What is the Difference between Term and Whole Life Insurance?

Many people, especially new parents or newly married couples, should start thinking about life insurance.  Someone else, be it a spouse or a child, is relying on you and your income and you need to make plans accordingly in case something happens to you in the near or long-term future.  Life insurance can be an essential vehicle to safeguard your loved ones in the event that you pass away prematurely.  
One of the first things you need to do is get an understanding of life insurance, the terms, the costs, the limitations and the tax treatment of life insurance proceeds.  There are two main types of life insurance: term life insurance and whole life insurance.  The first question you need to ask yourself is what is the difference between term and whole life insurance?  What are the advantages of one over the other and what are the disadvantages? 

Term life insurance is the simplest form of life insurance to understand. You enter into a contract with an insurance company for a set period (usually 10, 20 or 30 years) of time, called a “term”. During that term you pay the insurance company an amount of money, called a “premium”, each year to keep the insurance policy in force. In level term life insurance (the most common type of term insurance), you pay the same premium each year. That premium paid has no benefit to you other than to keep the policy in effect -- it is not an investment vehicle at all (unlike whole life as you’ll read later); it is just the cost of the insurance each year. There is a face value of the insurance policy (sometimes $100,000-$1,000,000 and generally in round numbers), which is the amount of money that will be paid to your beneficiaries upon your death.

So for instance if I’m a nice healthy 30 year old man, I would buy a $500,000 term life insurance policy for 30 years. My premium would be about $600 a year, and I would pay that amount every year to the insurance company. If I die in the next 30 years, assuming I’ve paid my annual premium, the insurance company will pay my beneficiaries $500,000 upon my death. If I don’t die in the next 30 years, then the policy expires on the day of the 30th anniversary of the policy and that’s the end of the insurance. It’s really as simple as that.

Whole life insurance is considered permanent insurance. As long as you keep up-to-date with your premiums, you will have this policy in force for your entire life. Whereas term life insurance is just life insurance, whole life combines the life insurance aspect with an investment aspect as well. It gets rather complicated, but it is basically a forced savings for you, and it combines your investing with your life insurance.

Because of this additional component, whole life insurance is much more expensive than term life insurance. Unlike in term insurance, you build up a cash value in your life insurance account that is ultimately your money. The life insurance will also pay out just like term insurance upon your death. So if you have a $600,000 policy, your beneficiaries will receive $600,000.

For the vast majority of people, term life insurance is the clear choice in this debate. If you’re under 45, the premiums on a 20 or 30 year term insurance policy will be quite inexpensive and then your family is covered for the period where they will need the money the most -- during what would have been your working years. Whole life insurance is a favorite of the insurance agent, because the commissions and fees are enormous. A good rule of thumb in life is to not buy something if you know someone else is making a huge commission off of it -- it’s usually a sucker’s bet.
The real question to ask yourself is this: if the life insurance aspect is the same in term and whole life (which it is), why would you pay an insurance company extra money to invest for you when you don’t have much info on the investment and they charge you 20-30% in expense fees? Instead you can just invest with your investment firm (Fidelity lets you open up a free account for instance) and pay only around 1% in fees, which is a much smarter option.
I guarantee you the agent will try to push the whole life insurance, because it is in his best interest monetarily, but it is not in yours. Buy the term insurance, pay a small amount each year and sleep well at night knowing your family is secure if anything were to happen to you.