What Is Term Conversion?

Whether you’re establishing a career or considering starting a family, a term life insurance policy is a great way for young people to build an important safety net at a low cost. The death benefit can help your family through a period when student debt, a mortgage or the costs of raising children could pose a crippling financial burden in the event of an unexpected death.

But term life insurance is temporary. The death benefit covers you only for a set number of years. And as your life progresses, your goals are likely to evolve. Perhaps you earn more money and have the opportunity to build wealth, and your initial goals of buying a new home or sending your kids to college may morph into a desire to leave something behind for your loved ones.

As you get older, the benefits of permanent life insurance—such as the ability to build stable cash value and leave a legacy—may become more appealing. Rather than buying a completely new policy, people will often use a term conversion to move from term insurance to a permanent policy.

What is term conversion?

While it’s becoming more common to get life insurance without a medical exam, most insurers still consider your health when you get a new policy. However, once you get a term life insurance policy, you may be able to convert that policy in the future—and the company won’t consider your health when you convert.

This is helpful for a couple of reasons:

• It’s easier than applying for a new policy.
• If you’re not as healthy as you were when you initially got your policy, you won’t have to worry about paying higher rates.
• The rates that you pay for your converted policy will still be affected by your age, but they won't be affected by any changes in your health.

Reasons to convert term life insurance to permanent life insurance

There are several key reasons to consider converting term life insurance to a permanent life insurance policy.

To build savings

When you convert all or part of a term policy into a permanent policy, you start building cash value (term doesn’t have this feature). As you pay your premiums, a portion of every payment goes toward the cash value, and that grows in a tax-advantaged way. With many types of permanent life insurance, the cash value is guaranteed to grow over time—and is unaffected by swings in the markets. This makes the long-term worth of life insurance cash value a unique part of a broader financial plan.

Just as with building home equity, someday down the road you could use that accumulated cash value for a number of purposes. And the earlier you start paying premiums into a permanent policy, the longer your cash value can compound and grow over time.

You’re making more money

You may have purchased a term policy when you were younger and needed coverage without going over your budget. Perhaps your salary has grown since then, and you’re able to dedicate more money toward your goals—without sacrificing what’s important today.

For estate planning

If you’ve accumulated a significant amount of money and property, your heirs could be on the hook for a significant estate tax bill after your death. Or perhaps you’re just looking for an efficient way to leave something behind for your family. Permanent life insurance will pay a death benefit—meaning your heirs will have money to pay those taxes or just as a source of ongoing income. Most of the time, proceeds from a life insurance payout aren’t considered taxable income.

Pros and cons of converting term life to whole life

There are some key differences between term and permanent life insurance. Whole life insurance is the most common type of permanent life. With whole life, your death benefit, required premiums, and cash value growth are all guaranteed.

Benefits of converting term to whole life

Lifelong death benefit

While your term policy will expire at some point, a whole life policy won’t. That means that as long as you pay the required premiums, your family will get a death benefit someday.

Cash value

Whole life insurance cash value is guaranteed to grow over time, and it’s unaffected by the markets. This feature makes it a unique asset that can work with your investment in a comprehensive financial plan.

That being said, the performance of cash value offered by some other types of permanent life insurance—such as variable universal life (VUL)—may be tied to financial markets, offering more potential for growth but also more risk of underperformance. It’s important to speak with your advisor to make sure that the policy you choose aligns with the rest of your financial plan.

Tax benefits

In general, a life insurance death benefit isn’t taxable income. This means that your heirs will receive the death benefit without having to worry about income, estate, or inheritance taxes. But you’re also able to access the policy’s cash value in a tax-advantaged way while you’re alive by borrowing against your policy with a life insurance loan. This can help you manage what you owe in taxes—particularly during retirement.

Cons of converting term to whole life

Cost

Whole life insurance is more expensive than term life, thanks to the guaranteed payout no matter when you die. While the added benefits of whole life are typically worth the additional cost, it’s possible that you’re not in a position to shoulder the expense right now. Whether or not whole life is the best choice for you depends on your unique circumstances.

One thing to note here is that the cost of whole life insurance is also based on age. That means the longer you wait to convert, the more a policy will cost in the future. Other factors to consider include your health, gender, death benefit, and how your policy is designed.

