Universal life insurance: How does it work?
Updated 10:59 AM EDT, Fri July 12, 2024
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Universal life insurance is designed to adapt with you over time. For instance, you can increase premiums if you want to build up your policy or decrease premiums if money is tight — all while keeping your policy in force, assuming it’s still properly funded. If you’re looking for the best life insurance to evolve with your needs, universal life insurance may be worth looking into.
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What is universal life insurance?
Universal life (UL) insurance is a permanent policy that has a death benefit and a savings component known as the “cash value” account. Your premiums go toward your death benefit and fees, and a portion gets invested inside your cash value account.
The part that goes toward your death benefit and fees is known as the cost-of-insurance component (COI). The part that goes toward your cash value is known as the wealth-building component.
You can borrow or withdraw from the cash value while you’re alive for retirement, UL premiums, emergencies, home renovations, college tuition and more. The account generally grows tax-deferred.
If you take a loan against the funds, you’ll only pay taxes on the balance that exceeds the amount of premiums you’ve paid into the policy if it lapses or is cancelled. And, if you withdraw more than what you’ve contributed to the account, you may create a taxable life insurance event since some of your withdrawal comes from interest earnings.
Furthermore, cash value withdrawals and loans can decrease the amount of death benefit available to your beneficiaries when you pass away. That being said, your policy’s death benefit won’t be reduced if you pay back your loan before you pass.
Your death benefit typically passes to your beneficiaries tax-free.
Example of universal life insurance
Imagine you’re 30 years old and buy a universal life insurance policy. You choose a death benefit of $1 million. Each month, you pay a $284 premium. Out of that, $241 goes toward your insurance coverage and your carrier’s fees, and $43 goes into your cash value account.
Over time, say the $43 investments grow to $10,000. You can borrow against that total, withdraw from it or use it to pay your premiums while you’re still alive.
When you pass away, your beneficiaries will receive the $1 million death benefit. However, if you still have a cash value loan of $4,000 when you pass, the outstanding balance will be deducted from your death benefit before it’s paid out.
How does universal life insurance work?
Universal life insurance lasts your entire life — subject to the policy’s maturity date — as long as you pay your premiums.
Death benefit and premiums
Compared to whole life insurance, you’re not locked into the same policy and premium payments. You have the power to adjust your premiums up and down, within certain limits, as your needs change.
“Technically, a policyholder can change premiums as often as they like, but it’s wise to work with the issuing insurance carrier or a professional insurance agent to understand the impact,” said Eleanor Johnson, founding principal at Highland Capital Brokerage.
The death benefit of a universal life policy is less flexible. While lowering it might be an option, you typically can’t increase it without completing another medical exam (although a guaranteed insurability rider may be available, which would waive the exam requirement for specific amounts of additional coverage).
“In practice, most insurance contracts will not allow an increase in death benefit post-contract issue,” Johnson said. “So, a new policy would have to be issued for additional insurance coverage.”
Cash value
Your cash value account grows at an interest rate that’s impacted, in part, by market performance. However, your account will typically receive a guaranteed minimum.
Riders
You can also add other riders to customize your policy. Riders vary by insurer, but some common universal life insurance riders include an accelerated death or living benefits rider, a chronic illness rider, a waiver of premium disability rider and an accidental death rider.
Maturity date
Even though universal life insurance is a type of permanent coverage, policies typically include a maturity date. Maturity dates typically range from 95 to 100 years old, depending on the insurer and policy. If the insured reaches the maturity date before passing away, their coverage usually ends. In some cases, the policyholder receives the cash value, and in others, they receive the death benefit. There may be tax implications in either situation.
Who is universal life insurance for?
Universal life has all the same appeals as other types of permanent life insurance — you have lifetime coverage as long as you pay your premiums, and you can build wealth through a cash value account. If needed, you can borrow against this cash value while you’re alive to help supplement retirement income, pay for long-term care and cover emergencies, among other things.
But when, specifically, would you want to choose universal life over other permanent policies like whole life? Universal life may be good if any of these situations apply to you:
You’re looking for affordable permanent coverage
UL is often less expensive per dollar than whole life insurance because it offers fewer guarantees than whole life — but you must make sure it stays funded or it could potentially lapse.
Your life insurance needs may change in the future
If there’s a chance you may want to adjust your premium or death benefit amount as your family’s situation changes, UL can help you do that. It’s not as rigid as whole life where you have a set death benefit and premium amount for life.
You’re comfortable with rising premiums
Universal life insurance premiums may start out lower than whole life insurance, but they can also rise as you get older. With whole life insurance, you pay the same monthly premium regardless of age.
Types of universal life insurance
Outside of standard universal life insurance, there are other types of universal life policies to consider. These three are the most common:
1. Indexed universal
With an indexed universal life (IUL) insurance policy, your cash value growth is tied to a stock market index, like the S&P 500. If the index performs well, your policy’s cash value can grow at a higher rate. However, if the index performs poorly, your policy’s cash value may not grow at all. Some insurers may set a guaranteed minimum interest rate, as well as a maximum.
2. Variable universal
If you have a variable universal life (VUL) insurance policy, you can invest your cash value into various subaccounts. These are similar to mutual funds and can be made up of stocks, bonds or other securities. Your cash value returns fluctuate based on how these subaccounts perform. Because of this, VUL policies could be riskier than other types of life insurance.
