Your life insurance needs often change over time. Universal life insurance is a type of life insurance that gives you the flexibility to adjust your premiums and death benefit as your needs change.

Universal life insurance isn’t for everyone. But if you have people who depend on you financially, you need some type of life insurance coverage. A universal policy can be appealing as a financial planning tool because it offers a permanent death benefit, as well as a savings component called cash value that builds over time.

What is universal life insurance?

Universal life insurance is a type of life insurance policy that lets you adjust the death benefit amount and premiums, with a few caveats that we’ll discuss shortly. It’s sometimes called adjustable life insurance or referred to by the abbreviation UL. Some key features of universal life insurance include:

• It’s a type of permanent life insurance, which means that coverage lasts your entire life until the policy matures, often around age 100.

• Part of your premiums go toward the cost of insuring your life, while part of your premium goes toward your insurer’s costs. Any money that’s left over from the premium goes into the cash value component that’s similar to a savings account.

• Your cash value will grow based on market interest rates.

• Once your policy has built sufficient cash value, you can use the cash value portion to lower your premiums or even skip a payment. You can also withdraw money or take a policy loan.

• You can decrease the death benefit at any time, but increasing the death benefit usually requires a medical exam.

One of the biggest appeals of universal life insurance is its flexibility. If your income fluctuates or it decreases once you retire, you can opt for lower premiums. But if you reduce your premiums too much, you risk underfunding the policy, which means you could need to lower the death benefit or allow the policy to lapse.

How universal life insurance works

When you buy a universal life insurance policy, your insurer gives you a planned premium (also known as a target premium) that gives you an estimate of how much you need to pay to keep the policy in force for your entire life, or until age 100. Your premiums will go toward three components:

• Cost of insurance: The cost of insuring your life so that your survivors will receive the policy’s death benefit when you die.

• Insurer costs: The expenses your life insurance company incurs for administering the policy, plus profits.

• Cash value: A savings component that grows at market interest rates, though many insurers provide a minimum rate.

At the beginning of the policy, your planned premium is typically much higher than the cost of insuring your life. The remaining amount goes into the policy’s cash value component.

Because your risk of dying grows over time, the cost of insurance usually increases each year. Eventually, the planned premium may not cover the cost of insurance. In that case, the insurer would dip into the cash value to make up the difference. You may need to increase your premium payments to avoid depleting the cash value, which would cause the policy to lapse.

Universal life pros and cons

Universal life is appropriate for some people, but before you buy a UL policy, be sure to weigh the advantages and disadvantages:

Universal life pros:

• Flexibility: You can change your premium or your death benefit if your needs change.

• Permanent coverage: As long as you adequately fund the policy and keep it in force, UL insurance covers you for your entire life until the policy matures, usually at a specific age, like 95 or 100.

• Cash value growth: Cash value is a built-in savings feature that you can withdraw money from, borrow against or use to lower your premiums. If interest rates are high, your cash value could grow at a higher rate than it would grow in a traditional whole life policy.

Universal life cons:

• Risk: If your policy becomes underfunded (which can happen for a number of reasons that we’ll explain shortly), you may need to reduce your death benefit substantially. Or the policy could lapse altogether.

• High premiums: Compared to term life insurance, universal life insurance comes with substantially higher premiums in the early years. But if you reach advanced age, universal life premiums could be cheaper than you’d pay to renew term insurance.

• Complexity: Even for financial professionals, universal life policies can be confusing. As the policyholder, you’re responsible for monitoring your policy’s performance and determining whether you’re paying sufficient premiums.

Universal life insurance vs. whole life insurance

Both universal life insurance and whole life insurance are permanent life insurance policies that build cash value. However, there are several key differences between these types of policies.

Universal life: features and functions

As a cash value life insurance policy, universal life has several key features that you need to understand.

Death benefit and beneficiaries

Universal life insurance pays a death benefit as long as the policy remains in force and has a positive cash value. As with other life insurance, UL policies pay a death benefit that’s typically tax-free to beneficiaries.

The person you name as the policy’s beneficiary will receive the death benefit without having to wait on the probate process. The beneficiary can use the money however they choose, including paying for your funeral and other final expenses, income replacement, paying off debt, and education funding.

If you purchase a policy with a level death benefit, the death benefit will remain the same regardless of how much cash value you build. If you bought a $250,000 policy and you accumulated $50,000 in cash value by the time you died, your beneficiary would only receive $250,000.

Some policies allow you to choose what’s known as a combined death benefit or an increasing death benefit. This option allows your beneficiary to receive both the death benefit and the cash value, so in the example above, the payout to your beneficiary would be $300,000. You’ll pay higher premiums if you choose this option.

Cash value and cash value growth

The cash value in your universal life policy will grow at a rate that’s on par with money market fund interest rates, though most insurers guarantee a minimum interest rate. When interest rates are high, your cash value will grow at a faster rate. However, when interest rates are low, your policy will underperform.

You have several options for using your cash value in a UL policy:

• Use it to lower your premiums: Many policyholders use their cash value to reduce their premiums, particularly in retirement.

• Borrow from it: You can borrow against the cash value, though you’re expected to repay the loan plus interest. An outstanding policy loan will lower your death benefit.

• Withdraw it: You can also withdraw from your cash value, though doing so also reduces your death benefit.

