Universal Life Insurance and Whole Life Insurance: A Comparison

by Nora Dunn on 14 April 2009 21 comments
Photo: Nora Dunn

So you think you need life insurance, or you know it is time to review the insurance coverage you currently have (which is something you do every few years, right? Right).

 

You may already have a Universal Life insurance or Whole Life insurance policy, or you may have an insurance agent or financial planner in front of you telling you that you need one.

 

Read on for a comprehensive look at both forms of insurance, with pros, cons, and example applications for each.

 

Universal Life (UL) and Whole Life (WL) are both forms of permanent insurance. If you are in doubt as to whether you are in the market for permanent insurance or term insurance, check out this article first.

 

Please note that there is a large contingent of people who believe only in Term life Insurance. I will not argue the idea that Term Insurance is more often than not a cheaper and better life insurance product for most people. There are, however, times when permanent insurance may be a better choice. This article will help you determine if you are a good candidate for permanent insurance.

 

 

 

Permanent Insurance Primer – Insurance Part

  • Both UL and WL policies combine a permanent life insurance component with an investment component.
  • The life insurance component (investment component aside) is good for life, and the price doesn’t increase over time.
  • Because of the level premiums for the insurance component, the cost of insurance will be higher than an equivalent amount of Term (temporary) insurance. Over the life of the policy though, the permanent coverage (again, aside from the investment component) ends up being cheaper overall (in comparison to the cost of renewing a Term10 policy for life).
  • You don’t choose permanent insurance to have a whole heap of life insurance coverage for needs that are ultimately temporary. For example, don’t cover off your mortgage or kids’ education with permanent insurance, since these will eventually be paid off. Instead, look at issues like estate taxes and leaving a legacy in determining the amount of insurance coverage to get.

 

 

Permanent Insurance Primer – Investment Part

  • The investment component of both UL and WL grows on a tax-deferred basis. This allows for some good compounding of returns and accelerated growth over time. Permanent insurance is best bought with a very long time frame in mind.
  • There are limits to the tax-deferred growth. By purchasing “x” amount of life insurance, you are allowed to shelter a corresponding amount of investments from taxation. The formula for this is complicated, but the more insurance you buy, the more money you can shelter in the investment component.
  • Making a straight withdrawal from the investments in a UL or WL policy will subject you to taxation on all the growth. It is treated as income and taxed at marginal tax rates. The money you put in (the principal) is not taxable, since it is after-tax dollars to begin with.
  • If you borrow against the investment component of the policy, you can receive the investments (growth included) tax-free. You don’t need to make loan payments as the interest is accrued to the policy. The total loan amount (including interest) is paid to the bank after you die, with the remainder of the investment component, along with the life insurance component, going to your beneficiaries. Tax-free, of course.

 

 

WHOLE LIFE

Whole Life insurance is very difficult to get a full grasp on. There are a myriad of options and sub-options that can be selected, depending on your age and health, what you want the insurance for, your cash flow, intended premium payments, and the insurance company in question. It is best to consult with a knowledgeable insurance broker who can shop across the market for you if you want (or have) WL insurance.

 

Here are the basics:

  • You pay set premiums for a pre-determined amount of time (like 20 years). These premium amounts are rarely flexible, especially in the initial years of the policy, when most of the premium goes to the life insurance component with very little going into the investment component.
  • Each year, the insurance company pays out “dividends”, which are allocated to either your investment component or to purchase further insurance. The more insurance and investments you have, the higher your dividends will be.
  • The dividend options vary widely across policies and insurance companies. You can choose for the dividends to purchase extra term insurance, extra permanent insurance, or have it go directly into the investment component. Combinations thereof also apply.
  • Eventually once the dividend payments are large enough, you can choose to have them pay for the cost of the insurance. This is how you can have a permanent insurance product like WL and not have to pay premiums at all after 20 or so years.
  • You have little to no say in how the investment component is invested. You cannot, for example, choose to put it in US Equities or International Bonds. You will be provided with projections as to how the investment component will grow over time. Most of it is interest-based growth. (All dividends and growth are tax-free as long as they remain in the policy).
  • The larger your investment component, the larger your dividend payments are. So as time goes by and your investments grow, your dividend payments will also grow. This is why WL is best purchased with a long time frame in mind; it doesn’t become really viable until it has been in effect for many years, at which point it can grow fantastically.
  • After time you can use options like dividend offset, premium holiday, and policy loans to stop paying life insurance premiums out of pocket, and access some of the money in the investment component if you wish.
  • When you die, the full amount of the investment component plus the insurance component is paid to your beneficiaries – tax free.

 

 

UNIVERSAL LIFE

Universal Life Insurance a newer, more flexible version of Whole Life. It is also considerably easier to understand, and is generally preferred to Whole Life for these reasons.

