Coverage: Universal life insurance or whole life?

Universal life insurance and whole life insurance are both appealing options for individuals interested in using permanent life insurance as a way to grow wealth they can use while they’re living, while still providing their loved ones with financial security after they’re gone. But which one is right for your financial goals? In this article, we’ll break down the differences between standard universal life insurance and whole life insurance, plus explain the differences between each additional type of universal life insurance: guaranteed, variable, and indexed.

Cost

The cost of universal life insurance and whole life insurance is determined by the same factors, the most common being age, gender, and health status. Lifestyle also plays a big role, including tobacco and alcohol use, hobbies and recreational activities, job hazards, and travel. 

Despite similar underwriting considerations, universal life insurance generally costs less than whole life insurance, but with the reduced cost comes increased risk. Whole life insurance offers guarantees not found in universal life policies; while you may pay more, you’re guaranteed more benefits: your premiums are guaranteed not to change, your death benefit is guaranteed—provided your premiums are paid, and you earn a guaranteed rate of return from your insurance company.

With both types of policies, a portion of the cost goes to cover your death benefit (the face value of the policy) and administrative costs, which are typically front-loaded in the first few years of your policy. The rest of the cost goes toward your cash value. 

Cash Value

Both universal life insurance and whole life insurance have cash value components that function like a built-in savings account, which earns interest over time. 

With universal policies, the amount of interest you earn depends on the market or minimum interest rate (whichever is greater) and varies between different types of universal life insurance. Universal life insurance may earn larger gains in years the market performs well, but it’s less predictable and rising policy premiums can cancel out or exceed gains in some years. Often, in years an insurer experiences subpar returns in the market, they increase policy premiums to make up the difference. For policyholders, this can mean diminished returns AND higher premiums.

Whole life insurance policies earn a guaranteed rate of return, regardless of market influence, and may also earn dividends when structured through mutual insurance companies. The cash value of a whole life policy doesn’t decrease in the event of a market downturn and premiums remain level for the lifetime of the insured. The cash value of whole life insurance is more dependable, offering returns you can count on, which is helpful for individuals who rely on their cash value as a source of business capital or to fund retirement. 

Policy Premium Payment

Most universal life insurance policies have flexible premiums. There is a minimum and maximum premium each pay period and the policyholder can choose how much they wish to pay, provided it falls within this range. This makes universal life an appealing option for individuals whose incomes fluctuate. Most whole life insurance policies have fixed premiums.

Universal life insurance premiums typically increase as you get older and your insurance company may choose to increase premiums whenever they wish, whereas whole life insurance premiums remain the same for the duration of your life. Ideally, you will have enough cash value accumulated in your universal policy to cover your increasing premiums—but if you can’t pay or your cash value is zero, your insurance will lapse. This means your policy could eventually lose all value, leaving you without living benefits and your family without a death benefit.

Whole life insurance premiums remain level, and the earlier you get insured, the more favorable your premiums will be. You can lock in a low premium with a good rating from your insurer and keep that low premium for life. Like universal life, your accumulated cash value can be used to cover your premiums. If your cash value equals zero, you’re still insured as long as you pay your premiums. If you can’t pay your premiums, your policy will lapse and you and your family will lose all insurance benefits. 

In spite of its fixed cost, whole life insurance still offers some flexibility in when and how you can pay your premiums, including changing your payment schedule, using dividends (if your policy is underwritten by a mutually owned, dividend-paying insurance company), reducing payment on some riders—like a Paid-Up Additions rider, and reducing coverage as a last resort.

Policy Loans

Universal and whole life insurance policies both allow individuals to take out tax-free policy loans up to the amount of cash value in the policy. Any outstanding loans, plus interest, will be deducted from the policy’s death benefit, thereby reducing the amount of the death benefit for beneficiaries. 

You don’t need pre-approval or a certain credit score to utilize the policy loan feature of your insurance. Funds are typically available within just a few days and are deposited into a bank account associated with your insurance policy. And you determine the payback schedule for your loan.

You can utilize a policy loan for anything you’d like, including to help pay policy premiums, covering tuition costs for your children, purchasing real estate, capitalizing on investment opportunities, operating a business, and funding retirement. The cash value of your insurance policy can also function as an emergency savings account. 

Regardless of the amount of your policy loan(s), you still earn interest or market gains on the full cash value of your policy. In essence, each dollar of cash value can serve two functions at once: it can be borrowed and earn at the same time.

Withdrawals

The cash value inside your insurance policy is yours to use as you choose, and that includes withdrawing it. Both universal life insurance and whole life insurance policies allow you to withdraw your cash value, but there are few things to consider before you opt to use your cash value this way.

First, any amount over your basis (the amount you’ve paid in policy premiums) is considered taxable income.

Second, withdrawing cash value may reduce the face value of your policy—the death benefit—leaving loved ones with less after you’re gone.

