Universal fixed life policies are probably the most misunderstood policies in life insurance, maybe in all of insurance period.
The problem is two-fold.
First, they are a kind of hybrid product and secondly, a lot of times they’re not explained very well during the presentation process which leaves people confused about how they really work.
Just like any insurance product, if you understand what you’re getting and they fit your needs, they can be a great option with lots of upside.
There are two different types of universal life policies, fixed and variable. In this discussion, we’ll talk about fixed and leave the variable for another time.
The Two Parts of a Fixed Universal Life Policy
In generalized terms, a fixed universal life policy has two parts.
The first part is a yearly 1-year-term policy. Each year, the term policy is renewed automatically and the premium is slightly higher because every year you get a little older.
The death benefit is fixed at on whatever number you decide when you put the policy inforce.
And as long as you continue to pay the premium, when you pass away your beneficiary(ies) will receive the death benefit in full.
The second part is a general account that extra money goes into and earns a fixed interest rate.
Rates can vary depending on insurance companies, but in today’s economic climate, the fixed rates are better than you would get for CDs, savings accounts or money markets.
A few years ago, you could get fixed rates as high as 4.5%. Today 2-3% is much more common.
Now, this general account is not a savings account, but just like a savings account, you can use the power of compounding interest to your advantage to build additional cash value.
When you pass away, your beneficiary(ies) will get not only the death benefit, but also the built up cash value plus interest earned, and they will get it all tax free.
The Main Advantage
Hopefully, the main advantage of a fixed universal life policy is fairly obvious.
It allows you to build up a cash value over and above your death benefit.
This means a greater amount of money for your beneficiary(ies), but the cash value also has other advantages for you as well.
Namely, you can access the cash as repayment of premiums you’ve paid in or even as loans to yourself.
The premium repayment doesn’t have any ill effects except you’re limited to the amount of premium you’ve paid in over the years and your cash value in the general account will drop in proportion to what you withdraw.
After that point, you can still access the cash value in the form of loans.
If you chose to take out loans there is interest you’ll have to repay on the money you’ve borrowed.
But as long as you’ve built up enough cash value in the policy and you keep up on the interest, it can become a great alternative source of funds should you need them down the road.
Now, here’s what you need to watch out for with all universal life policies.
First, when you get a quote on a universal life policy ask for the maximum amount you can put in your policy BEFORE it becomes a Modified Endowment Contract.
In layman’s terms, this is the maximum amount of money you can put in your universal life policy and still take advantage of the tax benefits that life insurance gives you.
If you go over this amount, Uncle Sam gets involved, basically because people cheated the system using life insurance to try to avoid taxes, and the government responded with limits.
So make sure you’re not overfunding them.
On the other side of the spectrum, make sure you look at the illustrations!
If you’re only putting $50 or $75 a month on a universal life policy, you need to know when it is going to run out, because it will run out and probably before you do.
This is the main complaint I hear about universal life policies. People buy them and don’t fund them properly.
Remember at the beginning when I said the first part of the universal life policy was a 1-year-term policy?
Well, every year that policy gets a little more expensive.
Once the cost of the 1-year-term policy exceeds your yearly premium payments the insurance company will start to use the cash value to keep the policy in force.
So if you don’t fund them properly in the beginning, more and more of your cash value will go to pay for the term policy until there’s nothing left.
If you pay attention to the illustration, you’ll be aware of when this is going to happen. Or better yet, fund them properly and the compounding interest you’ll earn will make sure the policy doesn’t quit on you right when you need it!
Finally, when you’re getting a quote, pay attention to the fees and the penalty period.
Every universal life policy I know of has a penalty period and yearly fees attached.
If it’s just a fixed universal life the fees shouldn’t be huge, but you need to know what you’re paying for.
These policies also have a set number of years, known as the surrender penalty period when you can’t withdraw or cancel the policy, or you’ll lose not only the policy but also the cash value.