If you have dependents, life insurance is crucial to protect your loved ones from financial hardship if you pass away. There are various types of life insurance policies, including universal life insurance.
This policy stands out because it allows you to adjust your premiums and coverage amount based on your changing financial needs. However, universal life isn't for everyone due to its price and complexity.
Understanding universal life insurance
Term and whole life insurance hybrid
Universal life insurance shares features from a term policy and whole life insurance. Like whole life insurance, it offers permanent coverage and a cash value component. Like term life insurance, it allows you to adjust your death benefit and, therefore, your premiums throughout your life.
The cash value component
Cash value is unique to a permanent life policy. In a traditional universal life policy, a portion of your premium earns interest on a tax-deferred basis, growing your policy. Since universal life insurance offers adjustable premium payments, you can pay higher premiums to build more cash value.
The cash value of a permanent life insurance policy can be used during your lifetime for financial milestones such as paying your children's college tuition, funding a business, or purchasing a second home. Many people use their cash value as additional income in retirement.
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How does universal life insurance work?
Potential for cash value growth
A traditional universal life insurance policy's cash value is typically invested in your insurance company's general portfolio. It earns interest based on current money market rates and other economic conditions, which can fluctuate over time. However, many insurers set a guaranteed minimum interest rate, ensuring the cash value won't fall below a certain threshold, even if market rates are low.
Indexed universal life (IUL) and variable universal life (VUL) are also types of universal life. An IUL's cash value grows based on the performance of a specific stock market index, such as the S&P500. A VUL invests your cash value in subaccounts that mirror the performance of underlying investments, similar to mutual funds. These types of universal policies come with higher risk due to market volatility but also offer the potential for increased returns.
Flexible death benefits and premiums
Universal life insurance also allows you to increase or decrease your death benefit based on your current financial situation. For example, if you lose your job, you can call the insurance company to decrease your death benefit, lowering your payments.
However, the flexibility of a universal life policy adds to its complexity. Reducing or skipping premiums can cause your cash value to drop. If your cash value drops below a certain threshold, it can result in your policy lapsing or ending. That said, universal life insurance requires more oversight to ensure your coverage stays active.
Cash value loans and withdrawals
Universal life insurance allows you to take early withdrawals or life insurance loans. Loans are tax-free but must be repaid with interest; otherwise, they reduce the death benefit. If you choose not to repay it, your death benefit will go down.
If you decide you don't want your permanent life insurance policy anymore, you can cancel your policy to get your cash value back. Be aware that you no longer have coverage once you cancel your policy and liquidate your cash value.
"If you cash the policy in," Mark Williams, CEO of Brokers International says, "there's no more death benefit; you are literally canceling the policy. This is also known as cash value surrender, giving up a permanent life insurance policy with cash value." As a result, your beneficiaries won't receive a death benefit when you pass away.
You should discuss any early withdrawals with a tax professional. Depending on how much you withdraw and other factors, penalties may apply.
Upgrade your policy with riders
All types of permanent life insurance, including universal life, offer riders that can be added to the policy. Several riders include:
- Waiver of premium: Pause your premium payments if you are sick, hurt, or disabled
- Long-term care: Use the policy's death benefit toward assisted living (such as in-home care or a nursing facility) during your lifetime.
- Family rider: Puts the entire family under one policy
Every rider has an additional cost that increases the premium on your policy, but it's usually cheaper than having multiple policies. Williams noted that riders vary depending on the insurance company and that you must buy riders up front.
Is universal life insurance worth it?
High-net-worth individuals with at least $1 million in liquid assets often have permanent life insurance policies for tax benefits, endowments, and gifts. The cost is considerably more than term life insurance because permanent life insurance is also a wealth-building tool.
If you can't afford universal life insurance, term life insurance is sufficient for most people who need a substantial amount or coverage temporarily. For example, term life is likely enough if you only need coverage until your children become adults and move out or once you pay your mortgage.
If you're considering universal life insurance, it's wise to consult an accountant and financial advisor. Professionals can help you determine which policy is best for you and advise you of the tax benefits and implications. It's also worth taking the time to find the best policy for your situation. Once you've signed on the dotted line, making can be difficult.
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FAQs
How does universal life insurance differ from other permanent policies?:
Unlike a whole life insurance policy, universal life insurance allows you to adjust your death benefit and premiums based on changing financial needs. Unlike term life insurance, universal life insurance offers lifelong coverage and a cash value component.
What are the types of universal life insurance?
There are three types of universal life insurance: guaranteed or traditional universal, indexed universal, and variable universal life insurance.
Is universal life insurance a good investment?
While universal life insurance can be a good investment, it tends to yield subpar returns compared to traditional investment vehicles (think stocks, bonds, and mutual funds). However, if you've maxed out your retirement accounts (i.e., 401(k) or IRA) for the year, a universal life insurance policy can be a smart way to diversify your portfolio.
How are interest rates credited to my cash value?
It depends on the type of universal life insurance. Traditional universal life policies have minimum guaranteed interest rates set by the insurer. IULs and VULs, however, are based on the performance of underlying investments. These policies come with increased risk but may lead to higher returns if the market performs well.
Who should consider universal life insurance?
You should consider universal life insurance if you want flexible coverage and premium payments. However, this policy is significantly more expensive than a term life policy. Therefore, it may be best for high-net-worth individuals who can afford the additional premium and want to utilize their policy as a wealth-building tool.
