Term life insurance is a contract which promises a payment – called the death benefit- to beneficiaries only, usually to replace the income needed to support a family. This benefit is in exchange for consistent payments of “premiums,” over the course of the term. Cash value or “whole life” insurance promises the death benefit in exchange for premiums, but also acts as a savings vehicle with tax and estate features. It can pay money even before the insured person dies, and sometimes it is used to protect things other than income and parental services. Of course, these savings and other benefits come with a cost, but they can be powerful tools when used properly.
Term Life
The death benefit of term life insurance is paid only in the event that the insured person dies, and only if the insured dies during the existence of the contract or “policy.” The term policy ends at a certain point, and the insurance company no longer has to pay any death benefit. One small variation is that mutual insurance companies which are owned by the policyholders, sometimes offer a return of premiums paid, called “dividends.” These are usually much smaller amounts, and are never paid by insurance companies owned by stockholders.
Since it is less expensive, and has a defined term, it is ideal to protect families during the years when they have not yet reached financial independence, and must work to pay the bills. Most families have one or two parents who work to earn a paycheck, or take care of the kids and household. Both of these jobs have real value which should be insured. This is probably the most common use of life insurance, that is to pay the survivors money, either to buy the things that the deceased working parent cant earn anymore, or to pay replacement workers, like nannies and housekeepers when the stay-at-home parent dies and can no longer perform those duties. Life insurance provides a financial benefit when the one who is insured dies. That payment usually goes to the family of the insured.
Whole Life
Whole life policies have a savings component in addition to the death benefit. The premiums are higher with whole life because part of the money is used for the death benefit coverage, and some of the money is used to build value and earn a return. The extra money goes into an account that either pays interest or a rate of return based on the stock and bond markets.
While costly, whole life insurance offers the advantage that it stays in place even after premiums are no longer being paid. Also, the insured can use the money stored in the policy while still alive by taking out loans. These loans are not usually paid back, and they are taken free from income tax. Because of this advantage, whole life insurance is often used as an additional retirement fund.
Because of the laws of life insurance, the death benefit is be paid free from income tax under certain circumstances. This means a family can plan for large income or estate tax bill to be paid with the proceeds from whole life insurance. For very wealthy families with income and estate tax bills at death, whole life insurance is a valuable planning tool to pay these obligations.
Summary
Both term and whole life insurance pay death benefits to the insured’s beneficiaries. While term life is cheaper and very effective for working families, whole life is flexible enough to be used to insure a family’s income, and for retirement and estate planning. In all cases, when considering life insurance, research and working with an ethical vendor are extremely important.