As you consider different selections, it’s important to understand how these types of insurance differ from another. Among permanent life insurance, two widely-purchased options are whole life insurance and indexed universal life insurance.
While term life insurance is the most straightforward, it covers you only for a short-term period. Conversely, whole life and indexed universal life policies give lifelong coverage, so long as a policy remains active.
But they are more complex, tend to cost more than term coverage, and can be better-suited for long-term objectives. With that said, the cash value component of permanent insurance may be attractive for a number of reasons, including for efficient legacy planning, tax-advantaged wealth building, and tax-deferred retirement saving.
If you’re exploring term life insurance versus whole life insurance and indexed universal life insurance, it’s prudent to be diligent. You will want to research and consider your options carefully, and to help you get started, here's a quick guide on the differences between these life insurance types.
When it comes to life insurance, people often focus on two things: length of coverage and price. Chances are you have heard of trendy sayings like “term over perm” or “buy term and invest the difference.” But the question of what life insurance someone needs isn’t an “either-or” situation. Nor is term insurance the “best” option by default.
Sure, term coverage may be purchased at the lowest initial cost. But when you need to renew your policy, term rates often increase substantially. You may also find that you actually need more than one type of life insurance policy.
So, any life insurance purchasing decision should include a vigorous fact-finding and analysis of your personal and household financial needs. In fact, some other variables to consider are:
- Your risk tolerance
- Your age
- How your number of dependents might change
- Your health status
- Your time horizon before retirement
- Whether your needs extend beyond just protection
Term Life Insurance
Compared to whole life and indexed universal life, term insurance provides the simplest coverage. The policy owner holds the guarantee of a death benefit for a certain period. That can last anywhere from 10-30 years, with most term policies lasting for 20 years.
When a term policy expires, that’s it. Your loved ones won’t receive any payouts since the policy has ended. You may be able to renew your term policy, but your new rates will be based on your current age and the actuarial risks that come with it (for example, heightened health risks, shorter life expectancy, so on).
The benefits of term life insurance are:
- Premiums stay fixed
- Simplest form of life insurance coverage you can purchase
- Available at lower cost than whole life and IUL, at least initially
- Provides a straightforward, guaranteed death benefit for a preset duration
- May come with ability to convert to a permanent policy
- Some policies include riders for healthcare and long-term care costs
- Flexible, short-term protection when people need it
- Policy may lapse if premium payments are late or missed
- No death benefit provided upon expiration
- Renewal rates can be far more costly than your initial rates
- No cash value included in the policy
- For some people, no “return benefit” for potentially decades of premium payments can be hard to stomach
- Creating protection for households in high-need years, such as when they first have children
- Providing immediate financial resources if a primary income earner dies unexpectedly
- Covering the economic value of a homemaker should they pass away
- Giving coverage for debts or expenses, like a mortgage, if an income earner deceases
Whole Life Insurance
Whole life insurance has been around for decades. It is the most basic form of cash value life insurance. A whole life insurance policy comes with predictable premiums that don’t rise with age. It also confers guaranteed benefits.
Whole life insurance comes with a cash value, which can be accessed in later years. When comparing whole life – and other cash value insurance for that matter – to term life, it’s similar to buying versus renting a home. Sure, renting will be less expensive in the short run. But over the long term, it may prove to be the most costly. In contrast, buying a home enables someone to build up home equity over time – not to mention it may be potentially lower cost over time.
Whole life is like owning a home that has a corresponding equity component. Over time, this equity component, or the cash value grows tax-deferred, and your premiums don’t increase. With that said, whole life insurance does come with more costs to cover, including management fees.
The benefits of whole life insurance are:
- Premiums stay fixed, don’t rise with age
- Comes with guaranteed benefits
- Simplest form of cash value life insurance
- Ability to pay up policy face value in 10-20 years, or at age 65
- Can access cash value via loans or withdrawals later on
- No age 59.5 withdrawal rules, so long as the policy doesn’t become a Modified Endowment Contract
- Cash value grows on tax-deferred basis and money can be taken out on a potentially tax-free basis
- Insurance company may pay dividends to policy owner
- Often the interest rate is not guaranteed
- Comes with more costs to pay than term insurance
- Premium payments aren’t flexible
- Premiums must be paid consistently or policy will lapse
- Likely to earn lower interest
- Policy lapse may trigger taxable event
- Most whole life policies don’t build cash value early on
Indexed Universal Life Insurance
Index universal life insurance, or “IUL,” can enjoy stronger opportunities for cash value growth than whole life insurance. Its interest-earning potential is tied to an index, like the S&P 500 price index. Unlike whole life insurance, IUL does offer flexibility in premium payments, with certain conditions. The cash inside an IUL policy grows tax-deferred, just like with whole life, and the cash value can be tapped for premium payments.
While the growth potential may be more substantial, indexed universal life insurance is a newer innovation in the insurance marketplace. Your premiums may increase over time, as the cost of insurance may rise. Insurance carriers may hold derivatives as underlying investments in IUL policies, which can make these policies even more complex.
While IUL does let you enjoy growth potential tied to an index, it comes with limits. IUL insurance carriers “cap” the growth potential at certain predetermined rates, and likewise they may protect against negative index changes with a “floor.” While many IUL policies have a floor of 0%, or your cash value doesn’t drop in value when the index goes down, this applies to when the insurance carrier credits interest to your policy. In fact, your policy may lose value due to policy costs you have to pay, should you earn no or low interest at a given point.
If a policy owner relied on high interest-earning years to fund the cash value, it could lead to a policy lapse in later years, should the policy get low interest in later times. Likewise, taking policy loans and paying loan interest can be risky if earned interest doesn’t surpass the costs of the loan.
Some of the benefits of indexed universal life insurance are:
- Guaranteed benefits, though fewer than whole life insurance
- Ability to obtain a bigger death benefit than with whole life
- Flexible payments for premiums possible
- Potential to receive more interest than whole life insurance
- Cash value can be accessed via loans or withdrawals
- No age 59.5 withdrawal rules
- Tax-deferred retirement money growth potential
- Ideal vehicle for supplementing income or maximizing an estate for beneficiaries
- Premiums may increase over time
- Opportunity to earn interest depends on index performance
- Interest-earning potential “capped” by insurers
- Policy may lose value when costs outpace low interest
While indexed universal life insurance may be a solid retirement planning vehicle, it is more complex than other cash value life insurance. Working with a qualified financial professional to properly structure a policy, according to your needs and goals, is a prudent strategy.
While this overview showcases some of the critical differences of IUL, whole life, and term life insurance, it’s by no means exhaustive. If you are considering life insurance as part of your financial strategy, especially permanent insurance, be prudent.
Conduct a careful due diligence and consider guidance from a financial professional who acts in your best interest. And when planned and implemented properly, a life insurance policy can go a long ways to bringing you more financial security and peace of mind.
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