Understanding Types of Life Insurance

Life insurance protects your loved ones’ financial stability by paying out a lump sum benefit if you pass away. This cash can be used to pay for funeral expenses, finish paying a mortgage, and cover remaining debt obligations.

Life insurance benefits are not considered income. They are only taxed as part of estate taxes, not income taxes, which is another reason that life insurance is a great investment in your family’s financial future.

There are lots of options when it comes to life insurance. Many employers offer life insurance as part of their benefits packages for employees. Keep in mind that while these group rates tend to be incredibly cheap, the coverage will stop when your employment ends — whether that’s taking a job elsewhere, retiring, or losing your job.

"Employer offered life insurance is great if you have it, but must realize there is no flexibility. If your employment situation changes, you'll have either a temporary or permanent lapse in coverage and getting coverage later in life is usually much more expensive than if you opted to get private term life insurance when you were younger and generally healthier," says Mark Cluett, Director of Content and Digital Assets.

“The options for life insurance are vast — from whole life insurance to universal life insurance to many variations and permutations of the above, some with market participation and investment exposure and others with a dizzying array of riders and features that will make your head spin. Be very wary about purchasing something that you don't fully understand,” advises Joel Ohman, MBA, MDiv, CFP ®, and Insurance Providers CEO. 

Understanding your options is the one of the first steps in finding and buying a life insurance policy. This article focuses on the basics of each kind of life insurance available. For more information on common riders, see “7 Common Life Insurance Policy Riders.”

Jump ahead to: What kind of life insurance should I buy?

What is Term Life insurance? 

When you sign up for term life insurance, you agree to give your insurer monthly payments for a limited period of time for a fixed coverage amount. 

Term Life insurance is usually the cheapest form of life insurance because it only lasts a certain length of time. With most term life policies, the monthly premium is set for the length of the term. This is convenient because medical conditions can develop. Some medical conditions, like diabetes, increase monthly premiums. It’s convenient to lock in costs early. However, if you renew your policy, you’ll likely have higher rates.

Most insurers that offer term life policies have several term length options. These options tend to start at 5 years and can be up to 30 years. These options allow clients to choose the length that best fits their needs.

Some life insurers also offer a term conversion rider with their term life insurance policies. This rider allows policyholders to convert the term life insurance policy into a permanent one during a set period of time. This rider is great because it allows policyholders to purchase a very affordable term life insurance policy with the ability to convert it to a permanent policy later.

Another common rider available for term life insurance policies is guaranteed renewability. This feature allows policyholders to renew their policy within a certain time frame. While the premium rates may be different when the policy is renewed, the life insurer will renew the same coverage.

Some life insurance carriers offer a return of premium with their term life insurance policies. This means that if the company does not pay out a death benefit, the total of the premiums is returned when the policy expires. 

What do experts say about term life insurance? 

Jeff Root from Rootfin Insurance Blog

“A simple rule of thumb is if you're in your prime income earning years (30–65), buy enough term life insurance to replace your income until your estimated retirement date. Don't worry about permanent life insurance until you reach a high income level.” 

Richard Best, personal finance expert at Don’tPayFull

“The most practical use of term insurance is for situations where you can be certain that the need for life insurance will not exist after a specific period of time. For example, if you need life insurance coverage to ensure the needs of your children are met through the time they graduate from college and are out on their own, your term coverage might only need to last until they complete college.

The problem with term coverage is that, if you determine that your need for coverage will last beyond your intended time frame, you would need to renew the term coverage or purchase a new policy at substantially higher premium costs. And, if you develop any health conditions, you could be denied coverage.”

Joel Ohman, MBA, MDiv, CFP ®, InsuranceProviders CEO

“It's very rare that you need any type of fancy life insurance policy other than a plain vanilla term life policy. Term life is simple, straightforward, and likely much cheaper than you think.” 

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What is Whole Life insurance? 

Whole life insurance is a form of permanent life insurance, which makes it more of an investment than term life insurance. Whole life insurance policies have a death benefit and the ability to accrue cash value through investments. The fixed monthly payments that you contribute to go into a tax-deferred account that accumulates interest over time. 

Whole life insurance policies accrue cash value at specified minimum rates and are not subject to the high level of fluctuation in the market. However, if the life insurance company does well, the cash value can grow more. This stability is a nice feature of a whole life insurance policy.

The cash value of the policy contributes to the death benefit as it grows. Whole life cash value acts like a savings account. As the cash value accrues, policyholders can use it as an asset when applying for loans or even borrow from their cash value. If the insured passes away before paying back the borrowed cash value, the death benefit will be reduced by the outstanding balance. 