Sometimes you need your cash value and have no intent of paying it back like you would with a policy loan; this is when you would consider a withdrawal. It enables you to access your cash value without obligation while still keeping some level of insurance intact, rather than surrendering your policy. 

Surrender Value

In the instance a policyholder decides they no longer want insurance coverage, they can sell the policy back to the insurance company and receive the surrender value of the policy—the cash value minus any applicable surrender fees, which vary by insurer. This is true of both universal and whole life policies. 

Keep in mind that if you’ve been using your cash value to pay your universal policy premiums, the surrender value of your policy may be very small.

Universal life insurance policyholders experiencing diminishing returns who wish to salvage as much of their tax-advantaged cash value and earned interest as possible also have the option of converting their universal policy to a whole life policy via a 1035 exchange

A 1035 exchange is a tax provision that allows an individual to transfer cash value in a universal life insurance policy into a whole life policy without paying taxes on gains. Depending upon the amount of cash value available, it can be put toward the initial premium payment for a whole life insurance policy or it can purchase additional insurance—a Paid-Up Additions rider—which will help the new whole life policy accumulate more cash value faster and earn more compounding interest over the life of the policy.

Policy Riders

Policy riders are types of supplemental insurance that customize both universal life and whole life insurance policies. The types of riders available for each kind of insurance vary. Adding riders to your policy increases the benefits available to you, but may also increase costs. Some riders are free, some only charge if you use the rider, and others have annual premiums. 

The most common riders purchased with a universal life insurance policy include variations of disability, chronic illness, terminal illness, and waiver of premium riders. The riders serve to protect the policyholder in the event they cannot pay premiums due to disability and allow the policyholder to access a portion of their death benefit while they are still alive, should they become terminally or chronically ill or disabled.

These same riders are also available with whole life insurance policies, but whole life also allows the policyholder to purchase a Paid-Up Additions rider. As previously mentioned, Paid-Up Additions helps a whole life policy accumulate cash value faster and earn more compounding interest over the life of the policy. It allows the policyholder to front-load their policy, contributing as much as possible within specified IRS limits to optimize tax benefits while growing and protecting wealth.

Maturity Date

Permanent insurance is meant to last your whole lifetime, unlike term life insurance, which only insures the policyholder for a specified term. But that doesn’t mean permanent insurance doesn’t expire. Both universal and whole life policies have maturity dates, at which point your insurer will provide a payout and your policy will terminate. Typically, permanent insurance policies mature when the policyholder is around 100 years old or older, but it’s important to check with your insurance company to verify your policy’s maturity date, as some policies can mature as early as 85 years old. 

Types of Universal Life Insurance

In addition to standard universal life policies, there are three additional types of universal life insurance commonly purchased: guaranteed, indexed, and variable. Here are the differences between each type of policy:

Guaranteed Universal Life Insurance

Guaranteed universal life functions like term life insurance that doesn’t expire. It may still earn cash value (or it might not), but the returns are typically very small. For this reason, guaranteed universal insurance policies tend to be the least expensive of all the types of universal life insurance. 

Guaranteed universal life insurance is best suited for individuals who need lifetime coverage but who don’t care about the cash value component of permanent life insurance. Its primary purpose is to provide a death benefit regardless of when the policyholder passes away.

Indexed Universal Life Insurance

Indexed universal life policies ties the growth of cash value to the performance of an index, like the S&P 500. Policyholders invest a portion or all of their accumulated cash value into indices and may earn greater returns based on market performance. Be mindful that some insurers place a cap on how much a policyholder may earn—often 10%-12%—and can limit participation rates. Indexed policies also tend not to provide a guaranteed minimum interest rate in the event of poor market performance.

Indexed universal life insurance offers more control than standard universal policies, but that control comes at a cost of little to no guaranteed minimum interest. For better returns and more control, a whole life insurance policy may be more ideal.

Variable Universal Life Insurance

Like indexed universal policies, variable universal life insurance allows policyholders to invest a portion or all of their accumulated cash value in the hopes of earning greater returns. With variable universal life, performance is tied to groups of stocks or bonds, similar to mutual funds. Because you’re dealing with funds that require managing, there are additional administrative fees to consider. High fees can eat away at returns, and may be charged regardless of how well invested cash value performs. 

Whole life insurance is divested from the market, so regardless of stock or bond performance policyholders can enjoy guaranteed returns year after year. In fact, whole life policies can act as volatility buffers for individuals with market-based investments, providing a source of cash flow in the years following a down market. This allows invested funds time to rebound and makes whole life policies valuable assets to a well-balanced financial portfolio. 

If you’re thinking about whole life insurance instead of riskier universal life insurance, the expert Wealth Strategist at Paradigm Life are here to help. Consultations are always free and we prioritize your financial goals. Let’s find a policy that fits your needs and budget today.