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What is Variable Universal Life Insurance and How Does It Work?

What Is Variable Universal Life Insurance?

Variable Universal Life Insurance (VUL) is a type of permanent life insurance that combines the features of universal life policies with the potential for investment growth.

Like other life insurance policies, VUL policies provide death benefits to your beneficiaries when you pass away. However, a VUL also has an investment component, where the cash value portion of the policy can be invested in a variety of sub-accounts similar to mutual funds. The investment options allow you to potentially increase your cash value based on the performance of the sub-accounts.

The Importance of Life Insurance

Life insurance is a crucial financial tool, particularly for households that rely heavily on one person’s income. In fact, a recent study showed that approximately 68% of U.S. households with life insurance coverage say they would feel financially secure following the unexpected death of their household’s primary wage earner. In comparison, only 47% of households without insurance feel the same.

Permanent life insurance, as its name implies, provides lifelong coverage. Unlike term life insurance, which protects you for a specified period (or term), permanent life insurance policies remain in effect as long as you continue to pay the premiums. Permanent life policies also have a cash value component that functions similarly to a tax-deferred savings account.

Variable universal life is a type of permanent life insurance that allows owners to invest the policy’s cash value into sub-accounts similar to mutual funds, providing the potential for market-driven growth and a risk of investment losses.

How Does Variable Universal Life Insurance (VUL) Work?

A variable universal life insurance policy combines standard life insurance policy features and an investment portfolio. VULs require premium payments, which are used to cover the policy’s insurance costs and administrative expenses. The remaining amount is then allocated to the policy’s cash value.

You can invest the cash value into a range of sub-accounts. Sub-account options typically include stocks, bonds, or money market accounts. The performance of the sub-accounts directly affects your policy’s cash value, which could increase or decrease based on market conditions. A VUL policy also offers flexibility, allowing you to adjust the premium payments and death benefits to suit your financial needs.

Key Features of Variable Universal Life Insurance

  • Investment options: The ability to invest the policy’s cash value into a range of sub-accounts
  • Flexibility: The ability to adjust premium payments and death benefits to meet your financial needs
  • Tax advantages: Tax-deferred growth of the cash value and potential for tax-free death benefits
  • Lifetime coverage: A death benefit that lasts as long as the policy remains active
  • Loan options: The possibility to borrow against your policy’s cash value

Cash Value Growth

The cash value of a VUL policy is the part of your premium that’s invested. Cash value growth is tax-deferred over time based on the performance of your chosen sub-accounts. The growth of the subaccounts is not taxed unless you withdraw it.

If the sub-accounts perform well, your cash value grows, possibly enhancing your death benefit. Conversely, poor performance can shrink your cash value, impacting your financial flexibility and the policy’s death benefit.

Can You Access Your Cash Value Before You Die?

During your lifetime, you can access the cash value through withdrawals or loans, providing a financial cushion when needed. You may use your cash value for things like funding your retirement, paying policy premiums, or covering the cost of financial emergencies.

It’s important to note that accessing a VUL policy’s cash value decreases your death benefit and may be taxable if you withdraw more than what you’ve paid in premiums. When you pass away, the insurance company typically absorbs the remaining cash value, and your beneficiaries receive the policy’s death benefit. Some policies may have features that allow the remainder of the cash value to be paid to the beneficiaries, but this may come at an extra cost. 

The Role of the Securities and Exchange Commission (SEC) in VUL Policies

Due to the investment aspect, variable universal life insurance policies fall under the Securities and Exchange Commission (SEC) regulations. The SEC oversees the sub-accounts where your cash value is invested, ensuring they comply with securities laws designed to protect investors.

The SEC also regulates the sale of VUL policies, requiring insurance companies to provide detailed information about the investment risks, fees, and charges associated with the policies. Disclosure requirements help policyholders make informed decisions about their cash value investments.

Variable Universal Life Insurance vs. Other Types of Life Insurance

Choosing the right type of life insurance policy depends on your individual needs and financial goals. To understand where variable universal life insurance may fit into your plan, it may be helpful to compare it with other common types of life insurance.

