SoCali4niaInsurance- Brian J Stidham

Universal Life Insurance

universal life insurance

Universal Life Insurance is a type of cash value life insurance, sold primarily in the United States. Under the terms of the policy, the excess of premium payments above the current cost of insurance is credited to the cash value of the policy, which is credited each month with interest. Interest credited to the account is determined by the insurer but has a contractual minimum rate (often 2%).

When an earnings rate is pegged to a financial index such as a stock, bond or other interest rate index, the policy is an “Indexed Universal Life” contract. Such policies offer the advantage of guaranteed level premiums throughout the insured’s lifetime at a substantially lower premium cost than an equivalent whole life policy at first.

uses of universal life insurance

  • Final Expense Insurance, such as a funeral, burial, and unpaid medical bills
  • Income replacement, to provide for surviving spouses and dependent children
  • Debt coverage, to pay off personal and business debts, such as a home mortgage or business operating loan
  • Estate liquidity, when an estate has an immediate need for cash to settle federal estate taxes, state inheritance taxes, or unpaid income taxes on income in respect of a decedent (IRD).
  • Estate replacement, when an insured has donated assets to a charity and wants to replace the value with cash death benefits.
  • Business succession & continuity, for example to fund a cross-purchase or stock redemption buy/sell agreement.
  • Key person insurance, to protect a company from the economic loss incurred when a key employee or manager dies.
  • Executive bonus, under IRC Sec. 162, where an employer pays the premium on a life insurance policy owned by a key person. The employer deducts the premium as an ordinary business expense, and the employee pays the income tax on the premium.
  • Controlled executive bonus, just like above, but with an additional contract between an employee and employer that effectively limits the employee’s access to cash values for a period of time (golden handcuffs).
  • Split dollar plans, where the death benefits, cash surrender values, and premium payments are split between an employer and employee, or between an individual and a non-natural person (trust).
  • Non-qualified deferred compensation, as an informal funding vehicle where a corporation owns the policy, pays the premiums, receives the benefits, and then uses them to pay, in whole or in part, a contractual promise to pay retirement benefits to a key person, or survivor benefits to the deceased key person’s beneficiaries.
  • An alternative to long-term care insurance, where new policies have accelerated benefits for Long Term Care.
  • Mortgage acceleration, where an over-funded UL policy is either surrendered or borrowed against to pay off a home mortgage.
  • Life insurance retirement plan, or Roth IRA alternative, people who prioritize having a source of tax-free funds in retirement over a current tax deduction may do well to evaluate Roth plans and life insurance as an alternative
  • Term life insurance alternative, for example when a policy owner wants to use interest income from a lump sum of cash to pay a term life insurance premium. An alternative is to use the lump sum to pay premiums into a UL policy on a single premium or limited premium basis, creating tax arbitrage when the costs of insurance are paid from untaxed excess interest credits, which may be crediting at a higher rate than other guaranteed, no risk asset classes.
  • Whole life insurance alternative, where there is a need for permanent death benefits, but little or no need for cash surrender values, then a current assumption UL or GUL may be an appropriate alternative, with potentially lower net premiums.
  • Annuity alternative, when a policy owner has a lump sum of cash that they intend to leave to the next generation, a single premium UL policy provides similar benefits during life, but has a stepped-up death benefit that is income tax-free.
  • Pension maximization, where permanent death benefits are needed so an employee can elect the highest retirement income option from a defined benefit pension.
  • Annuity maximization, where a large non-qualified annuity with a low-cost basis is no longer needed for retirement and the policy owner wants to maximize the value for the next generation. There is potential for arbitrage when the annuity is exchanged for a single premium immediate annuity (SPIA), and the proceeds of the SPIA are used to fund a permanent death benefit using Universal Life.
  • RMD maximization, where an IRA owner is facing required minimum distributions (RMD), but has no need for current income, and desires to leave the IRA for heirs. The IRA is used to purchase a qualified SPIA that maximizes the current income from the IRA, and this income is used to purchase a UL policy.
  • Creditor/predator protection. A person who earns a high income, or who has a high net worth, and who practices a profession that suffers a high risk from predation by litigation, may benefit from using UL as a warehouse for cash, because in some states the policies enjoy protection from the claims of creditors, including judgments from frivolous lawsuits.

living benefits of life insurance

Many people use life insurance, and in particular cash value life insurance, as a source of benefits to the owner of the policy (as opposed to the death benefit, which provides benefit to the beneficiary). These benefits include loans, withdrawals, collateral assignments, split dollar agreements, pension funding, and tax planning.


