Universal Life Insurance
Although death isn’t always an enjoyable topic to consider (uniquely your own), we all know it will eventually happen.
You’ve probably heard at least part this quote, typically credited to Benjamin Franklin:
“…but in this world, nothing can be said to be certain, except death and taxes.”
Cynical as it may be, there is truth to it.
Chances are, some people depend on you, and not just emotionally but financially as well. That’s where universal life insurance comes in.
These policies help ease the burden when you are no longer able to support your family and anyone with whom you have shared assets.
And much like setting up a will, a life insurance policy is about ensuring your loved ones will be taken care of after you are gone.
What Is Universal Life Insurance?
There are many types of life insurance. Universal life insurance gets its name from the flexibility it provides.
In particular, you have the option to choose how much to pay in premiums (within a specific range).
There are two primary components of universal life insurance: the cost of insurance and the cash value. The cost of insurance is self-explanatory; the cash value can be used like a savings or investment account.
How Does A Universal Life Policy Work?
Typically, the cost of insurance is the minimum amount you must pay every month to maintain the policy. Cost of insurance covers several items, such as:
- Your death benefit
- Administration fees
- Other costs in maintaining the policy
It will vary depending on things such as your age, insurability, and the amount of risk there is in insuring you.
Another key aspect of universal life insurance is that you have some discretion in how much you pay each month. There is a minimum set by the policy, but you may opt to pay more than the premium. In that case, the additional amount will be added to your policy’s cash value.
The cash value of the life insurance policy can also help cover increases in the cost of insurance, if necessary.
Types of Universal Life Insurance
Although this article is about universal life insurance as a whole, there are three different types. Indeed, things can quickly get convoluted when discussing insurance – but we’ll try to make things as simple as we can.
Indexed Universal Life Insurance
If you’ve ever held shares in an index fund, this type of universal life will have some familiar elements. But, in case you haven’t, we’ll go over exactly what this means.
Remember that your universal life insurance policy has a cash value. If you have an indexed universal life insurance policy, the cash value of the policy is linked to the stock market. More specifically, it’s linked to an index, such as the S&P 500.
That means the value will fluctuate. These indices typically rise in the long run, but in the short term, you will sometimes see the cash value decrease.
And there is another downside to this setup. The life insurance company will charge a fee for managing your money. Maybe you’re okay with a fee, but they may be charging more than you’d pay if you had your money invested elsewhere.
Variable Universal Life Insurance
A mutual fund is a professionally-managed fund that pools money to purchase equities. Due to the large pool of cash (other people will be invested in the same pool), they can purchase stocks from many different companies. That diversification lowers your risk.
The downside is that, again, the fees for these funds can be significant. While it’s always nice to see your money grow, there may be better ways to accomplish that.
Guaranteed Universal Life Insurance
Guaranteed universal life insurance is better if you would rather not see the cash value of your policy decline. This policy is about consistency: your premiums will never change, and the rate is set when the policy is established.
Plus, the policy will never expire, which can’t necessarily be said for the other types of policies.
With this option, the cash value of your policy won’t benefit from long-term market performance. That is probably the biggest downside of guaranteed universal life insurance: the cash value won’t increase much.
Still, if you value stability, this might be the best option for you.
How Does Universal Life Insurance Cash Value Work?
The main thing that sets universal life insurance apart from other types of insurance is the cash value. Generally, with an insurance policy, you pay a monthly premium and are covered up to a particular dollar value.
When you have a universal life insurance policy, the cash value of the policy earns a return based on the greater of market performance, and the minimum interest rate. The minimum rate is often 2%, and the market will often provide a better return.
That all sounds well and good, but remember that there are often high fees associated with these policies, making the returns much less than they could be.
Nevertheless, policyholders can access the cash value of the policy even while still paying into it. The money will be taxed upon withdrawal, but there is otherwise no penalty for withdrawing money too early.
This is unlike retirement accounts, which often have a specific age requirement.
Another possibility is to borrow against the cash value of the policy. The policyholder will not be taxed in this case, but there will be interest on the loan. Plus, the loan amount will reduce the death benefit, and unpaid interest will be taken from the residual cash value.
What Happens to the Cash Value After I Die?
In all their savings-savviness, you will sometimes hear people in the financial independence community say they want their net worth to be exactly $0 when they die.
