All You Need to Know about Variable Universal Life Insurance

When considering a life insurance policy, you have a variety of options available. While all life insurance policies provide a death benefit, if you’re seeking one that offers flexible premiums and opportunities for cash value growth, a variable universal life insurance policy may be of interest. However, among different types of life insurance, variable universal policies can be more complex compared to straightforward term and whole life policies. Bankrate is committed to assisting you in navigating the insurance market. Our editorial team possesses extensive experience in the insurance industry and aims to simplify the insurance shopping process, enabling readers to make well-informed financial decisions. Below, we outline essential details about variable universal life insurance to help you understand its nuances.

Variable universal life (VUL) insurance is a form of permanent life insurance that combines a death benefit with a cash value component. Permanent life insurance encompasses several types, each with distinct features:

  • Whole life insurance: Offers fixed premiums and a guaranteed interest rate for gradual cash value growth. Some variants may earn dividends.
  • Universal life insurance (UL): Provides flexibility in premium payments and earns interest based on the insurer’s investments, with a minimum guaranteed rate.
  • Indexed universal life insurance (IUL): Offers flexibility like UL but ties cash value growth to market index funds.
  • Variable life insurance (VL): Features fixed premiums but allows policyholders to direct investments without guaranteed interest.
  • Variable universal life insurance (VUL): Allows adjustable premiums and investment choices managed by the insurer, without guarantees on interest rates or cash value.

VUL stands out for its flexibility, enabling policyholders to modify death benefits and premium payments once sufficient cash value accumulates. The cash value can potentially grow faster through investments in sub-accounts linked to various investment vehicles.

However, higher potential returns come with increased risk. Like stock market investments, the cash value in VUL policies can fluctuate, leading to gains or losses. This volatility makes VUL less suitable for short-term investors uncomfortable with frequent market changes. Additionally, VUL policies typically have high surrender charges that decrease over the initial 10-15 years, impacting liquidity.

Because VUL policies are classified as securities, they require a prospectus for sale. This document, mandated by the SEC, details costs, investment options, benefits, and policyholder rights comprehensively.

The investment subaccounts within a variable universal life insurance policy serve as the vehicles for investing your cash value. These subaccounts commonly include stock funds, bond funds, and money market funds. Additionally, some policies offer investments in fixed accounts with guaranteed minimum interest rates. Management fees for these subaccounts typically range from 0.05% to 2%, depending on the specific policy.

Think of subaccounts akin to mutual funds, but with a key distinction: they offer tax-deferred growth. Moreover, unlike traditional mutual funds, you may have the option to access your cash value sooner. With a variable universal life insurance policy, you can potentially borrow against or withdraw funds from your subaccounts as needed.

Variable universal life insurance policies aren’t suitable for everyone, but they can be advantageous if you possess investment knowledge and aim to maximize your cash accumulation. Before delving into their benefits, here’s a quick overview of the pros and cons associated with VUL policies.

Pros

  • Flexible premiums: Adjust payments to align with your financial situation.
  • Investment control: Direct where to invest your cash value.
  • Tax advantages: Enjoy tax-deferred growth and potentially tax-free death benefits.
  • Adjustable death benefit: Modify the benefit amount as circumstances change.
  • Potential for high returns: Aggressive market investments can lead to significant cash value growth.

Cons

  • Investment risk: Cash value may decrease based on market performance.
  • Complexity: Requires careful management and understanding.
  • Costs: Various fees can impact overall returns.
  • No guarantees: Typically no guaranteed interest rates or cash value growth, except with the fixed account option.
  • Cash value risk: Potential loss of cash value may reduce the death benefit or terminate the policy.

Variable universal life (VUL) policies typically provide the choice between level or increasing death benefits, similar to traditional universal life insurance policies. In a VUL policy, you’ll find two primary components: the death benefit and the cash value. Upon the insured’s death, the policy will either pay the cash value to the policyowner or provide a death benefit to the policy beneficiaries. When the death benefit is paid out, the cash value is not accessible. An exception to this occurs with increasing death benefit policies, where the initial death benefit includes the cash value.

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

  • Target Premium Payments: These function like fixed premiums where you pay a consistent amount at regular intervals. The aim is to keep the policy active until approximately age 95 or 100. However, these premiums are not guaranteed, and if your cash value diminishes significantly, you may need to increase premiums or reduce your death benefit.
  • Minimum Premium Payments: After the first year, you can choose to make minimum payments. The policy will utilize the cash value to cover expenses, but if the cash value depletes, the policy may be at risk of termination.
  • Prefunding: This strategy involves paying higher premiums early on to accelerate the growth of your cash value. It enables quicker accumulation of earnings, allowing you to potentially use the cash value later to cover policy costs or access it through loans or withdrawals.

Moreover, VUL policyholders have the flexibility to make additional premium payments at any time or adjust payments as needed, which can be advantageous as financial circumstances evolve over time.

Unlike other types of permanent life insurance policies where the cash value usually earns a conservative amount of interest, a variable universal life (VUL) policy offers policyholders more control over the growth of their cash value. In a VUL policy, you have the option to invest the cash value in subaccounts, potentially leading to greater growth opportunities.

However, this increased potential for higher returns also comes with higher risk. VUL policies provide limited guarantees, and the cash value can fluctuate depending on the performance of the chosen investments. This means there is a possibility of losing some or all of the cash value, which could consequently reduce the death benefit or lead to the termination of the policy.

Under a VUL policy, the death benefit received by your beneficiaries is typically exempt from federal income taxes. Moreover, the earnings from your cash value investments are generally tax-deferred, meaning you are only required to pay federal taxes under specific circumstances. Here’s a breakdown of what this entails:

  • Tax on gains: Federal taxes are applicable only on the amount withdrawn if the earnings exceed your total contributions (known as your “cost basis”).
  • Borrowing: You can borrow against the cash value of your policy without incurring taxes. However, if your policy lapses or terminates with an outstanding loan balance, taxes may be due on the unpaid amount. At death, any remaining loan balance will be deducted from the death benefit.
  • 7-pay test: This test, akin to IRS Section 7702 guidelines, ensures that your policy is primarily funded for protection rather than as an investment. Failing this test could result in the loss of tax benefits and reclassification as a Modified Endowment Contract (MEC), which carries different tax implications.

Here are the types of individuals who may find a variable universal life policy most advantageous:

  • Experienced investors: Understanding the complexities of the stock market and mutual funds, along with the risks associated with a VUL, can benefit seasoned investors looking for life insurance with investment potential.
  • High-net-worth individuals: Estate planning is critical for minimizing heirs’ tax obligations upon your passing. A VUL policy can potentially pass on a significant inheritance tax-free, depending on your state’s estate tax laws.
  • Individuals who have maximized retirement contributions: If you’ve already maxed out contributions to your 401(k) and IRA for the year, a VUL policy can serve as a vehicle to invest additional lump sums. However, due to higher fees and insurance costs, this option is typically considered after exhausting other retirement plan options.

For those who find the complexities of a VUL policy daunting, a universal life insurance policy may offer a similar balance of cash value growth and flexible premiums in a more straightforward manner.

When comparing life insurance quotes, it’s crucial to understand how premiums, death benefits, and cash values interact. Monitoring your cash value is particularly important with a variable policy to ensure it remains sustainable and does not risk termination.