitable if the objective is also to receive tax sheltered returns and the company has accumulated earnings problems. The cash buildup in life insurance policies held for legitimate business purposes is not counted towards the accumulated earnings limitation.
o. Level premium whole life insurance is often the preferred type of insurance for split dollar arrangements.
p. Level premium whole life is a tax-sheltered way to finance post-retirement health insurance for a selected group of executives or key employees by using life insurance policies on their lives. Cash values are available to the corporation to help meet future cash needs for health insurance premium payments for retirees. When the employee dies, the corporation receives the death proceeds free from federal income tax (except for some potential alternative minimum tax liability). The corporation is reimbursed for part or all of its costs for the post-retirement health insurance. Corporate Owned Life Insurance (COLI) offers certain advantages over other methods for recovering post-retirement health insurance liabilities.
2. What are the advantages of whole life insurance?
1. A fixed and known annual premium. Although, it should be noted that net premiums (fixed premiums minus dividends) for par policies generally will decline over the years.
2. Guaranteed ceiling on mortality and expense charges and guaranteed floor on interest credited to cash values.
3. Cash value interest or earnings accumulate tax-free or tax deferred, depending on whether gains are distributed at death or during lifetime.
4. Ordinary life, through the combination of guaranteed cash values and dividend formulas, frequently pays higher effective interest on cash values than is available from tax-free municipal bonds.
5. Cash values are not subject to the market risk associated with longer term municipal bonds and other longer term fixed income investments.
6. Policyowners can borrow cash values at a low net cost. Although policyowners must pay interest on policy loans, cash values continue to grow and as the insurance company credits at least the minimum guaranteed rate in the policy. Consequently, the actual net borrowing rate is less than the stated policy loan rate.
7. Life insurance proceeds are not part of the probate estate, unless the estate is named as the beneficiary of the policy. Therefore, the beneficiary can receive the proceeds without the expense, delay, or uncertainty caused by administration of the estate.
8. There is no public record of the death benefit amount or to whom it is payable.
9. In most cases, the death benefit proceeds are not subject to federal income taxes.
10. The death benefit proceeds are often fully or partially exempt from state inheritance taxes unless payable to the insured’s estate.
11. Policyowners can use life insurance policies as collateral or security for personal loans.
3. What are the disadvantages of whole life insurance?
1. Lifetime distributions of cash values are subject to income tax to the extent attributable to gain in the policy.
2. The premium may be unaffordable for persons of limited financial resources.
3. In the early years, the amount of protection is lower relative to the premium spent than with term insurance. However, later, as term premiums rise while the premiums for ordinary life remain level, the reverse typically will be true.
4. Surrender of the policy within the first five to 10 years may result in considerable loss because surrender values reflect the insurance company’s recovery of sales commissions and initial policy expenses.
5. Policyowners generally may not deduct interest paid on policy loans on their tax returns.
6. Cash values accumulating in the contract are subject to inflation. Whole life insurance is by definition a long-term purchase and the guaranteed return on this type of policy provides little inflation protection. However, a partial hedge against inflation is provided by the dividends paid on participating policies which reflect the favorable mortality, investment, and business expense results of the insurer.
7. The overall rate of return on the cash values inside traditional whole life contracts has not always been competitive in a before-tax comparison with alternative investments. However, when safety of principal, contractually guaranteed liquidity, and the cost of term insurance if purchased outside the policy are factored into the analysis, whole life often compares favorably to alternative types of policies as well as nonlife insurance investments on an aftertax basis.
4. What are the tax implications?
General tax rules
Death benefits are usually free of any federal income tax. In general, death benefits paid under these policies are subject to the same income, estate, gift, and generation-skipping transfer taxation rules as all other types of life insurance policies.
Taxation of living proceeds
Section 72 of the Internal Revenue Code governs the taxation of living proceeds from life insurance policies. Living proceeds are generally any amounts received during the insured’s lifetime. For tax purposes, payments are separated into three classes: (1) annuity payments; (2) payments of interest only; and (3) amounts not received as an annuity.
Annuity payments: Annuities include all periodic payments received from the contract in a systematic liquidation of the cash value. This includes both life contingent annuities and fixed term or fixed amount annuities. The rules of Internal Revenue Code section 72 determine what portion of each payment is treated as a tax-free recovery of investment in the contract and what portion is treated as taxable income or gain. To oversimplify, the rules essentially pro rate the recovery of investment in the contract over the expected payout period. Therefore, each payment is treated partially as recovery of investment and partially as taxable interest until the entire investment in the contract has been recovered. Any further payments are treated entirely as taxable income.
Payments of interest only: Payments consisting of interest only (i.e., they are not part of the systematic liquidation of a principal sum) are not annuity payments and are not taxed under the annuity rules. In general, if living benefits are held by the insurer under an agreement to pay interest, the interest payments are taxable in full when distributed or simply credited to the account.