Because a whole life insurance policy does not expire and requires more overhead management for the cash value accrual, monthly premiums are much higher than term life insurance premiums. Part of the monthly premium goes toward the death benefit, part of it goes to overhead, and another part goes to the policy’s cash value. 

When you sign up for whole life insurance, your payments are guaranteed to stay the same throughout maturity. Whole life insurance also guarantees that your beneficiaries will get the face value of the policy at a minimum.

Purchasing a permanent life insurance policy early is wise because it allows you to lock in lower rates.

What do experts say about whole life insurance? 

Richard Best, personal finance expert at Don’tPayFull

“The oldest and most basic form of permanent life insurance, whole life insurance is a fixed, guaranteed product, meaning the face amount, premium and cash value growth are determined at issue and guaranteed for the life of the contract. Some insurers pay dividends which can be applied towards the premium payment or used to buy paid-up additions which can increase cash value growth and the face amount.”

Travis Price, IFixMedicare.com Licensed Insurance Agent

“On the downside, Whole Life insurance tends to be the most expensive insurance type out there. If you're buying a policy in whole life, I tend to tell people that it should be enough to get you into the ground. That's a relatively low amount, from $10,000–$15,000, and keeps your premiums lower.

Some people simply can't qualify for insurance because of their health issues. In this case, whole life offers a guaranteed issue policy. The upside is that you get coverage, but the first two years you don't get the full face amount. Instead, the insurance company simply refunds the premiums that were paid plus 10 percent.”

Kurt Hemry, Ironwood Wealth Consultants President

“Whole life insurance may earn guaranteed cash value increase as well as an annual dividend. These are often considered the most conservative of policies regarding cash value growth. An upside to this type of policy is the protection of your cash in that you never lose money because of Wall Street losses.”

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What is Universal Life insurance?

Universal life insurance has many of the same features as a whole life insurance policy. It is permanent and has cash value. The monthly premiums go three places: death benefit payment, overhead management, and cash value building. The cash value grows interest from investments tax-deferred and can be borrowed while the policyholder is still living. The premium rates for universal life insurance policies are more expensive than term policies and also tend to be less expensive than whole life policies.

Unlike whole life insurance, universal life insurance gives policyholders the flexibility to adjust premiums and coverage levels according to their needs and investment goals.

What is Variable Universal Life Insurance? 

Variable universal life insurance allows policyholders to invest the cash value of their life insurance in separate accounts, sort of like mutual funds, with different stock and bond options. What makes this type of insurance still universal is that the policy owner can make flexible monthly payments.

If you are interested in variable universal life insurance, make sure to pay attention to the management fees and any penalties that come with changing your coverage amount.

What do experts say about variable universal life insurance? 

Richard Best, personal finance expert at Don’tPayFull

“Variable life insurance allows the policy owner to allocate funds among different investment options, such as various types of stock and bond accounts. Although the separate investment accounts are subject to market fluctuations, the death benefit is guaranteed. Some variable life policies offer minimum return guarantees as options.”

Daniel Ray, National Independent Life Insurance Agent and Owner of PinnacleQuote Life Insurance Specialists

“PROS: A permanent policy with an investment component that can accelerate cash value. CONS: You are at risk of market fluctuations which can affect your premiums and face amount.”

Kurt Hemry, Ironwood Wealth Consultants President

“With variable life insurance, you select from a number of mutual funds that you want your money to be invested. This provides you with the opportunity to earn as Wall Street goes up. However, when Wall Street goes down, so does your policy value.”

What is Indexed Universal Life Insurance? 

Indexed Universal life insurance has lower investment risks. The investments can only grow. If there is a year when the investments lose money, the cash value stays the same. 

Loans from an indexed universal life insurance policy are tax-free. These policies can also be used as retirement income and withdrawals are also tax-free.

What do experts say about indexed universal life insurance? 

Daniel Ray, National Independent Life Insurance Agent and Owner of PinnacleQuote Life Insurance Specialists

“PROS: A permanent policy that is tied into an index like the S&P. 

CONS: If the policy is underperforming in your later years, rates can double or more which can result in seniors losing insurance that they can't afford when they need it the most.”

Gordon E. Conwell, III of Americanterm.com

“Variable Universal Life and Indexed Universal Life are both investment type of life insurance policies, primarily for people that are looking for both life insurance and/or an investment. Many people over-fund these policies to potentially gain a larger investment from the tax deferred benefits of these policies, so it's not easy to show rates for this type of coverage as most people will purchase the smallest amount of insurance for the amount of the premium they want to pay for this coverage to maximize their investment potential.”

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What is Final Expense insurance? 

Final expense insurance is a kind of permanent life insurance. It is also called funeral insurance, cremation insurance, or burial insurance. 

