Universal Life Insurance
Universal Life is a type of permanent life insurance based on a cash value. That is, the policy is established with the insurer where premium payments above the cost of insurance are credited to the cash value.
The cash value is credited each month with interest. The policy is debited each month by a cost of insurance (COI) charge and any other policy charges and fees which are drawn from the cash value if no premium payment is made that month. The interest credited to the account is determined by the insurer; sometimes it is pegged to a financial index such as a bond or other interest rate index.
Uses
Universal Life is used as a tax-advantaged way to purchase life insurance. In the early years of the contract, the premium far exceeds the cost of insurance charges. The difference between the two (the "cash value") will grow tax-deferred so long as the policy remains in force.
If the policy is held until death, the cash value will escape taxation entirely. This is because the premiums are paid with after-tax money, so the money going in has already been taxed and only growth would be taxed. However, since you only pay taxes on the growth of an investment and you rarely see growth relative to premiums paid, the money in the end is able to escape taxation. Also, the death benefit of life insurance policies generally does not face income tax as long as certain circumstances don't occur.
Types
Single Premium
Single Premium UL is paid for by a single, substantial, initial payment. The policy remains in force so long as the COI charges have not depleted the account. Since changes in the tax code, this type of policy is now called a "Modified Endowment Contract (MEC)" and is subject to less advantageous tax treatment. All policies paid up in 5 or less years are subject to this same negative tax treatment.While the premiums and accumulation will be taxed just like an annuity upon withdrawing, the accumulations will grow tax deferred and will still transfer tax free to the beneficiary under Internal Revenue Service Code 101a under certain circumstances.
Fixed Premium
Fixed Premium UL is paid for by periodic premium payments. Generally, these payments will be for a shorter period of time than the policy is in force. For example, payments may be made for 10 years, with the intention that thereafter the policy is paid-up. If the experience of the plan is not as good as predicted, the account value at the end of the premium period may not be adequate to continue the policy as originally written. In this case, the policyholder may have the choice to either:
- Leave the policy alone, and let it potentially expire early (if COI charges deplete the account)
- Make additional or higher premium payments, to keep the death benefit level
- Lower the death benefit.
Many universal life contracts taken out in the high interest periods of the 1970s and 1980s faced this situation and lapsed when the premiums paid were not enough to cover the cost of insurance.
Flexible Premium
Flexible Premium UL allows the policyholder to determine how much they wish to pay each time premium is due. In addition, Flexible Premium UL may offer a number of different death benefit options, which typically include at least the following:
- A level death benefit (often called Option A or Option 1, Type 1, etc)
- A level amount at risk (often called Option B, etc). This is also referred to as an increasing death benefit.
Policyholders may also buy Flexible Premium UL with a large initial deposit, thereafter making payments irregularly. Universal Life Insurance is frequently offered by agents as a tax-sheltered investment from which the policy holder can borrow against as needed later without tax penalties.