Universal life insurance: What it is & how it works

Most life insurance shoppers have to decide between term life insurance and permanent life insurance. While term insurance is straightforward, permanent life insurance comes in a variety of forms, each with a different way of accumulating money over time.

One popular type of permanent insurance is universal life insurance, a flexible life insurance policy that comes with a cash value. What makes the policy flexible is its payment structure — 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 If you decrease how much you spend on premiums, the difference is withdrawn from your policy’s accrued cash value.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 to have that flexibility. It’s geared towards high earners who are trying to build a nest egg without entering a higher income bracket or someone with a permanent life insurance need. 

However, universal life insurance can be confusing and expensive, so term life insurance is the best option for most people. 

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, your contributions toward it are usually taxed income. 

How does universal life insurance work?

Universal life insurance is known for its flexibility — the policy allows you to adjust your premium payments and death benefit amount depending on your needs. This means you won’t have to sacrifice protection for your family if your financial health changes. If, after some time, you decide to stop paying or lower your monthly premiums, you can use the accumulated cash value to pay for 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,” explained 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 and legacy costs. 

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,” explains Pat Hanzel, Advanced Planning Specialist and Certified Financial Planner 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 due to the floor, 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 7-10%. Additionally, some of the most profitable savings accounts can get over 2% interest, and the money would be available to you at any time. 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 —  a reality for many Americans who bought universal life insurance policies in the 80s when interest rates were unusually high. 

How much does universal life insurance cost?

Because universal life insurance policies are permanent and accrue cash value, the premiums are a lot higher. However, 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. 

The actual cost of universal life insurance isn’t fixed when you buy it, making it financially risky. 

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. 

Types of universal life insurance 

Three policies that fall under the universal life insurance umbrella: 

1. Guaranteed universal life insurance, which guarantees a death benefit payout and uniform premium payments for the duration of the policy.

2. Indexed universal life insurance, which provides the opportunity for stock market gains.

3. Variable universal life insurance, which 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. 

However, indexed universal life insurance is expensive and the limitations on accrued interest mean you won’t get returns that match the stock market when it's successful. Because of its poor returns and high cost, it’s not the most cost-efficient type of life insurance policy.

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Universal life insurance pros and cons

The advantages and disadvantages of universal life insurance make it a good choice for a select few, but not recommended for most people.  

Advantages of universal life insurance

For high earners who need an additional tax-deferred savings vehicle, universal life insurance comes with some key advantages:

• It lasts your entire life

• Accrues cash value at an interest rate that does not dip below 0%

• Cash value accrual is tax-deferred

• Premium payment amounts can be decreased

Disadvantages of universal life insurance

Most people will find that the disadvantages of universal life insurance outweigh the advantages. 

• It is a lot more expensive than term life insurance

• Cash value accrual is capped at a relatively low interest rate

• The actual cost of insurance increases with time

• Using cash value to pay premiums risks a policy lapse

• Policy needs to be managed the entire time it’s active

Who should buy universal life insurance?

Universal life insurance products are usually for high net worth individuals with very specific tax or investment needs. If you have maxed out all other investment components, for example, you’d 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,” said 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],” explained Lee. “Life insurance is the third option for me.”

Additionally, individuals with permanent life insurance needs may opt for universal life insurance. For example, if your spouse relies on your pension or your children will be liable for estate taxes when you die.

Is universal life insurance worth it?

A universal life insurance policy can be very expensive, and for most people, purchasing a term life insurance policy and investing the difference in an IRA, 401(k), or traditional investments will provide 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. 

Speaking to a financial advisor is the best way to determine whether or not a universal life insurance policy fits into your financial plan.