Thoughts on Universal Life Insurance

When universal life insurance debuted in 1982, it quickly became a popular alternative to whole life insurance policies which had been losing favor due to its low yields, high premiums and nontransparent structure.  In the high interest rate environment of the 80’s, consumers were looking for competitive rates on their money and more flexibility in the way they could structure their life insurance policies.

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Consumer’s Choice

The life insurers responded with universal life which is, essentially, an unbundled whole life plan with its components loosely coupled to allow the consumer to make modifications according to their needs and changing financial picture.  Also, by creating a separate cash value account, life insurers were able apply more competitive rates of return, but without the absolute guarantees that are provided in whole life policies.  With the interest bearing accounts of universal life policies, the policyholder takes on the interest rate risk although there are some minimum rate guarantees. 

The premium schedule can be adjusted based on the growth of the accumulated cash values.  If the cash value growth exceeds the baseline needed to maintain the minimum face amount of the policy, the policyholder can reduce premium payments.  If the cash value accumulation drops below the baseline, additional premium payments could be required in order to maintain the policy.  It is possible that, at some point, if the accumulated values are sufficient, the policyholder can suspend payments altogether.

Additionally, life insurers provided for partial withdrawals from the accumulated values.  In a given year, a policyholder can withdraw up to 10% of the accumulated values without charge. This adds more flexibility for the policyholders to manage their money to meet other financial needs.  The policyholder can also borrow from the accumulated values for a slight interest charge.  In either case, funds taken from the policy (and not paid back in the case of a loan) will the effect of reducing the face amount and, there are tax consequences, and, possibly IRS penalties associated with withdrawals.

Universal Life Insurance as a Financial Management Tool

In addition to providing the consumer with a low cost alternative for permanent life insurance, universal life provides the consumer with a financial management tool that can play a vital role throughout the financial life of a family.  Let’s consider the example of a young family planning for their future.

The Family Plan

A young family, consisting of a couple in their early thirties, a 2 year-old boy and a baby girl on the way is looking ahead to their future goals and needs for family protection, college education, spousal earnings protection and retirement.  Instead of a piece meal plan that might include adding additional life insurance policies as their lives progress, this couple would rather buy one plan that offered the ability to change it as their needs change. They also would prefer that their money at work do as much double and triple-duty as possible so as to minimize their total outlay.

Premium Dollars Working Multiple-Duty

A universal life policy with an Option II would provide for increasing coverage on a growing family while allowing their premium dollars to function as a tax favored accumulation account for college savings.  The Option II plan would pay a death benefit equal to the original face amount plus the accumulated cash value, so the family would receive a much greater benefit in the event of the premature death of the primary breadwinner.

Tax Favored Growth and Distribution of Funds

As interest rates rise, they will benefit from greater growth of their cash values, and, because they aren’t taxed, they will accumulate, over time, faster than taxable equivalents such as bank CDs.  Ultimately, the cash values can be accessed via withdrawals tax free up until the full amount of principal has been withdrawn. Policy loans are also not taxed.  Death benefits are generally not taxed either.  The end result is that their money at work will grow and be distributed without the encumbrance of taxes.*

Keeping Options Open

If interest drop too far for their tastes, they have the option of taking a portion of their values as a withdrawal to invest it in a more aggressive vehicle.  They may also need to access the values to cover short term needs or contingencies.  In either case, they need to be concerned about reducing their face amount.

Funding College

By starting their plan early, their accumulated values can grow sufficiently to provide the funds needed to supplement college costs.  Although withdrawals made during the kid’s college years will reduce the face amount, their need for the additional protection will decrease once the kid’s finish college.  Funding college expenses this way also keeps other financial aid options open because life insurance is not an includable asset for considering financial need.

Long-Term Protection

At that point, the insurance protection will be used to replace the lost earnings of the breadwinner so the surviving spouse has sufficient income to maintain a desired lifestyle and, ultimately, provide for retirement. 

Cashing in at Retirement

After college graduation, the couple can begin to contribute additional premium to the account value to accumulate more tax favored dollars for retirement.  Universal life is a great way to save for retirement if they have made the maximum contributions to other tax qualified retirement plans.

Summary

For young families with the foresight to plan for future events and needs, a universal life policy can become a complete financial management tool. The advantage is that their money at work will be working harder to help them address multiple needs.  Also, for individuals concerned about their future insurability, a universal life policy not only provides for permanent coverage, it can also provide for increasing coverage as the family’s protection needs increase.

*Withdrawal of accumulated values that exceed the principal amount saved is taxed as ordinary income. Loans that are not repaid may be subject to taxes should the policy be surrendered early.  If the policy accumulates cash values over a certain limit, it may become a Modified Endowment Contract which would make it ineligible to receive favorable tax treatment.  Issues involving potential tax consequences should be discussed with a qualified financial professional.

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