What Is Term Conversion?

Lynda Taylor is an assistant director of Risk Product Development at Northwestern Mutual.

When you’re young and starting a family, a term life insurance policy is a way 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 and the costs of raising children would represent a crippling financial burden in the event of an unexpected death.

But term life insurance is temporary. The death benefit covers you for a set number of years. You hope that your family never gets a dime from the policy because you hope to live a very long life.

And as your life progresses, your goals are likely to evolve. You may earn more money and build wealth, the kids will grow into adulthood, and protecting their ability to go to college may morph into a desire to leave something for them.

As you get older, the benefits of permanent life insurance—such as the ability to build stable cash value and leave a legacy—may be 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:

1. It’s easier than applying for a new policy.
2. 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 value 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 grow.

You’re making more money

You may have purchased a term policy when you were younger and needed a lot of coverage without adding a significant cost to your budget. Now, perhaps your salary has grown, 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 someday, 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. That makes it a unique asset that can work with your investment in a comprehensive financial plan.

Tax benefits

In general, the death benefit from a life insurance policy passes to your heirs tax-free. But you’re also able to access the policy’s cash value in a tax-advantaged way while you’re alive. 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. While the added benefits are typically worth the additional cost, it’s possible that you’re not in a position to shoulder the expense right now. One thing to note here is that cost is also based on age. That means the longer you wait to convert, the more a policy will cost in the future.

What else should you know about converting term life insurance to permanent life insurance?

Conversion Credits

Sometimes insurance companies will offer conversion 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. 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.

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 are 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.

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.

Replacement policy

If you have 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 a lot of value over time. In addition to its life-long 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. The conversation often helps to uncover blind spots and opportunities. With this knowledge, your advisor is an expert at using the right balance of investments and insurance (term and permanent) to 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