When looking for a life insurance policy, you might find you have more options than you think. While all life insurance provides a death benefit, if you’re seeking a policy with flexible premiums and the potential for cash value growth, a variable universal life insurance policy could be appealing. However, variable universal policies can be more complex than simpler term and whole life options. Our editorial team, with extensive experience in the insurance industry, is committed to clarifying the insurance shopping process to help readers make informed financial choices. Below, we explain the key points you should know about variable universal life insurance.

Variable universal life insurance policies

A variable universal life (VUL) insurance policy is a type of permanent life insurance that includes both a death benefit and a cash value component. Here’s a look at some common types of permanent life insurance:

  • Whole Life Insurance: This policy features fixed premiums and offers a modest guaranteed interest rate, leading to steady but slow cash value growth. Some whole life policies, known as participating whole life, may also earn dividends.
  • Universal Life Insurance (UL): This type allows for projected level premiums with flexibility in the amount you choose to pay. It earns interest based on the insurer’s investments and includes a minimum guaranteed crediting rate.
  • Indexed Universal Life Insurance (IUL): Similar to UL, this policy offers flexibility, but the cash value is tied to market index funds like the Nasdaq Composite or S&P 500.
  • Variable Life Insurance (VL): This policy has fixed premiums but does not guarantee interest earnings. Instead, the policyholder can choose from various investment options.

VUL insurance is particularly flexible among permanent life insurance products, allowing you to adjust the death benefit and modify premium payments once sufficient cash value is built up. The cash value can grow potentially more by investing in sub-accounts that reflect various investment options.

However, the potential for higher returns comes with increased risk. The cash value in a VUL policy can fluctuate like any stock market investment, leading to possible gains or losses. These policies are not ideal for short-term investments due to daily portfolio value changes, which may be unsettling for risk-averse investors. Additionally, VUL policies typically have high surrender charges that decrease over the first 10-15 years, affecting liquidity.

Since VUL policies are considered securities, they cannot be sold without a prospectus, which the SEC requires. This document outlines essential details about the policy, including costs, investment choices, benefits, and your rights as a policyholder.

What are variable universal life insurance subaccounts?

Investment subaccounts in a variable universal life insurance policy are where your cash value is invested. These subaccounts often include options like stock funds, bond funds, and money market funds, as well as fixed accounts that offer guaranteed minimum interest. Typically, these subaccounts are subject to management fees, which can range from 0.05% to 2%, depending on your policy.

Think of subaccounts as similar to mutual funds, but with a key distinction: they are tax-deferred. Additionally, you may have the flexibility to borrow against or withdraw funds from your subaccounts, allowing quicker access to your cash value without the typical waiting period associated with other investment vehicles.

Benefits of variable universal life insurance

A variable universal life insurance policy may not be suitable for everyone, but it can be an attractive choice for those with investment knowledge looking to maximize earnings on their accumulated cash value. Here’s a brief overview of the pros and cons of VUL policies.

Pros

  • Flexible Premiums: Adjust payments according to your financial situation.
  • Investment Control: Choose where to invest your cash value.
  • Tax Advantages: Enjoy tax-deferred growth and typically a tax-free death benefit.
  • Adjustable Death Benefit: Modify the benefit amount as needed.
  • Potential for High Returns: Aggressive market investments could result in significant cash value growth.

Cons

  • Investment Risk: Cash value can decline based on market performance.
  • Complexity: Requires careful management and a good understanding of investments.
  • Costs: Various fees can affect overall returns.
  • No Guarantees: There are no guaranteed interest rates or cash value, unless you opt for the fixed account option.
  • Cash Value Risk: Loss of cash value could reduce the death benefit or lead to policy termination.

Guaranteed death benefit

Variable universal life (VUL) policies generally provide the choice between level or increasing death benefits, much like traditional universal life insurance. Your VUL policy consists of two components: the death benefit and the cash value. When the insured passes away, the policy pays either the death benefit to the beneficiaries or the cash value to the policyholder. However, when the death benefit is disbursed, the cash value is not available. The exception is in an increasing death benefit policy, where the cash value is added to the initial death benefit.

Flexible premium payments

Unlike most life insurance policies with fixed monthly premiums, variable universal life insurance (VUL) allows you to adjust your premium payments based on your financial situation and investment goals. VUL policies typically offer three payment options:

  • Target Premium Payments: These function like fixed premiums, where you pay a consistent amount at regular intervals. This approach aims to keep your policy active until around age 95 or 100. However, the target premium is not guaranteed; if your cash value significantly decreases, you may need to pay higher premiums or reduce your death benefit.
  • Minimum Premium Payments: After the first year, you can choose to make minimum payments. The policy will use the cash value to cover costs, but if the cash value is exhausted, the policy may be terminated.
  • Prefunding: This involves paying higher premiums early on to build cash value more quickly. This strategy can accelerate earnings accumulation, allowing you to use the cash value later to cover policy costs or access it through loans or withdrawals.

Additionally, VUL policyholders can make extra premium payments anytime or skip payments as needed, providing flexibility to adapt to changing financial circumstances.

More control and greater growth

In most permanent life insurance policies, the cash value typically earns a modest interest rate. In contrast, a variable universal life (VUL) policy offers you more control over the growth of your cash value. You can invest this cash value in subaccounts, which may lead to greater growth potential.

However, higher potential returns come with increased risk. Since VUL policies have limited guarantees, the cash value can fluctuate based on investment performance. This means you could lose some or all of your cash value, which could reduce the death benefit or even lead to policy termination.

Tax-deferred earnings

With a variable universal life (VUL) policy, your beneficiaries typically receive the death benefit free from federal income taxes. Additionally, the earnings on your invested cash value are usually tax-deferred, meaning you only pay federal taxes under certain conditions. Here’s a summary of these tax implications:

  • Tax on Gains: You only incur federal taxes on withdrawals that exceed your total contributions to the policy (your “cost basis”).
  • Borrowing: You can borrow against your policy’s cash value without facing immediate tax consequences. However, if the policy lapses while you have an outstanding loan, you may owe taxes on the unpaid balance. Any loans remaining at the time of death will be deducted from the death benefit.
  • 7-Pay Test: This test, outlined in IRS Section 7702, ensures that your policy is not overly funded and serves primarily as insurance rather than an investment. If your policy fails this test, it may lose its tax advantages and be classified as a Modified Endowment Contract (MEC), which comes with different tax rules.

Who might benefit from a variable universal life policy?

Here are three groups of individuals who may find a variable universal life (VUL) policy particularly beneficial:

  • Experienced Investors: VUL policies are more complex than standard life insurance products. Investors familiar with the stock market, mutual funds, and the associated risks may find value in this type of insurance.
  • High-Net-Worth Individuals: For those focused on estate planning, a VUL policy can be an effective tool to minimize heirs’ tax liabilities. Depending on estate tax laws at the time of your passing, a VUL can allow you to leave a substantial, tax-free inheritance to your beneficiaries.
  • Individuals with Maxed-Out Retirement Accounts: If you’ve reached the contribution limits for your 401(k) and IRA, a VUL policy could be a viable option for investing a lump sum. However, due to higher fees and insurance costs associated with VULs, it’s typically advisable to explore maxing out other retirement accounts first.

While the complexities of a VUL policy can be daunting, if you’re seeking a permanent life insurance option that provides cash value growth and flexible premiums but is easier to navigate, you might consider a universal life insurance policy.

When comparing life insurance quotes, it’s crucial to understand how your premium, death benefit, and cash values interact. This is especially important with a variable policy, as monitoring your cash value is essential to avoid potential termination of the policy.