Universal life insurance: What it is & how it works

A universal life insurance policy can be used to build a tax-free inheritance for your family or supplement your retirement income, but it’s best for high earners.

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Nupur Gambhir

Nupur Gambhir

Senior Editor & Licensed Life Insurance Expert

Nupur Gambhir is a licensed life, health, and disability insurance expert and a former senior editor at Policygenius. Her insurance expertise has been featured in Bloomberg News, Forbes Advisor, CNET, Fortune, Slate, Real Simple, Lifehacker, The Financial Gym, and the end-of-life planning service Cake.

Updated|5 min read

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Universal life insurance is defined as a flexible life insurance policy that comes with a cash value. You can decrease (or increase) how much you pay towards premiums. If you decrease how much you spend on premiums, the difference is withdrawn from your policy’s cash value. 

A universal life insurance policy can be a good fit for someone who is looking for some flexibility in their life insurance — and can afford that flexibility. It’s best for high earners who are trying to build a nest egg without entering a higher income bracket. 

Key takeaways

  • The cash value of a universal life insurance policy can be applied to your premiums.

  • Individuals who need permanent life insurance or another vehicle for tax-deferred cash accumulation benefit the most from universal life insurance.

  • For most people, a term life insurance policy combined with a separate investment account will produce better earnings.

What is universal life insurance?

What makes universal life insurance different from other types of permanent life insurance is that it allows you to use the cash value to pay your premiums. But similar to other permanent policies, it lasts your entire life and pays out a tax-free death benefit to your beneficiaries when you die. 

Part of the premiums you pay goes towards the death benefit, while the remainder is contributed towards the cash value of your policy, which earns a small amount of variable interest and isn’t taxed while it grows. While you are alive, you can use the cash value to:

  • Pay your policy premiums

  • Withdraw cash, but with additional fees

  • Take out a loan, which you’ll have to pay back with interest

While the cash value grows tax-deferred, withdrawals are taxed as income. 

How does universal life insurance work?

Universal life insurance allows you to adjust your premiums and death benefit depending on your needs. If, after some time, you decide to stop paying or lower your monthly premiums, you can use the cash value to pay them. However, you cannot do this until it has accrued enough interest.

“For you to really start to see the fruits of your labor or a decent rate of return it takes years,” says Malik S. Lee, Managing Principal at Felton & Peel.

And if the policy’s investments underperform, you’ll need to resume making your premium payments. If you completely deplete your policy’s cash value and still don’t make a premium payment, your policy will lapse.

Because universal life insurance provides permanent coverage, some people choose it for their estate planning needs. The death benefit payout can be used to cover estate taxes. 

The cash value in universal life insurance 

The interest earned on the cash value of a universal life insurance policy is based on market index performance, such as the S&P 500, and is subject to market fluctuations. Your policy’s index depends on your insurer, as is the floor and cap on gains set by insurers. 

“The floor is almost always 0%. The cap for every product is different, but it’s usually between 8 and 13 percent,” says Patrick Hanzel, certified financial planner and Advanced Planning Team Lead at Policygenius.

This means that universal life insurance isn’t always the best option to save money for the future. While you won’t lose money, the capped returns realize a much smaller gain than you could get by investing the same amount in an IRA or 401(k). 

For example, an insurer may set the rate of return on universal life insurance at 2%, while the rate of return on an IRA or 401k that matches historical stock market averages is around 10%. [1] The lower rates of return on a universal life insurance policy are why many financial advisors recommend buying term life insurance and investing the difference. 

Additionally, the fluctuating interest rates mean you’ll need to monitor your policy yearly. Not doing so can mean paying for a universal life insurance policy that is unaffordable.

Average cost of universal life insurance

The actual cost of universal life insurance isn’t fixed when you buy it, making it financially risky. Because universal life insurance policies are permanent and accrue cash value, the premiums are a lot higher.

It can be difficult to create a long-term budget for this type of policy because of its flexible premiums. And before your policy builds up cash value, you’ll be paying a lot of money to have that flexibility. 

Additionally, the cost of a universal life insurance policy usually increases over time — on a policy that already has minimal investment guarantees — so it’s not the best vehicle for asset accumulation. You can get a universal life insurance quote from a license life insurance agent.

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The best universal life insurance options

The best three policies that fall under the universal life insurance umbrella are: 

  1. Guaranteed universal life insurance: Guarantees a death benefit payout and uniform premium payments for the duration of the policy.

  2. Indexed universal life insurance: Provides the opportunity for stock market gains.

  3. Variable universal life insurance: Invests in mutual funds that can increase or decrease the cash value.

Indexed universal life insurance is the most common type of life insurance policy people add to their investment portfolio. Its cash value has a minimum (and maximum) guaranteed interest rate — so if you’re purchasing the policy to enhance your investment portfolio, you’ll know that you’re never losing money. 

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Who should buy universal life insurance?

Universal life insurance products are for high-net-worth individuals with very specific tax or investment needs. If you have maxed out all other investment components, for example, you could benefit from adding a universal life insurance policy to your portfolio. Or, if you're a very high earner, you may consider adding a universal life insurance policy to your financial toolkit because it can help you build a nest egg without entering an even higher tax bracket. 

“Typically the people that are doing this strategy, they've kind of exhausted all other avenues already,” says Lee.

“You need to go through — what I call — the savings hierarchy. You need to look at your most tax-efficient investment and saving tools first. Next, you have your tax-deferred vehicles. Lastly, you need to look at your taxable accounts — your life insurance strategies [for example],” says Lee. “Life insurance is the third option for me.”

How to get universal life insurance

A Policygenius agent can work with you for free to get you the right policy for your needs. If a universal life insurance policy is best suited for your financial situation, an agent will help you customize the policy to your ideal price point.

Is universal life insurance worth it?

A universal life insurance policy is very expensive, and for most people, purchasing a term life insurance policy and investing the difference in an IRA, 401(k), or traditional investments provides greater returns for a lower cost. But for individuals in a high tax bracket, a universal life insurance policy can offer a tax-deferred asset accumulation option that also protects the financial security of their loved ones. 

Frequently asked questions

What are the benefits of universal life insurance?

There are four major benefits to universal life insurance: It lasts your entire life, accrues cash value at an interest rate that does not dip below 0%, the cash value accrual is tax-deferred, and premium payment amounts can be decreased.

What are the disadvantages of universal life insurance?

There are some major disadvantages to universal life insurance that make it not worth buying: It is a lot more expensive than term life insurance, its cash value accrual capped at a relatively low interest rate, the actual cost of insurance increases with time, and using cash value to pay premiums risks a policy lapse.

Is universal life insurance a good investment?

Universal life insurance is not a good investment for most people, but high earners may find it useful to grow tax-deferred savings.

What is the difference between whole life insurance and universal life insurance?

With a whole life insurance policy, you cannot use the cash value to pay your policy’s premiums, but with universal life insurance you can.