What is whole life insurance — and is it worth higher premiums?

Life insurance helps you ensure your loved ones are financially protected if you pass away. You have a few options when picking the right kind of policy — and depending on your circumstances, whole life insurance may be a good choice.

Whole life insurance is a type of permanent life insurance designed to provide coverage throughout the policyholder's entire life. Below, CNBC Select breaks down how it works, how it's different from other types of life insurance and how to decide if it's right for you.

When you have a whole life insurance policy, you pay fixed premiums and receive a guaranteed fixed death benefit. As long as you keep paying your premiums, your policy covers you for life.

Whole life insurance also has a cash value component, which acts similarly to a savings account: with each premium payment, you're contributing to the policy's tax-deferred cash value that earns interest. You can use this cash value to help pay your premiums or to make withdrawals (though withdrawing money may cause your insurance company to charge you a fee). You can even take out loans against it.

Your cash value is typically "use it or lose it" — if you have any left when you die, it goes to the insurance company and not your beneficiaries (who only receive the agreed-upon death benefit). But because you can customize just about any insurance policy, some companies offer a rider that will pay your beneficiaries both the death benefit and the cash value (usually at the cost of higher premiums).

Depending on the company you purchase it from, whole life insurance can also qualify you for dividend payments. You can use the dividends to pay your premiums, take them in cash or leave them with the insurance company to earn interest on the amount. While dividends aren't guaranteed, insurance companies typically pay them consistently. For example, MassMutual, CNBC Select's pick for the best whole life insurance provider, estimates to pay $1.9 billion in dividends to policyholders in 2023. Guardian is another highly-ranked insurer that issues dividends.

What is the difference between term and whole life insurance?

Unlike whole life insurance, term life insurance only covers a policyholder for a set number of years — usually 10 to 30 years. It won't offer a payout if the term expires before the insured person dies. It also doesn't build any cash value.

At the same time, term life insurance can be considerably more affordable, both in the short and long term. With whole life insurance, your policy is active as long as you keep paying the premiums. As a result, while your premiums remain the same, the overall cost of your policy increases as you continue making payments for the rest of your (hopefully long) life.

Whole life insurance can be an excellent choice, particularly if you want a policy that lasts your entire life and provides some fringe financial benefits. But its high premiums mean it isn't for everyone. Before you decide whether a whole life insurance policy will work for you, it helps to evaluate its pros and cons.

Pros of whole life insurance

• Whole life insurance is permanent. As long as you keep up with the premiums, the policy will stay active your entire life.
• Whole life insurance has fixed premiums and a fixed death benefit, which means it's predictable and consistent.
• Whole life insurance builds tax-deferred cash value. A portion of each premium goes toward the policy's value and you won't pay taxes on the interest it earns. You can use the value to pay your premiums, withdraw cash or take out a loan against your policy.
• Some companies offer dividends, which are also generally non-taxable — unless the amount you receive is higher than what you have paid in premiums in total. You'll also pay taxes on any interest your dividends accumulate with the insurance company.

Cons of whole life insurance

• Whole life insurance is typically more expensive, compared to term life insurance. According to Policygenius, the average non-smoking policyholder with a Preferred health rating would pay $540 a month in premiums for $500,000 in coverage vs. $28 per month for a 20-year term policy offering the same amount of coverage.
• Withdrawing money from the cash value decreases the death benefit. The same happens if you take out a loan against your policy and die before paying it back. If you withdraw all the money, the policy will terminate.

Considering these points, a whole life insurance policy can be a good choice if you need coverage to help support beneficiaries for the rest of their lives. For example, if you have a dependent who is disabled in a way that prevents them from earning an income, whole life insurance can provide a way to fund a trust to help cover their expenses for the long haul. 

It can also act as an investment vehicle that provides conservative but guaranteed growth, but you shouldn't expect the cash value part of the policy to earn high returns. Rather, you can use it to diversify if you're already maxing out your 401(k) and IRA accounts and want another place to grow your retirement savings.

If your main reason for purchasing life insurance is to protect your family from the short-term consequences of the loss of your income, term life insurance can provide sufficient coverage in most cases. For example, if you have young children, a 20-year term insurance policy should be able to keep you covered until they can rely on their own income.

With a fixed death benefit and premiums, whole life insurance provides coverage that can last your entire life. It can also be a vehicle for tax-deferred savings. At the same time, this type of life insurance coverage can be expensive and isn't a universally optimal choice. Consider your needs and circumstances, as well as those of your family and dependents, to choose the right type of life insurance for you.

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