A whole life insurance policy covers you for your entire life, not just a specified period. Your death benefit stays the same, as does your premium. This differs from term insurance, where premiums increase as you age to reflect your greater health risk.

Permanent life insurance differs from term insurance in two important ways:
1) With a permanent policy, you do not buy insurance for only one year at a time.
2) You build cash value with every premium added to your account.

Cash Value

Building cash value means your policy has value beyond its death benefit—the policy's face amount paid to beneficiaries when you die.

So what is the catch? Why would anyone choose term insurance over a policy with value beyond the death benefit? To answer that question, first examine how cash value whole life insurance works.

The Investment Concept

When you buy whole life insurance, part of your premium pays for the insurance itself, part goes toward cash value, and the rest covers administrative costs and your agent's commission.

The insurer invests the cash value portion, and you receive part of the earnings in return. Your share goes into your cash value. In a sense, this portion is an investment. Like any investment, it has its rewards.

Tax Benefits

One of the biggest differences between this investment and many others is that all investment returns are tax-deferred. You do not pay tax on gains until you withdraw them, unlike other investments on which you must pay capital gains tax. Whole life insurance becomes even more attractive when you consider the following:
- The portion of premiums used to buy your actual insurance reduces the amount of gain you receive.
- You pay tax only on the difference between total gains and total premiums paid, making your investment return significantly higher than if the entire amount were taxable. (Even capital gains tax is 20 percent, so you receive at least 20 percent more than if you deposited the same money in an interest-bearing savings account.)

For example, a 5 percent return on a $10,000 savings account gives you $500 at year-end. But you must also pay 20 percent of that return in income tax. You effectively earn only $400: 20 percent of $500 is $100, which, subtracted from $500, leaves $400. By contrast, if the $10,000 is in a tax-deferred account such as whole life insurance earning 5 percent, you earn the full $500.

If you are considering whole life insurance as an investment, remember that returns have historically been low, even accounting for tax savings. Judge any life insurance policy by the protection you are buying, not its investment return.

Rates of Return

The return on a permanent life insurance investment depends on the insurer's ability to invest wisely. The company pools cash value money from all policyholders and invests it, generally in low-risk investments that naturally earn less than many alternatives. Regardless of the company's investment return, most life policies guarantee at least a minimum rate. Anything the company earns above that—and above its costs—goes toward your cash value.

Dividends

Beyond the guaranteed return, some companies offer policyholders the chance to benefit from the company's success, much like shareholders. The company pays policyholder dividends based on its performance the previous year. Policies with this benefit are called participating policies.

• Your dividend amount depends on several factors:
• The company's overall financial success
• How well the company anticipated interest rates
• The number of claims the company had to pay
• How well the company's investments performed
• Your policy's specific terms

Dividends are factored into complex formulas that determine your premium, other company offerings such as loan benefits, and the guaranteed rate of return.

Some companies pay a terminal dividend—a kind of bonus—when the policyholder dies. Naturally, companies do not guarantee this or any other dividend, and you should account for that when comparing policies. However, most annual and terminal dividends are paid. Once the insurer declares a dividend, it can pay cash to the policyholder, use it to cover the insurance cost, add it to cash value, or apply it toward additional life insurance coverage.

The choice is generally the policyholder's, and each option has advantages. Naturally, the company hopes you will choose additional coverage; most illustrations and examples agents use in sales presentations select that option.

The portion of an annual cash dividend exceeding premiums paid for the year is taxable. A dividend credited to cash value or applied to premiums is not taxable until you withdraw money from the account.

Termination

If you cancel whole life insurance, you are entitled to a surrender value, essentially your accumulated cash value. Surrender value continues increasing as you contribute, but the amount grows at a progressively slower rate.

Loans

Another whole life benefit is the ability to borrow against cash value, generally at interest rates significantly below market rates, between 6 and 8 percent.

Rates are low because the lender assumes no risk: if you do not repay the loan, it can take money from your account. Borrowing against your policy involves no charges, and you can usually receive the money within a few days. If you die before repaying the loan, the outstanding amount is deducted from the death benefit.

If you surrender the policy, the outstanding loan balance is deducted from the cash surrender value.

Interest-Sensitive Whole Life Insurance

Interest-sensitive whole life pays adjustable, variable interest rather than a guaranteed rate. Like an adjustable-rate mortgage, the rate is often tied to an economic indicator, such as the Treasury bill rate.

Premiums, death benefits, and cash value all align with the variable interest rate, giving policyholders several choices. When rates rise, you can keep the same death benefit and cash value allocation percentage while reducing premiums. Or you can keep premiums and the death benefit steady while increasing cash value.

Some policies let you increase the death benefit while keeping premiums and the cash value rate of return steady.

Naturally, the opposite choices are available when interest rates fall: cash value returns decrease while premiums and the death benefit stay constant; premiums rise to maintain the same cash value return and death benefit; or the death benefit decreases while cash value returns and premiums stay at the same levels.

Interest-sensitive whole life policies are very similar to universal life policies.

Single-Premium Whole Life

Some insurers offer single-premium whole life for people with a large sum available to spend on insurance who are looking for tax benefits.

You buy the policy by paying a large amount for a specified death benefit. There are no annual premiums, and the death benefit stays constant or increases depending on the policy. The insurer takes your money upfront, invests it, and pays you a modest return, similar to other whole life policies.

Like other whole life policies, it builds cash value, generally with a guaranteed minimum return. When the insured dies, the death benefit plus any accumulated cash value goes to beneficiaries.

If you have cash available and want life insurance, consider this option. In effect, single-premium whole life lets you pay all premiums upfront, then lets the company use your money throughout the period.

In return, you receive benefits that may matter to you:
You receive a substantial discount on the insurance itself; and b) your lump-sum payment is less than the cumulative annual premiums on comparable whole life policies.

You receive significant tax savings.

Tax savings may be the main reason people buy this insurance. All money earned within a single-premium whole life policy is tax-deferred.

You can immediately borrow against the account's cash value. If you borrow only against cash value earnings, you will probably pay roughly the same interest the cash value earns. By keeping money with the company, you therefore give yourself the opportunity for a virtually interest-free loan.

Do not buy any insurance policy based on its return or tax benefit. If you do not need or want life insurance, look for more cost-effective ways to save or reduce your tax burden.

If you borrow against whole life insurance, pay close attention to possible tax consequences. If the borrowed amount includes tax-deferred gains—interest you have accumulated—you may owe tax on those gains. Consult your tax advisor before exercising this option.