Congratulations! You’ve finally gotten around to thinking about life insurance. We know it isn’t an easy subject to get excited about, so we’ll make it simple for you.
You’re here because you heard about universal life insurance. Maybe someone told you it’s a great way to make money because half of what you pay each month goes into a built-in savings account. And maybe you thought, That sounds like a win-win. I’m getting some!
Hang on a second! You should have the facts before you start calling up insurance companies. We want to show you why it’s never a smart move to invest money inside your life insurance. Are you ready? Let’s dive in.
What Is Universal Life Insurance?
Universal life insurance is a type of life insurance that lasts your entire life—into your 90s and beyond. It’s sometimes known as cash value life insurance. That’s because it has a savings account inside the policy.
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You pay into this savings account whenever your insurance premium is due (the premium is the monthly cost that keeps the insurance going). If you’ve built up cash value, you’re free to take some out—like you would with a regular bank account. But it’s not as easy as you might think. We’ll explain why later.
How Does Universal Life Insurance Work?
With universal life insurance, you pay a monthly fee that splits into two parts: One covers life insurance and the other goes into savings and investment.
It’s meant to be more flexible by allowing you, the policy holder, to choose how much premium you pay within a certain range. The minimum amount is set by the cost of insurance, which includes your death benefit and administrative fees.
Anything you pay over this premium is added to your cash value, which is guaranteed to grow according to a minimum annual interest rate set by the insurance company (though it can grow faster depending on how well the market is doing).
Many people choose to pay the maximum premium possible, which is set by the IRS, in the early years so they can build a larger cash value (and then use that cash to cover premiums later in life). But this is a risky move since the cost of insurance will increase the older you get! Question is, will you have enough cash value to cover it?
Types of Universal Life Insurance
Universal life insurance can get pretty complicated when you start to unpack it. In fact, there are actually three types to choose from. That’s three types of life insurance you definitely don’t need.
Indexed Universal Life
You’ve heard of the stock market, right? Have you heard of indexes like the S&P 500? The Dow Jones Industrial Average? Nasdaq? They measure how well the market is doing. For anyone with an indexed universal life insurance plan, the cash value is linked to one of these indexes. So if the market is doing well, the cash value will go up. But there is a catch—the rate will always be a little lower than the performance of the index because the insurance company will take their hefty share. And if the market is not doing well—you guessed it—the value will drop. This will impact your premiums for better or for worse.
Guaranteed Universal Life
If you don’t like the idea of having your premiums tied to market performance, the insurance agent may try to sell you guaranteed universal life insurance instead. With these policies, your premiums stay the same regardless of how well the index performs because the interest rates are set from the very beginning of the policy.
And it has a “no-lapse” guarantee (hence the name), so as long as you send in your premium check, you’ll have coverage for the rest of your life. This is the least risky universal life policy.
But here’s the catch. Since your premiums don’t adjust based on market performance, there’s hardly any cash value in it. That’s because this policy isn’t really designed to build cash. It’s too busy trying to keep up with the cost of insurance.
Variable Universal Life
This life insurance policy lets you invest the cash value part into a mutual fund. A mutual fund is a pool of money managed by a team of investment pros. Your cash value makes up part of that pool, and it’s invested into lots of different companies at once.
Don’t get us wrong. Mutual funds are a fantastic way to invest because they diversify your risk (that’s just fancy Wall Street talk for making sure you aren’t putting all your investment eggs in one basket). But remember, life insurance is meant to support your loved ones once you pass, not for investing. And all that investing ain’t cheap—insurance companies charge huge fees that’ll take a major bite out of your earnings.
As we’ll show you, it doesn’t matter which of these you choose. All three policies come with killer fees. And if you want the best bang for your buck, you won’t invest in cash value. Stick with investments outside of life insurance.
Understanding Universal Life Insurance and Cash Value
Universal life, along with variable and whole life, are the three amigos in the world of cash value life insurance. They do the job of covering your income if you die, but they also act as a savings account. Cash value is the cash build-up in that savings account. The insurance companies set their rates of return for cash value just like a bank would.
Whole life returns usually just keep up with—and sometimes fall below—inflation. Universal and variable rates are harder to nail down, but they can be considerably higher than whole life. But, as we’ve said over and over again, the fees tacked to a universal life policy will eat you alive.
That’s why you should always invest in a good growth mutual fund that is completely separate from your insurance policy. You could earn, on average, a 10–12% return without those heavy fees.
Plus, when you break down how much of your cash value premium goes toward making you cash, you’ll probably die a little inside, especially if you compare it to term life insurance (which we’ll look at later). Do the math and you’ll see, just like orange juice on cereal, you should keep your investments out of your life insurance!
