Getting to Know Universal Life Insurance
Universal life insurance is a flexible version of whole life insurance or permanent insurance. What makes this type of policy attractive is that unlike traditional versions of whole life, universal life insurance lets the policy holder change options during the policy term. Many of the decisions made when taking out the policy are not iron clad, such as premium payment dates and amounts, or the size of the death benefits.
Universal Life Insurance is still a permanent insurance policy and will accumulate a cash value, providing a savings element to the policy holder. Many policies offer multiple investment options, ranging from fixed interest to aggressive equity funds. Additional options may include a minimum guaranteed return regardless of market performance. The cash value of the policy will drive all the other factors, including potential changes in premium and death benefit.
Variable Universal Life Insurance
When the underlying investment holds equities and securities that fluctuate in value, the policy is a VUL (variable universal life policy). With this type of policy, the cash value is going to reflect the performance of the securities. The first five years will be critical, as the cost of insurance will be at it's highest and will depend on the gap between the cash value and the death benefit. Poor market performance in the first five years could have you playing catch up for years, though a policy holder can hedge against this by slightly over-funding the policy in the first years.
How Cash Value Affects the Policy
The cash value of the universal life insurance policy is the main driver of all the flexible features. When the market performance boosts the cash value higher than expected, the amount of insurance filling the gap to the death benefit is less. The end result is that the premiums can be reduced or payments can be sustained and the death benefit can be increased. Here are two real world examples of this:
A family takes out a $500,000 universal life insurance policy and over funds it initially with $200,000 in the first few years. The market performs better than expected and by year five the cash value is $300,000. Now the amount of pure insurance needed is only $200,000, which will cost less than planned. The family can choose to reduce the premium amount they pay each year or continue paying the same amount and increase the death benefit.
The same family takes out the same policy but in this example the market performs poorly, resulting in a year five cash value of $150,000. In this circumstance, to maintain the $500,000 death benefit the policy requires $350,000 of insurance to make up the gap between the cash value and the death benefit. This may require a higher premium payment amount or the policy holder could choose to lower the death benefit if higher premiums are not a possibility.
Who Should Use UL's?
Universal Life Insurance should be considered by families and business owners that need a combination of protection and savings elements. In more complex planning situations it can be a great tool for wealth preservation and tax planning. In many circumstances it is a more sensible choice than traditional whole life for the simple fact that many things change over ten or more years. Also, it makes more sense to have one flexible policy rather than a bunch of small whole life policies purchased whenever times are good.
Business owners find universal policies attractive for a number of reasons. First, most business owners are at higher income levels and can take advantage of the tax deferral savings element. Second, the flexible nature of the policy allows them to contribute more or less from one year to the next, which suits the typical business with up and down years.
Another great feature for high income families is the ability to use a UL as a kind of 'Roth' type savings. Funds can be added to the policy and essentially be loaned out later, saving or at least delaying taxes. This will require some careful planning, as the next section outlines there are two important situations to avoid with UL policies.
Universal Life Concerns
There are two situations that must be avoided when entering into a universal life insurance policy. Basically, don't let the cash value get too big or too small. Poor market performance, a shortfall in premiums, or other factors that cause a low cash value can lead to a lapse in the policy. This leaves the policy holder without the protection of a death benefit, a big risk for families and businesses that rely on the insured.
On the flip side, if the premiums and cash value are getting very high, there is a risk that the IRS could view your policy as a modified endowment contract (or MEC). This could mean substantial taxes and penalties on distributions from the policy. Build in the necessary flexibility and death benefit to avoid both of these situations.
There are some important features to consider adding to a universal life policy. Consider adding a 'No Lapse' guarantee, which will protect the policy holder from having a policy lapse and going uninsured. Also, have a look at guaranteed minimum interest rates, which would provide some market downside protection. Protection against MEC may be available (notifies policy holder when approaching a MEC situation), which may be able to automatically increase the death benefit and help prevent unwanted taxable events.
When planning to take out a policy, start a touch on the smaller side. As the example above demonstrates, having a cash value on the high side really provides for more attractive choices when it comes to the flexible features. So long as there is also flexibility to increase the death benefit as well, staying at or ahead of the cash value projection will provide the policy holder favorable choices like paying lower premiums or increasing protection.
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