Most universal life policies come with an option to take a loan on certain values associated with the policy. These loans require interest payments to the insurance company. The insurer charges interest on the loan because they are no longer able to receive any investment benefit from the policy holder’s money.

Participating loans are generally associated with certain Index Universal Life policies. Since these policies will never incur a loss on the investment portion due to hedging, participating loans are secured by the policy’s Account Value, and allow whatever index strategy that was in place prior to creating the loan to remain in place and unaffected as to whatever index return is realized. Standard loans require conversion of any ongoing index allocations to be terminated, and an amount at least equal to the loan moved into the policy’s Fixed Account.

Repayment of the loan principal is not required, but payment of the loan interest is required. If the loan interest is not paid, it is deducted from the cash value of the policy. If there is not sufficient value in the policy to cover interest, the policy lapses.

Loans are not reported to any credit agency, and payment or non-payment against them doesn’t affect the policyholder’s 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 affects the long-term viability of the plan. The cash values removed by loan are no longer earning the interest expected, so the cash values don’t grow as expected. This shortens the life of the policy.

Usually, those loans cause a greater than expected premium payment as well as interest payments. Outstanding loans are deducted from the death benefit at the death of the insured.


If done within IRS Regulations, an Equity Indexed Universal Life policy can provide income that is tax-free. This is done through withdrawals that do not exceed the total premium payments made into the policy. Also, tax-free withdrawals can be made through internal policy loans offered by the insurance company, against any additional cash value within the policy (This income can exceed policy premiums and still be taken 100% tax-free.). If the policy is set up, funded and distributed properly, according to IRS regulations, an Equity Indexed UL policy can provide an investor with many years of tax-free income.

Most universal life policies come with an option to withdraw 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 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 (i.e., “modified endowment contract”). Withdrawals are considered a material change that causes the policy to be tested for MEC. As a result of a withdrawal, the policy may become a MEC and could lose its tax advantages.

Withdrawing values 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 don’t grow as expected. To some extent this issue is mitigated by the corresponding lower death benefit.

Collateral Assignments

Collateral assignments are often placed on life insurance to guarantee the loan upon the death of debtor. If a collateral assignment is placed on life insurance, the assignee receives any amount due to them before the beneficiary is paid. If there is more than one assignee, the assignees are paid based on date of the assignment, i.e., the earlier assignment date gets paid before the later assignment date.

premium payment types

Single Premium

A Single Premium UL is paid for by a single, substantial, initial payment. Some policies contractually forbid any more than the one premium, and some policies are casually defined as single-premium for that reason. 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 before 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, premiums and accumulation are taxed like an annuity on withdrawing. The accumulations grow tax deferred and still transfer tax free to the beneficiary under Internal Revenue Service Code 101a under certain circumstances.

Fixed Premium

Fixed Premium UL is paid for by periodic premium payments associated with a no lapse guarantee in the policy. Sometimes the guarantees are part of the base policy and sometimes the guarantee is an additional rider to the policy. Generally, these payments are for a shorter time than the policy is in force. For example, payments may be made for 10 years, with the intention that thereafter the policy is paid-up. But it can also be permanent fixed payment for the life of policy.

Since the base policy is inherently based on cash value, the fixed premium policy only works if it is tied to a guarantee. If the guarantee is lost, the policy reverts to it flexible premium status. And if the guarantee is lost, the planned premium may no longer be sufficient to keep the coverage active.

If the experience of the plan is not as good as predicted, the account value at the end of the premium period may not be adequate to continue the policy as originally written. In this case, the policyholder may have the choice to either:

  1. Leave the policy alone, and let it potentially expire early (if COI charges deplete the account), or
  2. Make additional or higher premium payments, to keep the death benefit level, or
  3. Lower the death benefit.

Many universal life contracts taken out in the high interest periods of the 1970s and 1980s faced this situation and lapsed when the premiums paid were not enough to cover the cost of insurance.

Flexible Premium

Flexible Premium UL allows the policyholder to vary their premiums within certain limits. Inherently UL policies are flexible premium, but each variation in payment has a long-term effect that must be considered. To remain active, the policy must have sufficient available cash value to pay for the cost of insurance.

Higher than expected payments could be required if the policyholder has skipped payments or has been paying less than originally planned. It is recommended that yearly illustrative projections be requested from the insurer so that future payments and outcomes can be planned.

In addition, Flexible Premium UL may offer a number of different death benefit options, which typically include at least the following:

  • a level death benefit (often called Option Aor Option 1Type 1, etc.), or
  • a level amount at risk (often called Option B, etc.); this is also referred to as an increasing death benefit.

Policyholders may also buy Flexible Premium UL with a large initial deposit, thereafter making payments irregularly.