Buying life insurance is not the most uplifting part of your financial planning, and trying to figure out insurance jargon makes the process even less fun. Especially with younger insurance buyers, universal life can provide a combination of permanent life insurance protection and a significant degree of flexibility. Understanding how universal life works will let you use the policies you buy to meet your financial goals.
Cash Value Minus Insurance Costs
Visualize your universal life policy as a bucket. The insurance premiums you pay go into the bucket. Then each month the insurance company takes administrative fees and the cost of the life insurance from the bucket. Interest earned on the cash balance is credited to the bucket. The specific insurance policy details the amounts for the admin fees and insurance costs. The amount of interest your bucket of cash earns depends on the rate declared by the insurance company and how much money is currently in the bucket.
Cash Value Growth
The premium amount you pay for a universal life policy should be enough to cover the admin and insurance costs and leave money left over to grow the cash value. Over the years and as you grow older, the insurance charges will increase and with a growing cash value, earning a larger amount of interest each year will offset and hopefully exceed the increasing insurance costs. The cash value of a life insurance account grows tax-deferred, so you do not need to report the interest earnings on your tax return.
You have two choices concerning the life insurance amount and the cash value of the account. With what the insurance companies typically call option A, the amount of insurance coverage stays level. As the cash value builds up, the amount of life insurance you pay for decreases. With option B, the amount of the cash value is added to the initial amount of life insurance, providing an increasing amount of insurance as the cash balance grows. The trade-off with option B is higher insurance costs as you age and the level of pure insurance coverage stays the same.
With a universal life policy, you can pick the starting premium and later increase or decrease the amount you pay. The minimum premium amount should be enough to cover the admin and insurance charges, almost like buying term life insurance. If you go with a large premium amount, the cash value will build quickly with the policy eventually reaching the point where the interest earnings can cover the policy charges. Once you have built up some cash value, it is possible to skip a payment or two and not worry about losing your coverage.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.