When Whole Life Insurance Doesn’t Last Your Whole Life
When you see the term “permanent life insurance,” does that lead you to believe that it will cover you for your entire life? Many people think so, but that could potentially be a costly mistake.
Learn how whole life insurance works, how it’s different from term life insurance and the pros and cons of each.
What does permanent life insurance mean?
“Permanent life insurance,” as Tamara Holmes at InsuranceQuotes points out, is an umbrella term for insurance that covers you for a long period of time. Whole life, variable life and universal life are all types of permanent life insurance policies. Unlike term life insurance, which only covers a fixed period of 20 to 30 years or so, permanent life insurance comes in several tiers.
Whole life insurance policies require policyholders to pay a set premium but pays out a fixed amount if you die. Variable life insurance invests your premium and pays a benefit based on how the market performs. Universal life insurance, meanwhile, lets you adjust payments as needed, but it also adjusts the death benefit accordingly.
Permanent life vs. term life insurance
The two most common types of life insurance are permanent life insurance and term life insurance. Permanent life insurance protects you for your lifetime, whereas term life insurance offers coverage for a specific period of time.
You can purchase term life insurance for a set number of years, usually ranging from five years to 30 years. Because term life insurance offers less coverage, it’s cheaper than a permanent life insurance policy. The caveat is that term life insurance premiums can increase each year, whereas a permanent life insurance premium never changes.
Another difference between permanent and term life insurance is cash value. Permanent life insurance accumulates cash value, meaning your monthly payments compound and grow over time. When you withdraw your funds, you can pull that money out or reinvest it. Term life insurance policies don’t have cash value or a savings option.
As you get older, term life insurance policyholders have the option to convert their policy into a permanent life insurance policy. However, you can’t convert a permanent life insurance policy into a term life policy.
Pros and cons of permanent life insurance
If you’re debating whether to purchase permanent life insurance, it’s important to understand the pros and cons. One of the things that make permanent life insurance a popular choice for many people is that it’s tax-deferred. As your money grows, it’s not being taxed, which means you could end up with more money when you withdraw the funds.
Another benefit of permanent life insurance is that you can keep the policy for much longer than term life insurance. Most insurance companies allow policyholders to keep their permanent life insurance policy until age 120, assuming they continue paying the premiums. However, this can also be a con. At age 120, it’s unlikely that you have living beneficiaries who could use the money from your policy.
One of the biggest perks of a permanent life insurance policy is that you can access accelerated benefits if you get sick. If you have a qualifying medical condition, such as heart attack, stroke or late-stage cancer, you can use the money to pay off medical expenses and improve your quality of life before you die. However, if you get accelerated benefits, your beneficiaries won’t be entitled to your full death benefit.
What are death benefits and how do they work?
When a life insurance policyholder dies, their beneficiaries receive death benefits. A beneficiary is a survivor of the policyholder—usually a spouse, child or next of kin. They receive the money from the life insurance policy, which can be used as income or reinvested.
However, some permanent life insurance policies have a maturity date when they pay out the cash value to the policyholder. Many of those policies reach their maturity date when the policyholder turns 95 or 100. At that point, the death benefit is paid out in cash and comes with significant tax consequences.
It’s an increasingly plausible scenario. Eight percent of women who are currently age 45 can expect to live to 100.
“After years of paying premiums for a policy you expect to remain in place until your death, you may lose the benefit of passing wealth to your heirs tax-free,” says certified financial planner Shomari Hearn with Palisades Hudson Financial Group. “Sometimes you won’t even get full value from your policy.”
Do you pay taxes on death benefits?
A life insurance death benefit is typically exempt from federal taxation if it’s less than $5 million. If your policy matures, however, not only will your beneficiaries not receive the benefit, but the portion of the payout that exceeds the premiums paid will be taxed as ordinary income, according to Hearn.
In the case of a whole-life policy, the cash value will equal the death benefit plus accumulated interest, if any. Unfortunately, if you opt for variable life or a variable universal life to get a lower premium, you might be in for a surprise. “If investment results are poor, the cash value at maturity may be considerably less than the promised death benefit,” Hearn says.
Can you extend your whole life policy maturity date?
It’s possible to extend your policy’s maturity date. Hearn notes that if you’ve purchased your policy within the last 15 years or so, the maturity age is likely 120. Still, because age 100 was the default for many years prior to that, it pays to check the terms of your policy. Some older policies mature at 95 or 96.
If you’re stuck with an older policy and an early maturity date, you can ask your insurer for a “maturity extension rider” to extend the policy’s maturity age to 120. There may be a fee for the rider ($5 to $10 a month), but be aware that not all insurers offer it. Generally, though, the death benefit of a policy with an extension rider is the cash value of the policy at the original maturity date plus accumulated interest, without additional premiums.
“If the insurer grants the rider, you may be able to avoid a taxable event, and your beneficiaries will receive the policy’s benefits upon your death as originally planned,” Hearn says.
Even that may not prevent a tax hit. The Internal Revenue Service may rule that you still owe tax at the policy’s original maturity date under the principle of “constructive receipt.” Even if you don’t take the lump-sum payout, the IRS may have questions. Hearn notes that insurers are fighting the IRS on this.
“However, it’s still worthwhile because a maturity rider will secure the policy’s death benefit for your beneficiaries,” Hearn says.
Are there other ways to avoid a taxable event?
Hearn says even obtaining that rider may be difficult for those who choose universal life over whole life insurance. Even those with a whole life policy have to hope the insurer will cooperate. If they won’t budge, you may be able to buy a replacement policy with the now-standard age 120 maturity. This is much easier to do when you’re healthy and younger than 70 than when you’re older and sicker.
Another option, a Section 1035 exchange, allows you to swap an old policy for a new one without incurring a taxable gain. As long as the owner and insured are the same on the old and new contracts, it shouldn’t be a problem.
“Make sure you obtain the replacement policy before surrendering your existing policy to avoid being left without coverage,” Hearn says.
Finally, if you can’t or don’t want to make an exchange and the maturity date is coming up, the best bad option on the table involves converting the policy into an annuity. This spreads out the tax liability over several years instead of having it all crash down on you in one year. A portion of each annuity payment is taxable, Hearn says.
“As more people live to celebrate their 100th birthdays, a firmer answer on how the IRS and insurers will handle policies with too-short maturation dates should eventually arrive, Hearn says. “In the meantime, policyholders need to take proactive steps if they wish to capture the full value of their ‘permanent’ insurance policies.”