  • Although you would get a UL policy with the intention of paying a set amount of premiums for a pre-determined amount of time, these payments are very flexible. You must maintain the cost of the life insurance, and then you can contribute as much or as little as you wish to the investment component (subject to certain upper limits for tax-free sheltering).
  • You can choose how the investment component is invested, within the insurance company’s available options. Insurance companies will often pair up with investment firms to offer mutual fund types of investments specifically for UL policies. So although you cannot choose specific stocks or individual bonds, you can invest in certain asset classes according to your investment profile and desired performance.
  • Once there is an accumulated balance in the investment component, you can choose to have the life insurance premiums paid from the investments so you do not have to pay further premiums out of pocket after time.

 

 

WHY CHOOSE UNIVERSAL LIFE?

As an investment, Universal Life is best used for people who have large (but undetermined) amounts of money they wish to invest with an eye to shelter the growth from taxation.

 

Ideal Candidate #1:

An ideal candidate for Universal Life as an investment could be a single or couple in their 50s, whose income is high and expenses are low (ie: the mortgage is paid off, and the kids are out of school). This couple could choose to invest $10,000 per year, for the next 5-10 years, for example. This would be an easy reach for this candidate, since they are used to allocating much more than that towards housing and children – expenses they no longer bear.

  • The money will be allocated partially to “x” amount of permanent insurance, which will be a legacy for their kids, or will be earmarked to pay for estate taxes on death. (The policy would likely be structured to buy the minimum amount of life insurance required to shelter the maximum amount of their intended premiums in the investment component).
  • The rest of the premiums will go into the investment component, which will be invested as per their instructions and will grow on a tax-deferred basis. Please note that if the investment of choice is a market-based investment, it can decline in value like any other market-based investment.
  • In retirement, when the parents would like to supplement their retirement income (tax-free, of course), they can arrange for policy loans, borrowing against the investment value. The money is paid out without taxation (since loans aren’t taxable), interest is accrued to the policy, and when they die the loan amount plus interest is paid to the bank out of the investment component, and the remainder of the investments plus the insurance is paid to the beneficiaries (tax free).

 

Ideal Candidate #2:

A professional single or couple in their 30s or 40s with some disposable income can use a UL policy for long-term tax-deferred growth.

  • Unlike Candidate #1, this candidate would invest a much smaller amount of money each year for a longer period of time. Most of the premiums would pay for the insurance component, with any extra money going towards the investment component.
  • These payments would likely last through most of the candidate’s working career.
  • By the time they reach retirement, a nice nest egg would be set up in the investment component, which has compounded tax-free. Like Candidate #1, they can then use these investments to offset the cost of the insurance, as well as to supplement their retirement income in the form of policy loans.

 

 

WHY CHOOSE WHOLE LIFE?

With less flexibility around the choice of investments and annual premium amounts, Whole Life is ideal for somebody who knows they can pay and maintain a set premium amount for many years. Somebody who cites themselves as lacking discipline to invest might choose WL because of this inflexibility (thus using it as a forced savings plan of sorts).

 

Ideal Candidate #1:

Although there is a good argument for UL even in this case, one of the most common uses for WL is when parents purchase it for their children.

  • Mom and Dad purchase a WL policy on the life of their child while still a baby, and the cost of insurance is teensy.
  • The moderate premiums (eg: $30-$50/month) are easy to swallow, and maintained for the next 20-30 years.
  • When the child is old enough, the policy becomes theirs. Ideally by this point there are few if any premiums for the child to carry on paying, as the annual dividends can more than cover off the insurance premiums, with the remainder continuing to be invested and growing tax-free.
  • The child can use the investment component as a retirement nest egg, for a major purchase, or simply keep it all as paid-up (and ever-growing) life insurance.

 

Ideal Candidate #2:

Not dissimilar to Ideal Candidate #2 for UL, a young professional with a reliable long-standing disposable income and a need for basic life insurance may choose WL as their insurance investment. Because of the stricter premium structure, somebody without much discipline looking for a forced savings plan might see WL as being a good idea.

 

 

Truly though, Whole Life is an antiquated and confusing type of permanent life insurance, and there is little reason to choose it over Universal Life. With an easy to understand structure and more flexibility all around, Universal Life is generally the permanent life insurance product of choice.

 

 

 

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Guest's picture

Wow! This article is awesome. I've been considering a policy for awhile, but never got serious about it because I was baffled by the choices. This article serves as a great "decision tree" of sorts.

Thanks!

Guest's picture
Guest

Count me among those who only believe in term. Both UL and WL are riddled with fees and generally represent poor investment choices. Buy term and take the difference and invest it yourself. The only people who believe in UL or WL are those who sell it and those whom they have convinced to buy it.

Guest's picture
Hal

As an owner of 2 whole life policies at age 78, where both have death benefits of over 160 % of face amount and are growing (even tho I have had heart problems and cancer), I was asked today to explain a Universal Life policy for a friend in his early 60's which will last all the way to February 2014 IF he pays the full scheduled premium. It seems the Fed's super low interest rates have created some issues that do not affect my whole life. Oh, I fit both categories, I both bought it and sold it! Am I glad I did.

