Universal life insurance
Universal Life is a type of permanent
life insurancebased 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, and the policy is debited each month by a cost of insurance (COI) charge, which is drawn from the cash value if no premium payment is made that month. The interest credited to the account is determined by the insurer; often it is pegged to a financial index. Because only the amount of interest credited and not the cash value itself varies, UL policies offer a stable investment option. A similar type of policy that was developed from universal life policies is the variable universal life insurancepolicy, or VUL. VUL's allow the cash value to be directed to a number of separate accounts that operate like mutual funds and can be invested in stockor bond investments with greater risk and potential reward. Additionally, there is the recent addition of Equity Indexed Universal Life contracts that invest in Index Options on the movement of an Index such as the S&P 500, Russell 2000, and the Dow (to name a few). These type of contracts only participate in the movement of Index and not the actual purchase of stocks, bonds or mutual funds. They may have a cap (but not always) as to the maximum amount they will credit interest to and a minimum guarantee which keeps the principal of the contract from losing money in a down year. Typically each year the starting point is last year's ending point which means that: (1) the policy amount is locked in at the end of the year; and, (2)the beginning value from which the movement measured is reset.
Universal life is similar in some ways to, and was developed from
whole life insurance. The potential advantage of the universal life policy is in its flexibility and the potential for greater cash value growth if the interest rates offered outperform the insurer's general account (that whole life policy cash value growth is based on). Universal life is more flexible than whole life in two primary ways: the death benefit and usually the premium payment are flexible. The death benefit can be increased (subject to insurability) and decreased without surrendering the policy or getting a new one as would be required with whole life. Also a range of premium payments can be made to the policy, from a minimum amount to cover various guarantees the policy may offer to the maximum amount allowed by IRS rules. The primary difference is that the universal life policy shifts some of the risk for maintaining the death benefit to the insured. In a whole life policy, as long as every premium payment is made, the death benefit is guaranteed to be paid if the insured dies. In a UL the policy will lapse (the death benefit will no longer be in force) if the cash value or premium payments are not enough to cover the cost of insurance. To make their policies more attractive insurers often add guarantees, where if certain premium payments are made for a given period, the policy will remain in force even if the cash value drops to zero.
There are two other areas that differentiate Universal Life from Whole Life Insurance. The first is that the expenses, charges and cost of insurance within a Universal Life contract are transparently disclosed to the insured, whereas a Whole Life Insurance policy has traditionally hidden this type of information from the policyholder. Secondly, there are more flexible exit strategies within a Universal Life contract which increases the flexibility of that contract over a Whole Life policy including Zero interest or wash loans which virtually provide the policyholder the ability to access the growth inside the contract "income tax free."
Universal Life is used as a tax-advantaged way to purchase life insurance. In the early years of the contract, the
premiumfar exceeds the cost of insurance (COI) charges. The difference between the two (the "inside build-up") will grow tax-deferred so long as the policy remains in force. If the policy is held until death, this inside build-up will escape taxation entirely. This is because you paid the premium with after-tax money, so the money going in has already been taxed. So 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. Policyholders may also be able to access the inside build-up via a policy loanwithout incurring it as taxable income for the same reasoning.
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 different 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 under Internal Revenue Service Code 101a.
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:1. Leave the policy alone, and let it potentially expire early (if COI charges deplete the account), or 2. Make additional or higher premium payments, to keep the death benefit level, or 3. Lower the death benefit.
Flexible Premium UL allows the policyholder to determine how much they wish to pay each time premium is due. In addition, Flexible Premium UL offers two different death benefit options:1. A level death benefit (often called "Option A"), or2. A level amount at risk (often called "Option B"). This is also referred to as an increasing death benefit.
Policyholders frequently buy Flexible Premium UL with a large initial deposit, thereafter making payments irregularly.
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