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, and 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.
Similar life insurance types
A similar type of policy that was developed from universal life policies is the variable universal life insurance policy, 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 stock or bond investments with greater risk and potential reward. Additionally, there is the recent addition of Equity Indexed Universal Life contracts analogous to Equity Indexed Annuities 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 for the guarantee period 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 provisions within a Universal Life contract including zero interest or wash loans which in limited cases can provide the policyholder the ability to access the growth inside the contract without paying income tax. However if the policy lapses while the growth has been withdrawn, there may be substantial income tax owed.
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 (COI) 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. As long as the policy has not become a MEC (Modified Endowment Contract) it will not have a tax deferred status. Any gain in the policy will remain non-taxable unless withdrawn. Also the death benefit of life insurance policies generally does not face income tax as long as the policy was not received as a result of payment by you to the previous owner of the policy.
Living Benefits of Life Insurance
Many people use Life Insurance, and in particular cash value Life Insurance as a source of benefit to the owner of the policy. (as opposed to the death benefit which is provides benefit to the beneficiary.) These benefits include loans, withdrawals, collateral assignments, split dollar agreements, pension funding, and tax planning.
Loans
Most Universal Life Policies come with an option to take a loan on certain values associated with the policy. These loans require interest payments, which are paid to the Insurance Company. The Insurer charges interest on the loan because they are no longer able to receive any investment benefit from the money that has been loaned to you.
Repayment of the loan principal is not required, but payment of the loan interest is required. If the loan interest is not paid, it will be deducted from the cash values of the policy. If there is not sufficient value in the policy to cover interest, the policy will lapse.
Loans are not reported to any credit agency and payment or non payment against them will not affect the policyholders credit rating. If the policy has not become a Modified Endowment, the loans are withdrawn from the policy values as premium first and then any gain. Taking Loans on UL will affect the long term viability of the plan. The cash values removed by loan are no longer earning the interest expected, so the cash values will not grow as expected. This will shorten the life of the policy. Usually those loans will cause a greater than expected premium payment as well as interest payments.
Outstanding loans will be deducted from the death benefit at the death of the insured.
An illustration showing the effect of a loan is recommended in order to assess the outcome of this change.
Withdrawals
Most Universal Life Policies come with an option to withdrawal cash values rather than take a loan. The withdrawals are subject to contingent deferred sales charges and may also have additional fees defined by the contract. Withdrawals will permanently lower the death benefit of the contract at the time of the withdrawal.
Withdrawals are taken out premiums first and then gains, so it is possible to take a tax free withdrawal from the values of the policy. (this assumes the policy is not a MEC) Withdrawals are considered a material change and cause the policy to be tested for MEC. As a result of a withdrawal, the policy may become a MEC and cause lose its tax advantages.
Withdrawing values will effect the long term viability of the plan. The cash values removed by loan are no longer earning the interest expected, so the cash values will not grow as expected. To some extent this issue is mitigated by the corresponding lower death benefit. An illustration showing the effect of a withdrawal is recommended in order to assess the outcome of this change.
Collateral Assignments
Collateral Assignments will often be placed on life insurance to guarantee the loan upon the death of debtor. If a collateral assignment is placed on life insurance the assignee will receive any amount due to them before the beneficiary is paid. If there is more than one assignee, the assignee are paid in the based on date of the assignment. ie - The earlier assignment date gets paid before the later assignment date.
Types
Single Premium
A Single Premium UL is paid for by a single, substantial, initial payment. Some policies do not allow anymore than the one premium contractually, and some policies are casually defined as single premium because only one premium was intended to be paid. The policy remains in force so long as the COI charges have not depleted the account. These policies were very popular prior to 1988, as life insurance is generally a tax deferred plan, and so interest earned in the policy was not taxable as long as it remained in the policy. Further withdrawals from the policy were taken out principal first, rather than gain first and so tax free withdrawals of at least some portion of the value were an option. In 1988 changes were made in the tax code, and single premium policies purchased after were "Modified Endowment Contract (MEC)" and subject to less advantageous tax treatment. Policies purchased previous to the change in code are not subject to the new tax law unless they have a "material change" in the policy. (usually this is a change in death benefit or risk) It is important to note that a MEC is determined by total premiums paid in a 7 year period, and not by single payment. The IRS defines the method of testing whether a life insurance policy is a MEC. At any point in the life of a policy, a premium or a material change to the policy could cause it to lose its tax advantage and become a MEC.
In a MEC, the premiums an
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