Guest's picture
Brent

Both UL and WL may be riddled with fees, but they provide another method of tax sheltering. After your 401K is topped up, your IRA's are maxed and your college funding is getting paid where can you put your money to not be paying that marginal rate? Insurance. If you already need insurance and have your normal methods of tax-sheltering covered then Permanent life insurance can make it much better than term+investing.

Guest's picture

Wow Nora. Great article. You must have had some time on your hands.

Another product that has come along that usually has better rates than the typical guaranteed whole life insurance is universal life insurance with a no-lapse guarantee premium. It works just like a universal life insurance product in that your extra premiums can be invested with tax free build up, but if the crediting rate goes down or the investment piece doesn't turn out like you expected then as long as you are making the minimum payment your insurance stays inforce even if your policy fund value drops to zero. These products typically have more competitive rates than traditional whole life insurance and more investment upside.

Guest's picture
Guest

I've heard of that -a no-lapse guarantee, but I don't quite understand it. Is it a rider that is added?

Guest's picture
Guest

I love your article and I find the differences between what happens in the US and the UK very interesting !

Universal life insurance is not something we have over here and would be interesting to see if it would work in our economy !

Guest's picture
Lorne

More and more people understand the difference between term and whole/universal - this part of education duty of insurance professionals is almost done. But most of the potential clients still have no idea about the difference between whole and universal life. I am glad that after "Term articles wave" there are emerging more and more articles like this one

Guest's picture
Leslie

What's really confusing is this: if whole life insurance is not that good after all - why so many insurance agencies are still selling and advertising it?

Guest's picture
Stanley

That is because the agent selling whole life gets the best commission. Agent gets very little commission on term-life and often would push whole life rather.

Guest's picture
Kevin

Allstate has a some great tools comparing whole vs term life insurance policies. They have a calculator to figure out which is better for you, and your returns.

Hope this helps
Kevin
Allstate Insurance Advocate

Guest's picture
sandy

This post is wonderful. People have to take time to gain a reasonable knowledge about these topic.

Guest's picture

Excellent article. I like how your break down all of the different possibilities and the pros and cons of each policy, well done.

Guest's picture
Guest

this article is false! whole life is risk free tax free and 100% guarranteed!
universla life is a investment grade product, thats why you need a stockbroker lic to offer it. it has some guaranteed elements but overall is NOT risk free tax free and 100%,
therefore its not a modernized simpler version of whole life. if that was the case there would be no whole life anymore,so according to the authors logic whole life is obsolete. which is untrue.
if you want to buy shoes go to a shoe store.
dont buy life insurance from a stockbroker, cereal compony, department store or funeral home, BUY FROM A SPEACIALIST, one that only sells life insurence(there are only 2 types of life insurance whole and term , and they are not complicated)and remember tocheck am best(a rating compony that rates all insurance co) for a a+ superior rating or better. wake up peoples wall street makes money by exploiting main street, buyer beware!!!

Guest's picture
Guest

Wrong. You do not need a stockbroker's license to offer a UL policy.

Guest's picture
Guest

Quote: "...BUY FROM A SPECIALIST, one that only sells life insurence".

You can't even spell the word INSURANCE correctly. Clue #1.

On top of that, you're ignorant. You do not need a brokers license or a securities license to sell a "universla" (UNIVERSAL) life product.

Guest's picture
Guest

You need a Series 6/63 to sell a UL Policy. This is an easy question on the FINRA exam.

Guest's picture
Mary

True true true ..... Do due diligence before buying UL insurance. It's not the same as WL. Do be conned.

Guest's picture
Guest

Loved the article until the last paragraph. More is guaranteed with whole life coverage. I have seen too many UL policies fall apart because they got underfunded. The family was left trying to figure out how to afford the increasing premium for parents. Whole Life you know if you pay the premium you will have coverage. Ask to see a illustration showing the guarenteed premium on a UL policy. It will scare you.

Guest's picture
Jeff O., CLU

You need a securities lisc to sell only a Variable UL policy, not a standard one. I beleive the article was vague if not wrong in not pointing out that it must be "variable" for the consumer to participate in "the market" with funds beyond the insurance fees. If there is not investment choice offered to the consumer then a standard life lisc will suffice.

Guest's picture
Guest

Jeff, thank you. You can sell Indexed and Fixed Universal Life with an insurance licenses. There are G.U.L's which are guaranteed universal life insurance policies. These will last until 120yrs old. Please go to a life insurance specialist. Not Allstate which does sell Life Ins but they are mainly a Property&Casualty company. Their prices are terrible! Like stated earlier, Make sure you check AM BEST for company rating. Best part about a U.L is it can be customized for a specific individuals needs. Yes, they can fall apart but only if the agent doesn't do his/her job correctly. Safe Investment, final expense, and legacy nicely wrapped up in one package.