3. Guaranteed universal
Guaranteed universal life (GUL) insurance policies have a guaranteed death benefit that won’t change as long as you pay your premiums and don’t have any outstanding cash value loans. Even if your cash value isn’t enough to cover your monthly premium payments, the policy generally stays in force as long as your balance isn’t zero and you don’t have an unpaid loan. However, if your account has insufficient funds, your benefit period (the time during which beneficiaries can receive a death benefit) may be shortened.
How much is universal life insurance?
Universal life insurance is generally less expensive than whole life (because returns may not be guaranteed) but more expensive than term life insurance (because it’s more permanent and includes a cash value account).
The amount you pay for universal life insurance will depend on factors such as your age, health history, policy size, location and lifestyle. This table highlights average universal life insurance rates for various nonsmokers living in California:
| Age of buyer | Gender | Monthly cost of $500,000 policy | Monthly cost of $1 million policy | Monthly cost of $2 million policy |
|---|---|---|---|---|
30
| Female
| $157
| $284
| $562
|
Male
| $190
| $341
| $676
| |
| 40 | Female
| $226
| $415
| $824
|
Male
| $267
| $497
| $990
| |
| 50 | Female
| $335
| $638
| $1,271
|
Male
| $391
| $739
| $1,474
| |
| 60 | Female
| $604
| $1,172
| $1,172
|
Male
| $581
| $1,290
| $2,575
|
The best way to find affordable universal life insurance is to get quotes from multiple companies and compare their premiums, death benefits and policy conditions.
Pros and cons of universal life insurance
| Pros | Cons |
|---|---|
|
|
Pros explained
- Flexible policies: You can adjust your premium payments up and down as your financial situation changes (and as allowed by your insurer), which gives you the ultimate flexibility.
- Lifetime coverage: Unlike term life insurance, universal life insurance policies last your entire life as long as you pay your premiums and maintain a positive cash value balance. However, a maturity date may apply.
- Cash value component: Universal life insurance policies come with a cash value component that can grow over time based on market performance and serve as an additional source of savings.
- Potential tax benefits: Your beneficiaries will generally receive a tax-free death benefit when you die. While you’re alive, your cash value growth is tax-deferred, so you don’t pay taxes on earnings unless you pass away before paying off a loan or withdraw the earned interest.
Cons explained
- Complicated to understand: Universal life insurance policies are often complex and have many different options that can feel overwhelming for some policyholders.
- May carry risk: Returns aren’t guaranteed and depend on investment performance. If interest rates drop, your policy’s cash value growth might slow down or reverse, although several insurers offer a guaranteed minimum interest rate.
- Have to monitor cash value account: Your insurance policy could lapse or premiums could increase if your cash value account gets drained.
- Premiums aren’t fixed: Unlike term and whole life insurance, your premiums aren’t fixed and may increase over time due to inflation, greater cost-of-insurance fees and poor market performance.
Frequently asked questions (FAQs)
Both whole life and universal life are types of cash value life insurance policies that come with cash value accounts. But with whole life insurance, premiums don’t change, and the cash value grows based on a fixed interest rate.
With universal life insurance, you can adjust your premiums up and down over time (subject to limits), but your rate of return isn’t fixed because it can be influenced by how the market performs.
You may choose universal life insurance because you like the appeal of having lifelong coverage with premiums that can be adjusted as your income or financial situation changes and with a cash value component that can grow over time. It also generally has lower premiums than whole life policies since the death benefit and cash value funds aren’t guaranteed, but your policy’s fees can increase as the years pass.
Yes, you can cash out (or surrender) your universal life insurance policy, but it may not be the best option. If you surrender your policy, your coverage will end and you’ll receive the cash value of the policy, minus any surrender charges or fees — this is referred to as the “cash surrender” value. You may also be subject to taxes, so weigh options carefully before making a decision.
How the cash value grows in universal life insurance depends on the specific type of policy you have. With standard universal life policies, your account grows at a rate similar to money market accounts. Many insurers set a minimum interest rate to help guarantee at least a small level of growth.
If you have an indexed universal life policy, your cash value returns are based on the performance of a market index like the S&P 500. You’ll likely have a guaranteed minimum interest rate for this type of policy as well, but you may also be subject to a cap on how much you can earn.
Choosing a variable universal life policy provides more control over your investments but also creates more risk. You select from various investment subaccounts offered by your insurer, such as mutual funds, stocks and bonds, and your cash value (and your death benefit) can grow or decline based on their performance. You may also have the option to invest in an account with a fixed interest rate.
Yes, you can withdraw money from your universal life insurance policy’s cash value account. However, keep in mind that doing so may result in a tax bill and could potentially lower your death benefit.
If you withdraw an amount greater than what you’ve contributed to the policy via your premium payments, the excess funds will likely be considered as income and will be taxed accordingly. And, depending on your specific policy and the total balance of your cash value, your policy’s death benefit could also be reduced when you make a withdrawal. This means that your beneficiary will receive a smaller death benefit than originally planned.
Before withdrawing money from your universal life cash value, consult your agent to discuss potential consequences and possible alternatives, such as borrowing funds via a loan instead.
In most cases, universal life insurance premiums are not tax deductible. If you’re curious about whether or not you qualify for a deduction, consult a licensed tax professional to discuss your specific situation.
Editorial Disclaimer: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, airlines, hotel chain, or other commercial entity and have not been reviewed, approved or otherwise endorsed by any of such entities.
This content is for educational purposes only and is not intended and should not be understood to constitute financial, investment, insurance or legal advice. All individuals are encouraged to seek advice from a qualified financial professional before making any financial, insurance or investment decisions.
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