  • Universal life insurance: Like VUL, universal life insurance also provides flexibility in premium payments and death benefits. However, it lacks the investment feature of VUL. The cash value in Universal Life policies grows at a fixed interest rate set by the insurer.
  • Indexed universal life (IUL) insurance: IUL policies tie the growth of your cash value to a market index, such as the S&P 500, offering the potential for higher returns versus universal life policies. However, IULs do not provide direct market participation.
  • Whole life insurance: Whole life offers guaranteed cash value growth and fixed premiums but lacks a VUL policy’s flexibility and investment potential.  
  • Term life insurance: Unlike permanent policies, term life insurance does not build cash value. It provides coverage for a specific term (e.g., 10, 20, or 30 years). If you outlive the term, the policy ends without any payout.

How Much Does a VUL Policy Cost?

The cost of a Variable Universal Life (VUL) policy can vary widely based on several factors, including the policyholder’s age, health, lifestyle, and the amount of coverage desired.

Universal life policies, including VUL, offer flexible premiums within predefined limits.

However, it’s important to approach this flexibility with caution. If you consistently pay lower premiums for an extended period, you might find yourself facing higher premiums down the line to ensure the policy stays in effect. While adjusting premiums based on immediate financial constraints may be enticing, it’s critical to consider the potential future impact of those decisions.

In addition to the premium, VUL policies may have other costs associated with the underlying investments. Sub-account fees are similar to a mutual fund’s expense ratio and can lower your investment returns.

Factors That Affect Your VUL Premium

Understanding how the following factors affect the cost of a VUL policy may help you determine the appropriate time to purchase a policy:

  • Age: The older you are when you purchase a life insurance policy, the higher the costs.
  • Health: Good health could potentially lower your premium, while pre-existing conditions may increase it.
  • Lifestyle: Risky behaviors such as smoking or hazardous hobbies can increase premiums.
  • Coverage amount: Larger death benefits typically come with higher premiums.
  • Investment performance: The performance of your sub-accounts could impact your premiums, especially if you’re using the cash value to pay them.

Benefits and Drawbacks of Variable Universal Life Insurance

As an investment-linked product, VUL carries both the potential for significant returns and a certain degree of risk. For example, many owners appreciate a VUL policy’s flexibility, but failing to properly manage it can create serious problems. In addition, declining cash values following poor stock market performance or other market factors can derail a seemingly solid financial plan. Before deciding to purchase a VUL policy, it’s critical to understand both the potential benefits and drawbacks.

Benefits of VUL Insurance

Variable Universal Life Insurance carries a range of benefits that could make it an attractive choice for specific individuals, including:

  • Investment potential: With VUL policies, you can potentially amplify your policy’s cash value by investing in a variety of sub-accounts that include stocks, bonds, and mutual funds. These investment options can potentially deliver higher returns compared to other types of life insurance, provided the investments perform well.
  • Flexibility: VUL policies are known for their flexibility. They typically allow you to adjust your premium payments and death benefit so your policy continues to align with your changing financial circumstances.
  • Investment selection: VULs give you discretion over how your cash value is invested, allowing you to adjust to changing market conditions.
  • Tax advantages: Just like other types of life insurance, VUL offers tax benefits. The policy’s cash value growth is tax-deferred, meaning no taxes are due on the investment gains unless you withdraw them. The beneficiaries also typically do not owe taxes on the death benefit.
  • Loan option: You can borrow against your VUL policy’s cash value. However, policy loans accrue interest; if they’re not repaid, they reduce the cash value and death benefit. Policy loans are typically not taxable unless the policy is surrendered.
  • Lifetime coverage: As long as the premiums are paid, VUL policies provide a death benefit for the entirety of the policyholder’s life, potentially offering reassurance for those who want to ensure their loved ones are financially secure after they pass away.
  • Potential for increased death benefit: If the policy’s investments perform well, the cash value grows. Depending on the death benefit option you’ve selected, the growth can potentially increase the death benefit.

