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What is universal life insurance?
Universal life insurance is a permanent but flexible type of life insurance that marries the features of several types of coverage. It offers low-cost protection like term life insurance, but also allows you to save like whole life insurance. The money you save is invested to build cash value.
One major draw of universal life insurance is that it allows the policyholder to do two important things: review and alter the policy as circumstances change and use the interest from accumulated savings to help pay premiums.
A universal life policy might be a good choice if:
- You are looking for a long-term death benefit that permits you to leave your family with a potentially tax-free inheritance, or you want to make a charitable donation upon death.
- You have long-term savings goals and want to build tax-deferred savings.
Determining premiums can be confusing. There are two premiums: a minimum and a modal. The minimum premium represents the lowest premium you can pay in order to fund the death benefit. Your policy reverts to no-frills, with no cash value accumulation. The modal premium pays for the death benefit, builds cash and helps you avoid paying taxes. It is the maximum payment allowed under the terms of the policy.
If you ask any two people what they think about universal life policies, you are likely to receive very different answers. Life insurance plans that also build cash value have these potential disadvantages:
- The modal premium needs to be paid to build value.
- Cash value cannot be withdrawn during the first few years of policy life.
- Money you borrow comes from the insurance company, not from the savings you contributed to. Your savings simply acts as collateral.
- You must pay interest on the loan; if you don’t, the interest owed grows larger and reduces your cash value.
Examples of universal life insurance
In spite of any potential disadvantages, particularly if your premium payments lapse or you need to borrow against the cash value of your account, several features may work in your favor.
Premium flexibility. As long as the cash value of your policy covers premium costs, you can lower or even stop paying them. Although it’s a useful benefit when money is tight, there is a negative consequence. You can quickly use up the cash value in the account.
Loan capability. Each time you pay your premium, a portion of it goes to the death benefit, but a portion also goes to the savings component. After cash has accumulated in the savings portion of the account, you can withdraw or borrow against it, but doing so may cause a reduction in the death benefit or change the way the money is taxed.
Cash portion earns interest. Interest earned is normally around the amount being earned through money market accounts. Those interest rates fluctuate with the market, meaning that earnings can slow. Some universal life sellers offer protection through a minimum performance guarantee.
Lapse protection. Some universal life policies include lapse protection, meaning your policy will remain in force for a specified period of time if you fail to make payments. Lapse protection premiums vary according to your age when you started the policy, your gender, face value of the policy, and the underwriting class in which you are included.
Adjustable death benefit. Certain universal life companies allow you to increase the death benefit if you pass a medical exam. Some also allow you to reduce the death benefit in order to reduce the policy cost. This may be a good option if the size of your estate grows and your heirs will depend less upon the death benefit of your universal life policy.