Investors often underestimate the effect of taxation on their retirement planning. It's rather like striding up a "down" escalator: you can do it, and you can make good headway if you're determined, but the escalator is always working against you. That's why tax-sheltered investments, such as a 401k or IRA, are so important in retirement planning. However, IRAs and Roth IRAs have contribution limits, and some couples simply earn too much to contribute to a Roth IRA. Insurance products such as universal life are often suggested as an alternative investment.
Insurance and Tax-Sheltering
Insurance companies invest your premiums in a safe, conservative portfolio. The gains from the investments help fund the policies, and permanent policies such as whole life or universal life share in the profits. These profits build cash value, or equity, in the insurance policy and eventually become part of the death benefit. They're allowed to grow tax-free within the policy for a couple of reasons. For one thing, the premiums are paid for with after-tax dollars. For another, politicians are understandably reluctant to impose a "widows and orphans tax" on insurance money. This reluctance has inspired some creative planning by the insurance companies.
A traditional whole life policy works much like a mortgage. During the early years, you're primarily paying off the costs, and building relatively little equity. That reverses in later years, with most of every payment going to build equity. Universal life policies are more flexible. They allow you to "overfund" the policy, paying the insurance costs and storing away the rest as investment capital. This creates a larger investment in the policy's early days, creating better long-term growth. However, those returns are still driven by the insurance company's internal portfolio, which is required by law to be conservative.
To combine the flexibility of a universal life policy with the returns of market investments, the industry created a variation on the universal life concept. Depending on the company, it's called Universal Variable Life, Variable Universal Life or simply Variable Life. It's fundamentally the same as a universal life policy, except it puts your premiums into a portfolio of mutual funds or other market investments. Your policy benefits from the higher potential returns of a conventional portfolio, generating larger cash values. If the markets go down your holdings will decrease in value, but your beneficiaries will receive a guaranteed minimum if you should die.
The Virtues of UVL
At first blush, UVL looks like a good choice for those who can't contribute to a Roth IRA. Your money will grow tax-free inside the policy, there's no income cap for opening one, and there aren't any upper limits on the amount you can contribute. Furthermore, you can name one or more beneficiaries to receive the contents of your policy in the event of your death. The funds are paid directly to your beneficiaries within days, avoiding the expense — and public scrutiny — of probate. However, despite all its virtues, UVL has a significant downside.
The Downside of UVL
Although it provides opportunity for lots of capital to grow tax-free, UVL isn't necessarily a good choice. This is because of its expenses, which can siphon off much of your profit. First, there are the commissions paid to your broker. The insurance component of the plan has its own costs, and the investment pays management fees to the insurance company as well as the funds it's invested in. When you begin to draw income in retirement, Roth IRAs pay out tax-free. Income drawn from UVL policies is taxable, making the investment less valuable.
When UVL Works
In general, most couples can generate higher returns by investing through more conventional avenues and taking care of any insurance needs separately. However, in some circumstances a UVL policy might make sense. Ordinarily the high costs of the plan outweigh its tax advantages, but there are exceptions. Some companies offer UVL policies with lower-than-average costs, which make them more competitive. If your tax situation is unusually complicated, or if you're working with very large sums, a low-cost UVL policy can be useful. The insurance options can also be useful for estate planning and avoiding probate.
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