As it turns out, that is the ideal situation with your universal life insurance policy.
Why is that? Because if your policy has a non-zero cash value when you die, no one in your family will be able to access that cash. It will belong to the insurance company even though you paid that money into the policy.
The only benefit your beneficiaries will receive is the death benefit. While that is probably a significant amount, especially if you paid in for decades, it’s not ideal to imagine tens of thousands or even hundreds of thousands of dollars being lost.
Well, not lost, but claimed by the insurance company. Unfortunately, that is the reality of this type of policy.
Can You Cash in a Universal Life Insurance Policy?
The short answer is yes; however, you should use caution if you are considering cashing in your universal life insurance policy. If cashing in your policy is your only option, then it’s your only option – but you should be aware of the potential consequences.
For instance, it could cause a reduction in your death benefit. The policy’s death benefit is often one of the main reasons for paying into a policy, so be sure to check into this before cashing in.
Another potential drawback is that the money could be taxed upon withdrawal. If you withdraw money in the first 15 years of the plan, you may be required to pay taxes on that money. This happens primarily if the withdrawal causes a reduction in the plan’s death benefit.
Given that you typically fund a plan with after-tax dollars, this would mean double taxation. That is probably something you want to avoid.
So while it is possible to take money out of a universal life insurance policy, you should be sure to read the fine print before doing so.
What Are the Disadvantages of Universal Life Insurance?
Unfortunately, one of the main features of universal life insurance, which could be marketed as an advantage, is arguably more of a disadvantage.
That feature is the savings/investment account part of these policies. While saving and investing are always good ideas, there are many different ways to do so today.
Many portfolios can offer a variety of advantages, such as tax breaks and little to no management fees.
Typically, you will fund your life insurance policy with after-tax dollars. There are exceptions to this (such as having a policy within a qualified retirement plan), but in most cases, you are probably putting after-tax dollars into it.
Not only that, but life insurance contributions are not tax-deductible.
Fees for Universal Life Insurance Are High
Despite the advantages that universal life insurance presents – flexibility and the possibility to have your money grow with the market – those advantages come at a cost. The cost of insurance covers several different items, and those items will not be cheap.
The fees will vary greatly from policyholder to policyholder, but they will undoubtedly be exorbitant. The fees for this type of policy are usually several times higher than similar policies, such as term or whole life insurance.
If you are looking for a cheap alternative, this probably isn’t it!
What’s the Difference Between Whole & Universal Life Insurance?
The main difference between whole life insurance and universal life insurance has to do with paying premiums.
With whole life insurance, if you miss a premium payment, you will end up borrowing that amount against the policy balance. If this happens when the policy has no cash value, the policy terminates.
On the other hand, with a universal life insurance policy, a missed premium is simply deducted from the cash value of the policy.
With universal life insurance, you can use the cash value of the loan to pay your monthly premiums if you so choose – this is not an option with whole life insurance.
What’s the Difference Between Term & Universal Life Insurance?
Term life insurance works just the way it sounds: it’s only good for a specified term – typically 10, 15, 20, or 30 year term life insurance coverage. That is the biggest difference between term and universal, as universal life insurance does not have a specified end date. If all goes well, universal life should last until, well, the end of your life.
The premiums on term life insurance tend to be much lower because they are calculated for the next decade or two, whereas universal life assumes you will live a lot longer.
Plus, there is no cash value tied to term life insurance. While this means you can’t borrow against your term life policy or use the cash in it, term life is also much cheaper on a monthly basis.
Does Universal Life Insurance Make Sense?
That’s a tough question to answer. Sure, the insurance company will try to convince you that you need universal life insurance. But despite the flexibility this plan offers, they are expensive, and it’s possible you may be able to get by with a different plan.
Remember that although universal life insurance is a lifetime policy, your beneficiaries won’t receive anything more than the death benefit when you pass away.
Since life insurance’s purpose is to ensure your loved ones can still support themselves after you’re gone, the main thing to check is whether the policy will theoretically be able to replace your income for several years. Beyond that, the policy won’t do anything for your family.
What you can pass on is cash, investments, and other assets, so don’t forget to take those into consideration. As mentioned, you won’t be able to pass on the cash value of the policy.
So whether you need universal life insurance comes down to whether you think this policy is the best way to protect your loved ones after you are gone.