Variable universal life insurance

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When buying life insurance, you may have more options than you think. All life insurance policies offer a death benefit, but if you’re looking for a life insurance policy that offers flexible premiums and the opportunity for cash value growth, you may be interested in variable whole life insurance. However, of the various types of life insurance, variable whole life insurance can be more difficult to understand than the more straightforward term and whole life insurance. Bankrate is here to help. Our editorial team has extensive experience in the insurance industry and is committed to demystifying the insurance buying process so our readers can make informed financial decisions. Below, we outline what you need to know about variable whole life insurance.

Variable whole life insurance

Variable Life Insurance (VUL) is a type of permanent life insurance that provides both a death benefit and a cash value. There are many different types of permanent life insurance, but some of the more common ones are:

Whole Life Insurance: The policies have fixed premiums, offer a moderate guaranteed interest rate, and have a steady, slow growth in cash value. Some whole life policies (called dividend whole life policies) can even earn dividends.
Universal Life Insurance (UL): With this insurance, your premiums are expected to be fixed, but you have flexibility in how much you pay. Interest is earned based on the insurance company’s investments, and there is a minimum guaranteed interest rate.
Indexed Universal Life (IUL): This universal policy offers the same flexibility as a traditional UL, but the cash value is linked to a market index fund, such as the Nasdaq Composite or S&P 500.
Variable Life Insurance (VL): This type has fixed premiums but no guaranteed interest income. Instead, the policyholder has control over investment options.
Variable Life Insurance (VUL): This insurance offers the flexibility of choosing either fixed or adjustable premiums. The policyholder chooses the investment and it is usually managed by the insurance company. However, there are no guarantees of interest rates or cash values.

VUL policies offer some of the most flexibility of all whole life insurance policies. Once you have accumulated enough cash value, you can adjust the death benefit amount, change your premium payments, and even grow the policy’s cash value by investing in subaccounts that mirror your investment accounts.

It is important to understand that the potential for higher returns also comes with increased risk. Like any stock market investment, the cash value of VUL policies will fluctuate and you may experience gains or losses. These policies are not suitable for short-term investments as the value of your portfolio may change daily. They may not be suitable for investors who dislike frequent fluctuations. VUL policies also have high surrender charges that decrease during the first 10-15 years of the policy, thus affecting liquidity.

Because VUL insurance is considered a security product, it cannot be sold without a special document called a prospectus, which the SEC requires to explain all the important details of the policy, including costs, investment options, benefits, and your rights as a policyholder.

What is a Variable Whole Life Insurance Subaccount?

The investment subaccount for your variable whole life policy is where you invest your cash value. For most variable whole life policies, these investments typically include stock funds, bond funds, and money market funds. They also offer fixed account investments with guaranteed minimum interest rates. Subaccounts usually have a management fee, which varies by policy, but you can expect it to be between 0.05 percent and 2 percent.

It’s helpful to think of subaccounts like mutual funds, with one important difference: Unlike mutual funds, subaccounts grow tax deferred. You also may not have to wait to access their cash value. If you have variable whole life insurance, you can borrow against the subaccount or withdraw funds from the subaccount.

Benefits of variable whole life insurance

Variable whole life insurance isn’t necessarily right for everyone, but it could be a good option if you have investment knowledge and want to get the most return on the cash you’ve accumulated. Before we dive into the benefits, let’s take a quick look at the pros and cons of variable whole life insurance.

Strong Points

Flexible premiums: Adjust your payments to suit your financial situation
Investment management: choosing where to invest your cash value
Tax Benefits: Tax-deferred growth and generally tax-free death benefit.
Adjustable death benefit: Change your benefit amount as needed
High return potential: Actively investing in the market can lead to further growth in your cash value.

Cons

Investment Risk: Cash value may decline depending on market trends
Complexity: Requires careful management and understanding
Costs: Various fees can affect your overall revenue
No Guarantee: There are no guaranteed interest rates or cash values. The exception is if you choose to put all of your cash value into a fixed account option.
Cash Value Risk: Cash values may be lost, the death benefit may be reduced, or the policy may terminate.