Drawbacks of VUL Insurance

While VUL insurance offers numerous benefits, it also has some drawbacks to consider before making a purchase, including:

  • Investment risk: The cash value of a VUL policy is tied to the market performance of the chosen sub-accounts. If the market does not perform well, the cash value can decrease.
  • Complexity: VUL policies are more complex than other types of life insurance. Making informed decisions about where to invest your cash value and adjusting premium payments or the death benefit requires understanding investment principles and an active management approach.
  • Fees and charges: VUL policies generally have higher fees than other types of life insurance. Costs may include administrative fees, management fees for the sub-accounts, and insurance charges, which can reduce your policy’s cash value.
  • Risk of policy lapse: If you do not pay enough premiums or the cash value becomes too low to cover the costs of insurance and other charges, the policy could lapse, potentially leaving you without coverage.
  • Loan risks: While you can take loans against your policy’s cash value, the loans accrue interest. If not repaid, the death benefit could be significantly reduced. If a large loan leads to a policy lapse, it can also result in a taxable event.
  • Potential for lost benefits: If you decide to surrender the policy, you may face surrender charges, especially if the policy is relatively new. Surrendering a policy also results in the loss of the associated death benefit. 

Who Should Consider Variable Universal Life Insurance?

Variable Universal Life insurance may suit the needs of certain individuals, including:

  • Those who understand and are comfortable with investment principles: VUL is not just a life insurance product. It’s also an investment vehicle. Individuals with a good grasp of investment concepts and a willingness to face market fluctuations may be well-suited for a VUL policy.
  • High-income earners: A VUL policy can provide another avenue for tax-deferred investment growth if you’re in a high-income bracket and have already maxed out contributions to other tax-advantaged accounts.
  • Individuals with long-term financial obligations: The lifelong coverage offered by VUL can be particularly useful for those with long-term financial commitments, such as special-needs dependents or estate planning needs.
  • Those who value flexibility: VUL offers the ability to adjust premium payments and death benefits according to changing life circumstances. The flexibility VUL policies offer can be a significant advantage for those who want the ability to make adjustments in the future.
  • Individuals looking for tax advantages: The tax benefits of VUL, such as tax-deferred growth and potential tax-free death benefits, can appeal to those keen on maximizing their wealth tax-efficiently.

What This Means for You

Variable universal life is a type of permanent policy with built-in flexibility. VUL allows you to adjust premiums and death benefits and offers the potential for cash value growth via investment in sub-accounts. However, the growth is subject to market risks, and the policy can be complex to manage.

Keep in mind that costs can be higher than other life insurance types due to investment, management, and administrative fees. The appropriateness of VUL largely depends on your individual needs, financial objectives, and your comfort with investment risk. Speak with a trusted financial advisor if you or a loved one are considering purchasing VUL coverage and want to see if it may fit your financial situation.

You can purchase a VUL policy through a licensed agent or by working with a qualified financial advisor who can guide you through the process. You may need to undergo medical underwriting as part of the application requirements. 

If you can not pay the premiums on your VUL policy, the insurer may temporarily use your policy’s cash value to cover the premiums. However, if the cash value is insufficient to cover the costs, your policy could lapse, leaving you without coverage. Remember that if outstanding loans are against the policy, a policy lapse may lead to tax implications.

If the investments perform well, the cash value of your policy increases. Depending on your policy’s terms, the increase could potentially lead to an increased death benefit. However, if the investments perform poorly, your cash value can decrease, which may require you to pay higher premiums to maintain the death benefit and keep the policy in force.

VUL insurance can serve as a component of a retirement savings strategy due to its potential for cash value growth and tax advantages. However, its suitability largely depends on your individual circumstances, financial goals, risk tolerance, and the performance of your chosen investments.

Given the complexity and potential risks of a VUL policy, consider discussing your circumstances with a financial advisor or insurance professional before deciding to use it as a retirement savings tool.

Plan for your family’s future. Get a life insurance quote today.

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Plan for your family’s future. Get a life insurance quote today.

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