The True Purpose of Whole Life Insurance

What is the real purpose of whole life insurance?  Hint: it’s not to insure your life.

Answer: the best use of whole life insurance is to avoid estate taxes.

Whole vs. term life insurance

Term life insurance is a contract that, if you die during a specified period of time, your beneficiary will receive a sum of money (the death benefit).  After the term expires, the contract is worth nothing.

Whole life insurance will also pay your beneficiary a sum of money, in the event of your death, but in addition, the policy accumulates a value.  Part of your monthly (or quarterly or annual) payment goes towards the actual term life insurance portion of the contract.  The rest of the payment goes into an investment, depending upon the type of policy.  The investment builds up value over time.

If a policyholder terminates the contract, he can receive the “surrender” value of the policy.  In the early years of the contract the surrender value can be negligible, but the value rises in later years.

Irrevocable life insurance trust (ILIT)

To avoid estate taxes, you can create an irrevocable life insurance trust (ILIT) to own the policy.  This transfer the funds out of your estate and into the trust’s.  It lowers the value of your estate, and should you die, it reduces your potential estate tax bill.

Estate taxes

In 2009, estate taxes were as high as 45%; however, the exclusion was $3.5 million.  If your net worth was less than $3.5 million (which includes >99% of Americans), you did not owe any estate tax.  That is why whole life insurance (and ILIT’s) are only useful for the rich.

2010 is kind of a crazy year for estate taxes, because this year you get an unlimited exclusion — there essentially is no estate tax this year.  All bets are off for 2011.  Unless Congress acts, the estate tax will be reinstituted and the exclusion will drop to $1 million, subjecting a much larger percentage of Americans to estate taxes.

Boy, that sounds a lot like how the Alternative Minimum Tax (AMT) crept from the wealthy into the middle class.

Why does whole life insurance exist?

That is a mighty good question.  Why would a special exemption from estate tax exist?

But the special tax treatment might explain why whole life insurance is so expensive.

Buy term and invest the rest

Whole life insurance is significantly more expensive than term.  It’s simple to find online quotes for term life — not so for whole.  The cost of whole life insurance varies depending what options you select:  investment type, joint life insurance, survivorship, flexible payment plans, waiver of premium in the event of disability, and so forth.

For a $250,000 policy, you might pay $30 a month for term life insurance, but $250 a month for whole life insurance.  I’m only estimating these numbers, but I’m not willing to go through getting a whole life quote, and I suspect my estimates are at least in the ballpark.

Should you be considering whole life, you need to figure out whether it’s better to buy the whole life policy or by the term policy and invest the extra $220/month.  At an 8% return on investment, you’d have to invest $220/month for 27 years to accumulate $250,000.  So, at first blush, it might seem like a good deal.  But remember that the cash value of the policy is only the surrender value — a number calculated by the insurance company.

Because it is difficult to calculate the future value of your investment in a whole life policy (due to the opacity of the insurance policies), it is much more straightforward to buy the term policy and invest the difference.  At least with a brokerage account, you can look up the cash value anytime you want.

Disclaimer: The information in this article is presented for educational purposes only.  If you have questions about your particular financial situation, please see a financial professional.

Image Credit: Jiří Mašek on Flickr.

Tags: ILIT, life insurance, term life insurance, whole life insurance