You’ve probably heard of term and whole life insurance, but did you know there is another completely different category of life insurance? Take the stage: universal life!
With this flexible type of policy, you can customize it to fit your different seasons of life, with the potential to add riders and reap multiple kinds of benefits from it depending on how it’s structured. So long as it remains funded properly, the policy will not expire.
If you’re looking for a way to make a significant impact by leaving a legacy, consider these massive benefits which are offered by universal life.
How Does Universal Life Work?
Think of universal life as an insurance policy that is cheaper than whole life and requires responsible decision-making by yourself. Unlike whole life insurance, the premiums that you pay are flexible, within certain limits, allowing you to decide how much to pay and when.
How is that possible? Think of it this way.
If you’re 50 years old and decide to buy universal life insurance that lasts your entire life, then the insurance company is going to be at less risk of loss when you’re 50 years old than when you’re 80. So their premiums charged at age 50 will be less than those charged at 80. If you chose to pay the bare minimum requirement for a while, technically you could do that. But the premium will increase as you get older and, if not planned for, can become extremely expensive to pay out-of-pocket later on.
For that reason, the insurance company will often illustrate the recommended premium amount that should be more or less sustainable over the years, depending on how the cash value grows. Once you’ve built up cash value in the policy, it can help supplement the more expensive premium payments as the years go by.
The cash value earns interest and, in some cases, some market return. Insurance companies often have a minimum required cash balance to keep the policy active. It is the policyholder’s responsibility to monitor and keep the policy funded so that the policy does not lapse or reduce its death benefit.
So What’s the Benefit of Universal Life?
Let’s imagine Gary and Bernard are colleagues at work, and sadly their entire team has been let go. They are now back in the job market looking for work but aren’t sure whether they will be landing a new job tomorrow or 12 months from now.
Gary has whole life insurance, and Bernard has universal life.
Gary can’t afford to make payments on his whole life insurance without an income, so his whole life policy uses its feature of allowing an Automatic Premium Loan (APL) to be taken against the cash value to cover the next month’s premium. Most whole life policies allow for this APL to keep a policy in force as long as possible. If the premium goes unpaid for too long, the cash value will deplete and his policy will lapse.
On the other hand, Bernard also cannot make his premium payment. Instead of using an Automatic Premium Loan against the cash value, the premium is simply taken from the cash value and paid in full for that month. This is not a loan that is going to be accumulating interest.
Fortunately, they both land a job within 3 months of being let go.
Gary is required to pay back the loan with interest and renew his whole life insurance payments.
Bernard simply needs to keep the cash value above a certain minimum and to make sufficient monthly payments to make this sustainable.
Bernard may also choose after a few months to put a lump sum back into the policy to bring the cash value back to where it was.
So as you can see, universal life allows your premiums to ebb and flow depending on your capacity during different seasons of your life. As long as the premium gets paid via cash value or out-of-pocket, or both, the insurance company is happy. You don’t have to worry about paying back a loan with interest if a premium is paid from cash value.
Policy Riders Are Universal Life’s Superpower
This is where things get interesting. A whole variety of options for customization exist in the form of riders which can be added to the policy. While these are not totally unique to universal life policies only, I list them here because they are such a powerful way to leverage and protect wealth. Here are just a few popular ones to give you an idea of what’s possible:
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Long-term care rider
This might be my favorite rider, because long-term care insurance is so expensive to purchase (and not much fun to think about, either!).
This allows the insured to use up to a certain amount of the death benefit per year to cover long-term care costs if ever needed. -
Accelerated death benefit rider
This allows the insured to use up most or all of the death benefit for medical expenses if they are unfortunately diagnosed with a terminal illness. -
Critical illness rider
Similarly, this allows the insured to use the death benefit to pay for a critical or chronic illness. Each rider will have its own explanation of what is covered. -
Waiver of premium rider
If the insured becomes disabled and cannot continue working, this can act as disability insurance by reducing the death benefit by a certain maximum amount per year.