Conversion deadlines

While many term life policies offer conversion options, there are often strict deadlines after which conversion is no longer allowed. These deadlines can also limit your ability to convert in stages (as discussed below). This means that if you’re interested in potentially converting your policy, it’s important that you understand the timeline so you don’t miss your opportunity or find yourself settling for coverage that isn’t a good fit for your needs.

Initially slow growth

Cash value is one of the most powerful benefits offered by a permanent life insurance policy. Unfortunately, it accrues slowly—particularly in the earliest years of your policy. And because the premiums you paid when your policy offered term coverage don’t carry over, it may feel like wasted time. If you’re interested in maximizing growth, particularly in the short term, then other investment options may be a better fit.

What to consider when converting term life insurance

Before you purchase a term life policy with the goal of eventually converting to permanent life insurance—or before you initiate a conversion if you’re already covered—it’s important to fully consider all of your options. The factors below may influence your decision for (or against) converting.

Conversion credits

Sometimes insurance companies will offer conversion credits—also called premium credits—to offset the costs of increased premiums on a permanent life policy. The conversion credit may result in lowered premiums for the first year.

Exactly how these credits work will vary from policy to policy. For example, some policies may offer a 10 percent reduction on your new premiums for the first year, while others may offer a higher or lower percentage off or a flat-rate discount. If you’re looking into a term-to-perm conversion, be sure to inquire about a credit.

Convert in stages

You don’t have to convert your term policy in its entirety. Instead, you can do it in small chunks when circumstances warrant. That way, you can enjoy the benefits of both policies and gradually step into a permanent policy as your life evolves.

For example, imagine that you purchase a term life insurance policy in your 30s with a $500,000 death benefit, designed to pay off your mortgage and support your young children if you were to pass away unexpectedly. In your 50s, your children have grown, and your mortgage has become significantly reduced, so you decide to convert half of your policy—$250,000—to a permanent life insurance policy. This allows you to start accruing cash value that you might use to ride out market volatility in retirement or cover other unexpected costs while alive. In your 60s, you’ve paid off your mortgage entirely and begun thinking about your legacy, so you convert the rest of your policy to ensure a guaranteed financial legacy.

Ask about your options

Some companies allow term conversions for a limited period of time or will limit the kinds of permanent policies you can convert a term policy into. If you’re looking into purchasing a term policy, be sure to ask about your conversion options to ensure you aren’t locked into a permanent policy that’s more expensive or has fewer options than you want in the future.

Not all term life policies have the ability to be converted. Some will include it only if you purchase a rider or endorsement. If it’s important to you that your policy includes the ability to convert, you should speak to your advisor to ensure you’re purchasing the right coverage.

Research the company

Insurance companies vary in their financial stability. You’ll want to purchase policies from companies that have the strongest credit ratings from third-party companies like Moody’s or Fitch.

With a greater than $310 billion portfolio, an AAA rating from Fitch, and an Aa1 rating from Moody’s, Northwestern Mutual has a strong track record of both performance and stability.

Replacement policy

If you've heard someone mention the concept of replacing life insurance, it’s important to note that term conversion is different than replacing a policy. While the concept may sound familiar, a replacement policy is a completely new policy, which will often require a new health check. If your health has changed, that policy would be more expensive than a term conversion to that same policy.

The long-term value of permanent life insurance

People often look to convert to permanent life insurance because it can add significant value over time. In addition to its lifelong death benefit, your policy will grow cash value. The cash value has unique attributes that can help you throughout your life—particularly in retirement.

In fact, third-party research has found that when you properly allocate your wealth across investments, permanent life insurance, and deferred income annuities,¹ you’re more likely to outperform strategies that emphasize investments alone over the long term. Your financial advisor will get to know you, asking the right questions to learn about what’s most important to you. This conversation often helps to uncover blind spots and opportunities. With this knowledge, your advisor can recommend the right balance of investments and insurance (both term and permanent) to best position you to reach your goals while protecting you and your family from risks that could derail your plan.

¹ “Income Annuity” refers to a Deferred Income Annuity with increasing income potential, “which represents deferred income annuities with persistency bonuses and non-guaranteed dividends” referred to as “DIA with IIP” in the EY article.

The primary purpose of permanent life insurance is to provide a death benefit. Using cash values through policy loans, surrenders, or cash withdrawals will reduce benefits and may affect other aspects of your plan.