Evaluating the pros and cons of universal life doesn’t have to be difficult.
Whether you are buying variable universal life (VUL) or indexed universal life (IUL), your policy will be a type of permanent insurance and therefore offer many of same basic advantages and disadvantages.
If you are comparing term and universal life, and researching universal life insurance pros and cons to determine whether a universal policy is the best way to protect your family’s financial security, keep reading. This is our exhaustive list of all the best and worst aspects of this middle-ground life insurance policy.
The Full List of Universal Life Insurance Pros and Cons
While universal life insurance offers flexible premiums, builds cash value and has the potential to grow tax-free, for most American families, a universal life policy isn’t the smartest way to invest and save for retirement. If you just need a cheaper way to get permanent insurance, however, it may suit you.
But you don’t have to take my word for it. Below, we will discuss the pros and cons of universal life so you can make an educated decision on the best insurance policy for your needs. First, let’s talk about what it is, and how it works, at the most basic level.
What Is Universal Life Insurance?
Universal life insurance is a flexible policy that provides the same insurance protection as term life combined with the cash value or investment feature of whole life. However, unlike whole life insurance, policyholders choose how to allocate their premiums into different investment options, if the policy allows it.
Furthermore, universal life allows policyholders to use the interest and cash value build-up to help pay for premiums.
How Does Universal Life Insurance Work?
To define universal life insurance and understand how it works compared to other policies, here is a breakdown of features.
- Flexible Premiums – With UL, companies quote you a minimum and maximum premium. You can pay the minimum premium to cover the cost of insurance coverage or pay a higher premium to fund your cash value investments.
- Death Benefit – Life insurance payouts are generally not taxable and the proceeds will flow to your beneficiary tax-free.
- Cash Value Investment Options – Policyholders may invest their premiums in stocks, bonds, mutual funds, commodities, etc.
- Cash Value Growth – Your cash value investments will grow tax-deferred under current federal income tax laws.
- Access and Living Benefits – The funds in your cash value account can be accessed at any time through tax-free loans and may be used to help with education expenses, fund retirement, pay for long-term care, etc. While the “loan” to yourself doesn’t need to be paid back, the outstanding amount will be deducted from your future death benefit.
Since UL insurance can be purchased in many different forms, such as a fixed-rate, indexed, or variable universal life insurance, these features can change slightly.
Should You Buy A Universal Life Insurance Policy?
To preface our analysis of the pros and cons of universal life insurance, it is important to note that the policies themselves offer many benefits; however, when you take into consideration alternative investment strategies that separate life insurance and investing, consumers can get cheaper rates and more coverage with term life insurance policies and higher returns (and lower fees) with index mutual funds from a Roth IRA account.
Pro: Growth Potential
While your policy may guarantee a minimum rate of return ranging from 1 to 4 percent, your universal life insurance company will also invest a portion of your premiums into different investments. For indexed universal life insurance, this investment opportunity is an index fund tracking the S&P 500, Nasdaq 100, Russell 2000, DJIA or another popular index.
If your investments grow in value, your cash value has the potential to grow beyond the minimum rate of return. If the stock, bond, or commodity market does poorly, then your principal is protected and you will earn the minimum guaranteed rate. In this sense, a universal life policy offers the best of both worlds – protection on the downside with unlimited upside potential.
Pro: Flexible Cash Value
If your budget is tight one month or you are having cash flow problems, you can use your universal life policy’s cash value to pay your premiums until you deplete the funds or can make payments again.
Pro: Living Benefit
Universal life insurance offers you a living benefit, which means money can be withdrawn from your cash value account to be used as you see fit. Your withdrawals are tax-free assuming you do not exceed the amount you’ve paid into the policy thus far; if you start to exceed your total premium payments and pull out your earnings, those withdrawals will be subject to taxes.
While there is no strict regulation on what you can use the funds for, most policyholders use the withdrawal to pay for a child’s tuition, make a down payment on a home, cover long-term care, and other expenses.
Pro: Tax-Free Death Benefit
Like other life insurance policies, a universal death benefit payout is not subject to income or estate taxes. If your UL cash value remains untouched through the life of the policy, then your earnings will grow tax-free and your death benefit won’t be taxable either.
Con: Higher Premiums Than Term
Whereas whole life policies charge a fixed premium, universal life insurance rates give you a range – a minimum and maximum (modal) premium. The minimum premium can be paid to cover only the insurance (death benefit) portion of your policy and will not fund your cash value or help you accumulate a retirement nest egg. On the other hand, the modal premium is the maximum you can contribute and will pay for your death benefit as well as build cash value.
Unfortunately, monthly premiums on a universal policy are usually more expensive than a comparable term life policy and the cost of insurance only increases as you age. This means that the cost of your death benefit may start out affordable, but a universal life policy can become prohibitively expensive in the future.
For instance, a $1 million term policy may cost $75 to $100 per month and a $100,000 universal life policy may cost $60 to $100 per month. If you plan to only keep it a few years, save money by buying a term policy.
Con: Surrender Fees (Sometimes)
Although life insurance companies allow early cash withdrawals, some insurers charge “surrender fees”. The surrender fee will depend on how long you’ve had the policy and when you are withdrawing the funds.
You can access cash by loan to avoid the fees, but there is a small amount of interest which accrues the longer the loan is outstanding. The good thing is, the loan fee is usually less than you can get anywhere else, like banks or other financial institutions.
Con: Low Guaranteed Rates That Fluctuate
Earning 4% interest isn’t terrible, especially if the rate is guaranteed for the life of the policy. But therein lies the problem – your policy’s interest rates fluctuate and soon enough, your cash value is only guaranteed to earn 1 or 2 percent. Given that a long-term bank CD or US Treasury Bond yields more, you could have gotten a higher rate of return with another type of investment.
Con: Lapse Potential
Unless you can afford the costly premiums of no-lapse universal life, your policy has the potential to lapse and get cancelled.
As we mentioned, the interest you earn on the cash value may fluctuate and fall. Couple this loss in earnings with increasing premiums as you age and policyholders may find themselves with a slowly depleting cash value investment that could reach $0.
If you are unable to make payments and the policy’s cash value has no funds to cover your premiums, then your UL policy lapses.
The Verdict on Universal Life Insurance
Ultimately, whether or not you should buy universal life insurance depends on your personal financial situation and goals. Often times, a UL policy is best used as an estate planning tool to cover taxes for wealthy clients. Otherwise, if you’re looking to secure your family’s financial future in case of a tragedy, cheap term life is a better policy option.