Death Benefit

VUL policies typically offer the option to provide a flat or increasing death benefit, similar to traditional universal life insurance. VUL policies have two components: death benefit and cash value. Essentially, the policy pays a cash value to the policyholder upon the death of the insured, or pays a death benefit to the beneficiary. There is no cash value when the death benefit is paid. The exception to this rule is with policies with increasing death benefits, where the cash value is added to the initial death benefit.

Flexible premium payments

Unlike most life insurance policies that have fixed monthly premiums, variable whole life insurance policies usually allow you to adjust your premium payments based on your financial situation and investment goals. Variable whole life insurance policies typically offer three payment options:

Target premium payment: These act like a fixed premium where you pay the same amount periodically, and this approach is intended to keep the policy in force until around age 95 or 100. However, this premium amount isn’t guaranteed, and you may have to pay higher premiums or a reduced death benefit if your cash value declines significantly.
Minimum premium payment: After the first year, you can choose to make minimum payments. The policy uses the cash value to cover expenses, but if the cash value is depleted, the policy may be cancelled.
Pre-Funding: This involves paying higher premiums early on and building up cash value more quickly, which will help accumulate earnings faster and allow you to use the cash value later to cover premiums or access the cash value through loans or withdrawals.

Additionally, VUL policyholders have the flexibility to pay additional premiums at any time or skip payments if necessary, which is especially beneficial as their financial circumstances change over time.

More control, more growth

Other permanent life insurance policies usually offer modest interest on your cash value. VUL policies give you more control over how your cash value grows, and if you choose to invest your cash value in subaccounts, it can lead to even greater growth.

However, the potential for high returns comes with high risks. VULs have limited guarantees and their cash value may fluctuate depending on investment performance. This means you could lose some or all of your cash value, which could result in a reduction in your death benefit or cause the policy to terminate.

Tax-deferred income

With a VUL policy, beneficiaries generally receive their death benefit free of federal income tax. In addition, earnings on the invested cash value generally grow tax-deferred and therefore only pay federal tax under certain conditions, including:

Tax on profits: You only pay federal tax on the amount you withdraw if the earnings you withdraw exceed what you paid for your premiums (your “cost basis”).
Borrowing: There is no tax on borrowing against the cash value of your policy. However, if your policy lapses or terminates with an outstanding amount, you may have to pay tax on the unpaid amount. If you have an outstanding loan at the time of your death, the balance will be deducted from your death benefit.
7-payment test: This test is similar to that set forth in IRS section 7702 and ensures that the policy is not funded too quickly and is being used primarily for protection rather than investment. If the policy does not pass this test, it may lose its tax benefits and be classified as a modified whole life contract (MEC), which is subject to different tax rules.

Who can benefit from variable whole life insurance?

There are three types of people who may benefit most from variable whole life insurance:

Experienced Investors: Variable universal life insurance is more complex than other life insurance products. Investors who understand how the stock market and mutual funds work, as well as the risks involved with variable universal life insurance, can benefit from this type of life insurance.
Wealthy: Estate planning is important to minimize taxes for your heirs when you pass away. Depending on your state’s estate tax laws at the time of your death, you may be able to pass on significant savings to your heirs tax-free through variable whole life insurance.
People who have reached the retirement cap: If you’ve already maxed out the annual limits on your 401(k) and IRA accounts, a lump sum cash deposit into a variable universal life insurance policy may be the best option for you. Given the high fees and premiums associated with variable universal life insurance, this option probably doesn’t make sense unless you’ve maxed out your other retirement plan options first.

The complexity of variable universal life insurance may feel overwhelming to some. If you’re looking for whole life insurance that offers similar cash value growth and premium flexibility as variable universal life insurance, but is a little easier to understand, universal life insurance may be worth considering.

When shopping for life insurance quotes, it’s important to understand how premiums, death benefits, and cash values work together. Especially with variable insurance, tracking your cash value is key to avoiding the risk of your policy being surrendered.