What Happens to the Cash Value if I Don’t Use It?
There are a lot of bad things about universal life insurance, but the worst is what happens to that cash value when you die. The only payment your family will get is the death benefit amount. Any cash value you’ve built up will go back to the insurance company.
Just let that sink in a minute.
Plus, if you ever withdraw some of the cash value, that same amount will be subtracted from your death benefit amount. That’s a lose-lose situation. You can faithfully invest for decades, but one way or another that money will go back to the insurance company.
Truth is, that’s how they make their money—and it’s why they’re so quick to sell it to you in the first place. Don’t let them fool you!
How Much Are the Fees?
The fees you’ll pay for cash value life insurance are astronomical. There are fees to have the insurance in the first place, fees to cover commissions and fees to cover expenses for the insurance company. And the thing is, because of those crazy-high fees, you will build zero cash value in the first three years. There’s a reason insurance companies try to sell you universal life insurance. It’s because they make more money if they do.
Advantages and Disadvantages of Universal Life Insurance
As much as we’re opposed to you buying into universal life insurance, it would be wrong to say that there are zero benefits. So for the sake of being completely fair, we’ll give you the incredibly short list of advantages, then follow it up with all of the outsized drawbacks.
Here are the pros:
- It is a form of life insurance, so it does mean your family or other beneficiaries will get a payout in the event of your death.
- It’s designed to provide coverage for your entire life. Basically, universal is a bit better than running around with zero coverage of any kind, but not much better.
And the cons:
- Some of your premium goes toward a cash value account, making universal far more expensive than a nice, cheap term life policy. (Hint: we recommend term life all day long.)
- The cash value won’t get you much return on investment, and, again, falls way short of what you can expect if you put your money into tax-advantaged retirement accounts.
- The administrative fees are out of control.
- If your policy is indexed, your premium is going to vary a lot as markets fluctuate. That can do a number on your budget.
- And here’s a reminder of the worst con of all: If you should happen to die before you’ve spent the cash value portion of a universal life policy, all of that money goes into the insurance company’s bottom line. Repeat: Your beneficiaries won’t see a dime of it, just their defined payout.
Whole Life vs. Universal Life Insurance
Chances are, if you’re here reading about universal life insurance, you’ve probably heard of whole life insurance too. Both are designed to be long term. Both build cash value. And both are terrible ideas! But here’s how they’re different.
Universal life comes with what insurance geeks call flexible premiums. This means you have some say in how much you put into the cash value side of your policy and how much you’ll pay in premiums, but there are still rules for this set by your insurance provider. Whole life premiums are fixed, so they can’t change even if you wanted them to.
Remember earlier when we said that if you wanted to withdraw some of the cash value from universal life insurance, it would be taken out of the death benefit? Well, whole life insurance comes with a penalty too. If you take out a loan against your cash value, you’ll pay ridiculous interest rates on that loan.
And if you choose to surrender your whole life policy, you’ll be smacked with a painful surrender charge. And if you do that, you will no longer have coverage. Isn’t that the reason you took out life insurance in the first place?
Universal vs. Term Life Insurance
Unlike universal, term life insurance only lasts for a set number of years. We recommend a term of 15 to 20 years. And it’s just life insurance—nothing more, nothing less. Without that cash-value dead weight, the premiums are much, much cheaper.
So if you were to take the money you’d save going with term life ($36 a month) and invest it in a mutual fund over 20 years, you’d end up with $27,217! And all of that would go into your pocket—not the insurance company.
Plus, you won’t need universal’s lifetime coverage if you start investing for retirement now. You’ll be self-insured. What do we mean by self-insured? If you invest 15% of your household income for the next 20 years, by the time your term life plan comes to an end, you won’t even need that death benefit.
Term and universal do have one thing in common: If you die during the policy, the insurance company will pay the death benefit. But it’s where they’re different that really counts. You’ll need deep pockets if you choose universal life insurance.
How to Choose the Right Life Insurance Policy
Remember what Dave says about life insurance: “Its only job is to replace your income when you die.” If you get a term life insurance policy 15–20 years in length and make sure the coverage is 10–12 times your income, you’ll be set. To get an idea of how much coverage you need, check out our term life calculator.
Life insurance isn’t supposed to be permanent. So don’t overcomplicate it with a permanent policy like universal. The cash portion built into those products would serve you far better in your budget or saved for the future. By investing outside of your insurance, you can control how and where you use your money.
If you’re in the market for new life insurance or want an expert to talk to, we recommend RamseyTrusted provider Zander Insurance. They shop rates for you, allowing you to choose the quote that works best for you and then get the policy finalized. You’ll breathe a sigh of relief knowing your family’s protected if something happens.