Amounts not received as an annuity: In general, all living proceeds except for interest and annuity settlements are taxed under the “cost recovery rule.” Included in this category are policy dividends, lump-sum cash settlements of cash surrender values, cash withdrawals, and amounts received on partial surrender. These amounts are included in gross income only to the extent they exceed the investment in the contract (as reduced by any prior excludable distributions received from the contract). In other words, nonannuity distributions during life are first treated as a return of the policyowner’s investment in the contract (generally premiums paid less dividends received), and then as taxable interest or gain.
There are exceptions to this rule, but they are unlikely to arise with level premium policies. The first exception is with respect to policies that initially fail the seven-pay test under the Modified Endowment Contract (MEC) rules. Because level premium policies are designed to have premiums payable for the life of the insured, they are not likely to fail the seven-pay test. The second exception is with respect to policies that originally satisfied the tests to avoid MEC treatment, but that as a result of certain changes in the benefits of the contract, subsequently fail the tests. Once again, the types of changes that would jeopardize favorable MEC status are unlikely to arise with ordinary level premium whole life policies. Problems are more likely to arise with limited pay policies and universal life policies. If any life insurance contract is treated as a MEC, cash distributions are generally taxed under the interest-first rule. Under this rule, distributions are first attributed to interest or gain in the contract and are fully taxable. Only when the interest or gain is exhausted are distributions treated as a nontaxable recovery of investment in the contract.
Loan proceeds: Policy loans under non-MEC life insurance policies are not treated as distributions. If a policy loan is still outstanding when a policy is surrendered, the borrowed amount becomes taxable at the time of surrender to the extent the cash value exceeds the policyowner’s investment in the contract. Loans are essentially treated as if the borrowed amount was actually received at the time of surrender and used to pay off the loan.
5. What are the alternatives to whole life insurance?
There is no substitute for life insurance that provides an immediate estate upon a person’s death. All types of life insurance policies can provide tax-free cash upon death. The unique feature of level premium life insurance is its affordability. It provides lifetime coverage at the lowest level annual cost relative to other types of whole life policies. As a byproduct of level premium financing, the policy creates a tax-free or tax deferred cash buildup. Persons desiring a combination of tax preferred cash accumulation and life insurance may want to explore other alternatives:
A combination of a level premium deferred annuity and decreasing term insurance: Cash values accumulate in both annuities and level premium life insurance policies on a tax deferred basis. Therefore, a combination of a level premium deferred annuity and a decreasing term policy can provide levels of tax preferred cash accumulation and death benefits similar to a level premium policy.
There are some important differences, however. The tax rules treat withdrawals, lifetime distributions, or loans from each arrangement differently for tax purposes. Although most ordinary life policies do not permit withdrawals, as such, if a withdrawal of cash values is permitted or the policy is partially surrendered, the amount distributed is taxed under the cost recovery rule. That is, the amounts are included in taxable income only to the extent they exceed the investment in the contract. In contrast, distributions from annuities are taxed under the interest-first rule. In other words, the amounts are fully taxable until owner has recovered all of the excess over the investment in the contract. In addition, nonannuity distributions from an annuity contract before age 59½ may be subject to a 10 percent penalty tax. Furthermore, loans from life insurance policies are not subject to tax; loans from annuities, if permitted, are treated as distributions and taxed under the interest-first rule (i.e., loan proceeds are subject to the regular income tax and may be subject to the 10 percent penalty tax). Finally, loan provisions of deferred annuity contracts are generally more restrictive than those of life insurance policies.
The annuity-term combination will require some additional and increasing premiums over the years for the term coverage. In addition, the mortality charges for term insurance coverage are typically higher than the mortality charges in a level premium policy. Finally, the death proceeds from the insurance policy generally may pass to the beneficiary entirely income and estate tax free, regardless of who is the beneficiary, if the insured has no incidents of ownership in the policy. The gains on the annuity contract still will be income taxable to the beneficiary and will avoid estate taxation only if the annuitant’s spouse is the beneficiary and is a United States citizen.
A combination of investments in tax-free municipal bonds and decreasing term insurance: This combination can create a cash accumulation and death benefit similar to a level premium policy. Similar to the cash values in a life insurance policy, bond owners may use municipal bonds as collateral for loans without any adverse income tax consequences. However, interest paid on debt secured by municipal bonds is not deductible, while in some cases the interest paid on life insurance policy loans may be tax deductible. Also, the life insurance death benefits are transferred outside of probate, while municipal bonds are part of the estate. Finally, if the policyowner has no incidents of ownership, the death proceeds are paid estate tax free. The municipal bonds will escape estate tax only if they are left to the spouse and sheltered by the marital deduction