Final expense insurance is especially good for seniors and offers more limited coverage levels designed to cover funeral and final expenses. Because of the lower levels of coverage available, final expense insurance premiums tend to be fairly low.

It’s a great option for those who do not have another permanent life insurance policy and are not interested in term life insurance.

What do experts say about final expense insurance? 

Travis Price, IFixMedicare.com Licensed Insurance Agent

“For seniors, I suggest they only purchase the fixed amount that they would need to handle their final expenses if they don't have resources to handle it (like savings or 401k).”

Jeff Root from Rootfin Insurance Blog

“If you're nearing retirement and getting close to living on a fixed income, you no longer need that much term coverage and you should decide if permanent life insurance (whole life, indexed universal, guaranteed universal life, final expense) is needed. Will you need life insurance to cover any final expenses? Will you need life insurance for estate planning purposes? Then go from there.”

Daniel Ray, National Independent Life Insurance Agent and Owner of PinnacleQuote Life Insurance Specialists

“PROS: Small and affordable whole life policy to cover final expenses. 

CONS: Usually policies are between $2,000–$40,000, and are geared for seniors. But are limited to the coverage amount.”

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What kind of life insurance should I buy? 

“More important than what kind of life insurance you should get, is how much insurance you should have. I’ve never heard a widow ask me what type of life insurance her husband had; her concern is always how much did he have,” says Hemry.

Fortunately, many life insurance needs calculators are available online, which makes determining your coverage needs easy.

“If you find yourself getting bogged down with all of the various calculators and different formulas used then take a step back and just ask yourself this question, "What is the absolute minimum amount of money that my loved ones would need if I passed away to not have to worry about money, not have to change their lifestyle or dreams, and not have to get a new job?" Now double it,” says Ohman.

Once you’ve gotten a number, think about the pros and cons of each policy type and what your specific needs are.

“For every type of insurance product available, it is the right thing for some people and wrong for others. I suggest you think about it this way:

Use term insurance for short term needs and more permanent insurance for long term needs. For example, term insurance fits well to cover debt that you do not want to leave to your family such as a mortgage. Purchase term insurance that ends when the mortgage ends.

Use more permanent insurance for expenses that will not go away, such as funeral expenses, other final expenses and income needed for the people you leave behind,” says Nancy D. Butler, CFP ® , CDFA ™, CLTC, and owner of Above All Else, Success in Life and Business ®.

Remember that while term life insurance policies have an expiration date, some can last as long as 30 years. If the policy includes a guaranteed renewability or term conversion rider, you can extend the coverage longer.

“Term life insurance is the best choice for most people, especially those in their younger years looking for a pure protection product. Permanent life insurance and other products with an investment vehicle attached rarely payout the same dividends someone could achieve by opting for term insurance and making some modest investments with the money they save,” says Cluett.

Permanent life insurance policies can be advantageous because they accrue cash value that it not subject to income taxes and can be accessed while the insured is still living. 

“Permanent policies are used when the need for protection or capital will extend into well into the future.It’s often used in wealth transfer strategies, business planning situations, and where the need for income replacement extends beyond the dependency years of the children,” advises Best.

However, permanent life insurance policies are more complex and some are affected by the stock market, which can make them harder to understand.

“Within each of these sub-categories of permanent life insurance are a multitude of variations of each. The universe of different types of life insurance products is vast, and should be explored with your specific circumstances in mind along with the guidance of a qualified, and preferably, independent life insurance professional,” adds Best.

What questions should I ask? 

Daniel Ray, National Independent Life Insurance Agent and Owner of PinnacleQuote Life Insurance Specialists

“The questions you should ask when purchasing life insurance are

• What do I need to protect and for how long (Term Life)?
• Is it safer to overfund a permanent life policy rather than be limited with contributions to an IRA/401k? (Whole Life/Variable/IUL)
• Will my savings cover my funeral? Will my family have a financial burden when I pass? (Burial Policy/Final Expense)” 

Nancy D. Butler, CFP ® , CDFA ™, CLTC, and owner of Above All Else, Success in Life and Business ®

“How much do I need? What type(s) are appropriate? With Universal and Variable Life you need to know what interest rate the agent used when running the illustration to determine what the premium will be. If they use a rate that is too high, you run the risk of losing the policy in later years unless you substantially increase the premiums. I recommend a reasonable rate of return to use in an illustration today is 6 percent or less. High returns going forward are of course, not guaranteed regardless of past performance.” 

Taking these questions and expert tips into consideration will help you make a smart life insurance decision for yourself and your family and friends. Your decision will offer peace of mind and financial security for your beneficiaries.

Looking for more tips? Check out some good advice and bad advice that people have received.

Ready to start looking at companies? Check out Best Company’s top-ranked life insurers.