The basics of universal life insurance
If you want flexibility in how you pay for life insurance and want the option of having cash value to access, then a universal life insurance policy might be a good option.
Universal life is a type of permanent life insurance. How it differs from whole life is that the payments and the death benefit amount are never fixed.
When you buy universal life, your premium payments support the amount of coverage you elect to own, also known as the face amount. Each premium payment is placed in the policy’s account value, from which insurance costs and other policy charges are deducted. Whatever is left over after charges are deducted is considered the policy’s cash value, which earns interest.
The flexibility of universal life
The main benefit of universal life is its flexibility. You can vary the timing, amount, and frequency of your premium payments; it’s not like whole life or term insurance, which require regular payments.
Universal life policies allow you to pay each and every month, once a quarter or annually. You can pay more premium one month, then pay less in another month. You can pay more premium than is needed upfront, providing more cash value in which to earn interest. There may even be times when your policy doesn’t require a premium payment. As long as the policy has sufficient cash value to cover expenses, your insurance coverage will be available.
If you build up enough cash value over time, you can withdraw up to a certain percentage of your account value for a variety of purposes. Some people use the universal life cash value to fund a child’s college education, for supplemental retirement income, or to meet unforeseen expenses.
Cash value in a universal life policy grows tax-deferred plus, if structured correctly, can be withdrawn or borrowed against without paying income tax on the growth. And the death benefit passes to your heir’s income tax-free. That is part of why cash value universal life insurance is such a powerful financial tool.
The downside of its flexibility
Universal life’s flexibility can also be a detriment. In most cases, the policy’s death benefit is never guaranteed. If the cash value falls below what is needed to pay expenses, the policy may lapse. This can happen if you fail to pay enough premium, if you withdraw too much from the policy, or if the interest credited is less than what was projected.
During the buying process, your life insurance agent will provide you an illustration, which is a document that projects how your policy may perform based on certain assumptions, such as how much you plan to pay in premiums, how much you might withdraw from the policy and an estimate of how much interest the policy could earn. The illustration will show you minimum guarantees provided by the contract and estimates based on your situation.
You should also receive annual statements that show the actual status of the policy and help you ensure that the policy has enough cash value to keep the insurance in force.
Three types of universal life
There are three basic types of universal life policies., which differ mainly in how interest is credited to the policy’s account value.
Fixed UL. A fixed UL policy credits interest based on a fixed interest rate determined by the insurance company. Fixed rates largely depend on the overall interest rate environment.
Variable UL. Variable UL policies allow the policyholder to invest in mutual fund-like subaccounts. The interest you earn will vary — hence the name, variable — based on the performance of those investments. While some variable UL policies offer limited guarantees, this type of vehicle is not much different than regular investing: you either earn a small return by investing conservatively, or you take risks with your policy by putting more money in equities. If the investments decline in value, your cash value will decrease as well.
Indexed UL. Indexed universal life is considered a hybrid of fixed and variable UL. It credits interest based on the upward movement of a market index, such as the S&P 500. In exchange for offering downside protection, the insurer applies a cap to interest growth over a certain period. Basically, the policyholder receives much of the upside of a market index with none of the downside.