There’s a certain peace knowing your family won’t encounter financial hardship when you die. That’s the benefit of life insurance. For many people, a term life policy is an ideal starting point in working toward securing their family’s financial future. But adding a permanent life insurance policy to the mix, which has a few more added benefits, is often a wise decision for people looking to widen their protective economic moat.
What is universal life insurance and how does it work?
You may have heard of whole life insurance, which is the most common form of permanent insurance. But there are other types of permanent insurance, including universal life insurance. Though the names are different, they’re essentially two paths with the same destination – a lifetime death benefit and an additional cash value component that can earn interest.
This is different from term life insurance, which guarantees a death benefit only within a specified window of time. When that policy expires, it has no value and there is no longer a death benefit; it’s like moving out of a rented apartment – it was there when you needed it, but you parted ways when the lease agreement ended. Permanent life insurance policies feature a death benefit that never expires and offers ways to utilize the policy while living.
As the cash value grows in a whole or universal policy, it can be accessed for any financial need. Both types of insurance also allow you to take out loans against your policy’s value.
But there are important differences between whole and universal life insurance that might make one more appealing than the other, depending on your personal situation.
Universal life insurance can offer flexibility for premium payments
With whole life insurance, you pay the same annual premium over the life of the policy. Any missed payments must be made within a certain time frame for the policy to remain in place. While fixed costs are attractive for people who prefer consistency, others may want a little more flexibility in their premium and death benefit structure. That’s where universal life insurance differs from whole life.
A typical universal life insurance policy allows you to vary the amount and frequency of the premium you pay (within limits set by the company and federal tax law). Every month the cost of insuring you is calculated and charged to your policy. If you pay more than that amount, the surplus accumulates as cash value which earns interest every month. As you build cash value in a universal policy, you can use that money to cover your insurance costs without reducing your death benefit.
Universal life insurance vs. variable universal life insurance
There are two main types of universal life insurance: fixed or variable. With a fixed policy the amount you earn on your cash value is set by the insurance company. With a variable policy, your earnings may be tied to investment options.
If you put enough money into your universal life policy, and your need for the death benefit is reduced, the cash value accumulation can be accessed for opportunities or emergencies later in life, or even to supplement income during retirement.*
So long as you have enough cash value, you can vary the amount and the frequency of the premium you pay. Theoretically, you could stop paying your premiums altogether and the policy wouldn’t lapse — so long as there is enough cash value to cover your cost of insurance each month. However, if there is insufficient cash value to cover the cost of insurance, the policy may lapse, potentially resulting in significant adverse tax consequences.
Flexible premium payments may be appealing to someone whose income fluctuates, perhaps a business owner or sales person who is compensated through commissions. If money is tight you can pull back on the premium, or if you’re flush with cash you can pay a larger premium up front. With a whole life policy, you’ll need to pay that same premium regardless of how your financial situation changes.
Death benefit flexibility
Some universal life insurance policies feature a level benefit, meaning the death benefit paid to your family remains fixed throughout the life of the policy. Since the cost of insurance increases as you get older, a level death benefit can prevent those costs from climbing too high as you age.
Some universal life policies peg your death benefit and policy value together. Your death benefit rises as your policy value increases, which causes your expenses to rise as you get older. There are many other policy designs, so you’ll want to speak with a professional to find the right fit.
Universal life insurance risks
While premium flexibility is one of the biggest advantages of a universal life policy, it can also be its greatest shortcoming. If your policy doesn’t feature a death benefit guarantee, it will lapse if there isn’t enough cash value to cover monthly insurance charges. It’s a good idea to work with your financial professional on an annual basis to forecast future insurance costs and incorporate them into a larger financial plan to avoid a potential policy lapse and adverse tax consequences down the road.
*Accessing cash values will reduce benefits and may affect other aspects of your policy and/or plan.