Is Variable Universal Life Insurance Worth It?

Shopping for life insurance seems straightforward, but buying the right policy means knowing what each type of coverage offers. For example, variable universal life insurance provides a death benefit and includes an investment option, while another might offer the death benefit only. Here we'll look at what makes a VUL policy a unique life insurance product, and see how it differs from other types of permanent insurance.

What is variable universal life (VUL) insurance?

A variable universal life (VUL) policy is a type of permanent life insurance that includes policy cash value, variable investment options, flexible premiums, and a flexible death benefit that can be used in more than one way. A variable universal life policy offers lifelong coverage, as long as the premium is paid.

How does variable universal life (VUL) insurance work?

Variable universal life insurance is a bit of a unicorn. At first glance, it looks a lot like any other permanent life insurance policy, but there are unique features that set it apart.

Flexibility

Unlike with some types of coverage, a policyholder can adjust the amount of the premium instead of paying the same amount each year. Some years, the policyholder may want to pay more than their policy requires in order to build more equity. Other years, they may run into an emergency or unexpected expense and need to pay less. Policyholders can alter the amounts they pay as long as there is enough cash value in the account to cover policy expenses.

Accumulates cash value

A variable universal life insurance policy accumulates cash value that can grow over time -- depending on the performance of the investment options it is tied to. This cash value grows tax-deferred, meaning the policyholder does not owe taxes until they take withdrawals.

The policyholder decides where the cash goes

VUL insurance policies accumulate cash value. While some types of insurance are fully managed by a financial professional hired by the insurance company, the policyholder can determine where the money in a VUL should go, choosing investment options based on their preferred level of risk.

Lasts a lifetime

Unlike term life insurance, a variable universal policy provides coverage for the policyholder's entire life, as long as premium payments are current.

Value based on account performance

In a bull market, when the economy is strong and stock values are on the rise, a variable universal life insurance policy is likely to generate a strong return. On the other hand, when stock values are down in a bear market, the policyholder risks losing value.

Can borrow from accumulated cash

Once enough cash has accumulated, it is possible to borrow money via the policy. However, it can take years to build up enough cash value to borrow. Plus, borrowing from the cash value may leave too little in reserve to cover the premium if the policyholder runs into trouble and cannot make the monthly payments.

May include a surrender period

Variable universal life policies typically include what's called a "surrender period." While the length of the surrender period varies by carrier, it can be as long as 15 years. The policyholder is charged a surrender fee for canceling the policy before that time has passed.

One of the reasons to read a variable universal life policy carefully before signing is to learn the amount of any surrender fee. Let's say someone has $50,000 built up in their policy, and their surrender fee is 3%. If they surrender the policy early, the life insurance company keeps $1,500 of the $50,000 ($50,000 x 0.03 = $1,500).

Gains are taxed

Taxes are due on gains whenever the policyholder withdraws more than they've paid in premiums. Let's say someone has paid $40,000 in premiums and withdraws $50,000. They are responsible for paying taxes on the difference between what they've paid and the amount they withdraw -- in this case, $10,000.

Proceeds are taxed at the normal income tax rate. So if the policyholder's income puts them in the 24% tax bracket, they pay 24% of the proceeds in taxes. In this case, taxes would amount to $2,400 ($10,000 x 0.24 = $2,400).

Variable universal life pros and cons

When someone purchases a term life policy, they are interested in the death benefit protection. A variable universal life policy is more complex. The policyholder makes decisions regarding everything from investment objectives to income tax implications. Here are some of the good and not-so-good features of a VUL policy.

Pros

• Allows policyholders to manage investments
• Death benefit never decreases, as long as minimum premium payments are made on time
• Offers flexible premium payment options, depending on the financial circumstances of the policyholder
• May earn higher returns compared to other types of permanent life insurance

Cons

• Fees can be higher than with other types of permanent life insurance policies
• More complex than most types of life insurance, and requires detailed monitoring
• Poor performance by investment options can decrease the policy's cash value
• A policyholder who surrenders the policy early can get hit with a high surrender charge

Variable universal life compared to other types of permanent life insurance

This table compares variable universal life insurance to other policy types.

Alternatives to VUL

For someone looking to buy a life insurance policy that includes cash accumulation, here are three alternatives to a variable universal life insurance policy.

Universal life insurance

Universal is another type of permanent life insurance. It allows the policyholder to skip payments when needed, use the cash value to cover premiums, and pay premiums more often than required. In return, the policy accumulates cash value that grows at a variable rate.

The downside of a universal life insurance policy is that the premium can go up. And if the cash value falls into the red, the policy may lapse and coverage may end.

Indexed universal life insurance

An indexed universal life insurance policy builds cash value, and gains are locked in or captured. Cash grows tax-free.

Cons include the fact that indexed universal life premiums increase as the policyholder gets older. And when the policyholder dies, beneficiaries do not receive the total value of the account. While they do receive the face value of the death benefit, the insurance company holds onto any cash value that's built up. Let's say a policyholder has a $500,000 policy and has built $250,000 in cash value. All the insurance companies will distribute at the time of their death is $500,000.

Whole life

Whole life is the most common type of permanent life insurance in the U.S. Like other permanent policies, whole life allows the policyholder to build cash value. Premiums are fixed and never increase. And once enough cash has accumulated, the policyholder can take out a loan or withdraw funds.

On the flip side, whole life is more complex and more expensive than term coverage. And when you compare whole vs. term life insurance premiums, you find that it is always cheaper to purchase a term life policy than a permanent life insurance policy.

Should you get VUL?

The decision to buy a variable universal life policy should not be taken lightly. If you spend years paying premiums for a product that does not pay off the way you hoped, you're likely to be disappointed. Weigh the pros and cons and factor in fees. Don't just take an insurance agent's word for what's best.

Speak with a registered investment advisor. Here's why: Life insurance agents are not required to put your best interest first. Their primary obligation is to their company. You may be offered a product that is not in your best interest.

Your best bet is almost always to speak first with a financial advisor who is also a fiduciary. A fiduciary is legally and ethically required to put your best interest before their own (or their company's). If you're looking for an advisor who will put your needs first, check out the National Association of Financial Advisors' online search tool to find advisors in your area. Each advisor on the site promises to act as a fiduciary. If you're concerned, call an advisor from their list first and double-check that they are a fiduciary.

Buying a permanent life insurance policy can be tricky. A knowledgeable insurance agent can make a policy sound perfect for your situation. The truth is that there is no one-size-fits-all when it comes to any financial instrument. VUL insurance, like most permanent life insurance, is riddled with fees, and can lose value over time.

Consider your options and do the math. For example, a term life insurance policy is far less expensive than a permanent policy like a VUL. What would happen if an individual purchased a less expensive term life policy with the death benefit they require and invested the money they saved? If history is any indication, the chances are good that they'll end up with more retirement money.