A universal Life insurance policies offer more flexibility than a Whole Life insurance policy. Policyholders have the flexibility to adjust their premiums and death benefits. Universal Life insurance premiums consist of two components, cost of insurance (COI) amount, and a saving component, known as the cash value. The cost of insurance is the minimum premium payment required to keep the policy active.
The collected premiums in excess of the cost of insurance accumulate in a cash account. This cash value can earn interest based on current market interest rates. The policyholder may access the cash value and make withdraws from the plan however this would be taxed on a last- in- first- out (LIFO) or first- in- first -out (FIFO) basis depending on when earnings will be available.
The policyholder may also take loans against the cash value and be charged interest on the loans which would reduce the face amount or death benefit.
A indexed universal life (IUL) insurance policy can link your cash value to an index like the S&P 500 without the risk. Your account will participate in a percentage of the index gains yet when the index falls you will not lose any value. Tax-free income can be obtained from the IUL by taking tax-free loans against the cash value similar to other cash value policies mentioned here. These loans work similarly to home equity loans in the sense that the investor does not pay income tax on the money borrowed. Unlike a home equity loan, though, the investor does not have to pay back the loan balance during their lifetime. This is pertinent to tax codes 7702 and 72(e).
You can actually dump a large sum into an IUL but in doing so you would be creating a modified endowment or a MEC and that would adversely affect your tax-free distributions. So the way to do it as an example using 250k for a 50-year-old male would be to spread it over seven annual payments of $37,870.58 (factoring in 2% interest in the deposit fund) each thus avoiding creating a MEC. In this case, the initial death benefit would be $707,198.00.
There are some companies that allow you to deposit your lump some premium into a deposit account earning 2% interest on your premium while waiting to be applied to the policy. One A+ rated insurance company has a 135% participation rate in an index with NO CAP on the upside.
Using the example above of a 50-year-old male with an average annual rate of return on the index of 7.02% (the actual index averaged 7.56%) since current laws don't allow us to use anything higher for an illustration would create tax-free distributions starting at age 66 of $49,023.00 a year. The death benefit peaked at age 65 to $1,040,782.
By age 80 using the same example he would have taken a total of $735,345.00 in tax-free distributions and still have a death benefit of $364,636.00. Keep in mind that only $250,000.00 was put into this policy originally.
Whole life insurance provides coverage for the life of the insured. In addition to providing a death benefit it also provides a savings component where a cash value may accumulate. This type of policy is also called permanent or traditional life insurance. The cash value of this policy accumulates and grows tax- deferred based on a fixed interest rate. To build the cash value the policy holder is allowed to make premium payments higher than the scheduled payments or over fund the policy.
Variable universal life (VUL) is a type of permanent life insurance because a death benefit will be paid as long as there is sufficient cash value to pay the cost of the insurance. The cash value can be invested in separately managed equity sub accounts similar to a variable annuity which also has sub accounts with no caps on the upside though can lose value therefore has risk associated with it.