There are many definitions of “disabled,” so read the fine print before selecting this rider. -
Child rider
Instead of taking out a separate life insurance policy for each child, a lower-cost option is often to add a child rider to the UL policy to get them covered. -
Spouse rider
Adding the spouse rider provides a cost-effective way to get coverage for a policyholder’s spouse.
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Long-term care rider
Is Universal Life Better Than Whole Life?
The answer to this is going to depend on how you value guarantees.
Whole life insurance offers these features, assuming the premium is paid:
- A guaranteed premium payment that will not change.
- A guaranteed death benefit that will not change.
- A possibility of an annual dividend paid on the cash value.
- There is an overall higher cost for whole life due to the guarantees.
Universal life insurance offers these features, assuming premiums are paid within certain limits:
- A flexible premium payment, but with the possibility that more might be required if cash value drops below a certain minimum.
- A policy’s death benefit can either be either:
- Level death benefit: the death benefit remains fixed.
- Increasing death benefit: the death benefit could potentially increase if cash value hits a certain threshold, or it could decline if cash value drops below the minimum.
- Interest is paid on the cash value, often with a minimum guaranteed interest rate.
- Certain types (Indexed Universal Life) offer some degree of market return on the cash value, usually with a minimum loss threshold and maximum gain in any given year.
- There is an overall lower cost for universal life due to its flexible nature.
Is Universal Life Expensive?
While it typically costs less than whole life insurance, universal life premiums will still be more expensive than term. But it’s not money out the window that will never be seen again; you will get the return of value if you keep the policy in force for your lifetime. Think of it like this: it is an investment in the future for your beneficiaries, no matter when your final day on earth may be.
So let’s take John for example. John is 50 years old and wants to leave $1 million total to his beneficiaries. He qualifies for universal life insurance and decides to pay a premium of $500/month, although he has some flexibility within limits.
Now, John also could have decided to simply invest $500/month in a taxable investment account from now until his death. If he saw 7% annual growth on that theoretical investment, he would be at $1 million in about 36 years (age 86). That’s pretty close to life expectancy!
So why wouldn’t he just make this investment instead of buying life insurance? Because he’s not guaranteed tomorrow. John’s intention is to leave $1 million to his kids regardless of when he passes away, not simply if he happens to live into his mid-80’s and hopefully make that return on investment.
As far as taxes are concerned, there’s not a lot of difference. Universal life insurance is only subject to estate taxes (if above the threshold) but not to income or capital gains tax. A taxable investment account would actually get a stepped-up cost basis at John’s death, meaning that the value of the account at death would not be taxable for capital gains or income. It would only be taxable for any capital gains realized after the date of death, similar to if the kids had decided to invest the life insurance proceeds and made a return on investment.
John buys universal life insurance for the confidence that he will leave that legacy of $1 million to his kids, come what may. In addition, he could also choose to buy a policy with an increasing death benefit, so that he has the potential to leave even more than $1 million to his kids if he lives a long time and the cash value continues to grow!
Conclusion
Universal life insurance can be a terrific way to leverage up your estate for your beneficiaries, while simultaneously using one or more riders to protect against major unexpected expenses during life. It’s not as restrictive as whole life insurance, meaning you can bend with the wind of the seasons of life.
The “price” of more flexibility with premiums is that the policyholder is responsible to maintain the cash value within proper thresholds to keep the policy in force.
What I love about universal life is that you get so much more for your money than with whole life insurance. The tradeoff, again, comes down to the guarantees. I’ve written about why I think whole life insurance is not a great option for most people in this article.
Whole life insurance is too expensive, in my opinion, except in rare circumstances where someone may simply be willing to pay that price to know they have a guarantee. But guarantees can be overrated. Just a little more flexibility, and you can have a powerful universal life insurance policy that you know will be there for your beneficiaries so long as you maintain it responsibly over your lifetime!
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