• Surrender the policy: If you no longer need coverage, you can surrender the policy altogether and receive the policy’s cash surrender value. In the first 10 to 15 years of the policy, surrender fees will typically apply.

While cash value withdrawals can reduce your death benefit, having leftover cash value when you die typically won’t increase the death benefit. Unless your policy offers an increasing death benefit, unused cash value is typically forfeited to the insurer.

Interest rates and policy performance

Universal life insurance is sensitive to interest rates. If interest rates drop, your policy will build cash value at a slower rate than your insurer projected at the time you purchased your policy. Though there’s normally a guaranteed interest rate, these rates tend to be extremely conservative.

But interest rates aren’t the only factor that affect policy performance. If your insurer’s mortality costs are higher than it projected or other expenses rise, the company can increase the cost of insurance up to the maximum spelled out in the policy. That means less of your premium goes toward cash value.

Lower interest rates, especially when combined with increased insurance costs, could force you to pay higher premiums or reduce the policy’s death benefit. Some policyholders find that their only option is to allow the policy to lapse.

Premium payments and flexibility

The ability to adjust payments based on your financial situation is a major draw of universal life insurance. Some people choose to overfund their policy by paying more than the target premium early on to accumulate cash value faster. Having more cash value gives you more flexibility to reduce your premium later or skip premiums altogether. These options can be especially appealing in retirement, when your income typically drops.

But paying too little into the policy puts your coverage at risk. Making lower payments can quickly erode your cash value. Eventually, you may need to increase your premium to maintain the policy.

Policy loans and withdrawals

The ability to take loans and withdrawals from the cash value is another advantage of universal life insurance. Some people use their cash value to supplement their retirement income.

Keep in mind, though, that policy loans need to be repaid with interest. If you die with an outstanding policy loan, you’ll reduce the policy’s death benefit. Likewise, withdrawals will also mean less money for your beneficiaries.

Tax benefits and considerations

In addition to tax-free death benefits, universal life insurance offers tax-deferred growth. Essentially, that means that as long as money stays within the policy, you won’t owe taxes on the gains.

If you take money out of the policy, you won’t owe taxes if your withdrawal is less than your cost basis, or what you’ve paid in premiums. If your withdrawals exceed the cost basis, you’ll only owe taxes on the amount that’s attributed to earnings. For example, suppose you have $60,000 in cash value but you’ve only paid $50,000 in premiums. If you withdrew $55,000, you’d only owe taxes on the $5,000 above your cost basis.

Universal life riders

Life insurance riders are extra features that you can add to your policy for an extra cost. Some common riders that you can add to a universal life policy include:

• No-lapse guarantee rider: Keeps your policy in force even if your cash value is depleted.

• Accelerated death benefit rider: Lets you access part of your death benefit while you’re still alive if you’re diagnosed with a terminal illness.

• Accidental death and dismemberment (AD&D rider): Increases the policy’s death benefit if you die due to a covered accident.

• Child or spouse rider: Provides a small death benefit if your child or spouse dies.

• Long-term care rider: Allows you to receive some of your death benefit for long-term care costs.

• Waiver of premium rider: Lets you stop paying premiums and keep your policy in force if you become disabled. The policy won’t build cash value while payments are paused.

Types of universal life insurance

There are several different types of universal life insurance. These types of policies mostly vary in terms of how your cash value will grow.

• Indexed universal life (IUL): Indexed universal life insurance lets you base your cash value growth on the performance of a market index, such as the S&P 500 or the NASDAQ. IUL policies generally have a minimum growth rate, however, most also cap the amount you can earn. Though these policies have higher potential growth, they’re usually more expensive than a standard universal life policy.

• Variable universal life (VUL): Variable universal life insurance lets you invest your cash value in sub-accounts that can include stocks, bonds or both. These policies have the potential for substantially higher cash value growth. But if markets perform poorly, your cash value could decrease.

• Guaranteed universal life insurance: Guaranteed universal life insurance policies guarantee your premiums and death benefit, making them less risky than most universal life policies — but also less flexible. Compared to other types of UL, guaranteed policies have minimal cash value growth.

Universal life insurance quotes and cost

With any type of life insurance, your premiums will vary based on many factors, including your age, health, and the amount of your death benefit. Universal life insurance typically pays a higher death benefit per dollar compared to a traditional whole life insurance policy. However, due to the cash value component and the permanent coverage, it’s significantly more expensive than a term policy with a similar death benefit.

Guardian Life estimates that a healthy 40-year-old male can expect to pay $8,000 annually for a UL policy with a $1 million death benefit. By comparison, premiums on a $1 million 30-year term policy for a nonsmoking 40-year-old man start at about $1,200 annually.

If you’re interested in a UL policy, you’ll need to work with a life insurance agent or broker. Very few carriers offer online quotes for universal life policies.

Considerations and conclusion

Universal life insurance can be a good option for those who want to leave a death benefit for their loved ones, but who also want flexibility and the ability to build cash value. Assessing your life insurance needs can get complicated, though. Universal life policies are especially complex due to the ability to adjust your premium payments and the fact that your cash value and death benefit aren’t guaranteed.

Before you purchase a policy, consider evaluating your life insurance needs with a fee-only financial planner. You’ll need to determine how much coverage you need, as well as whether a universal life policy is right for your situation. Because a fee-only financial planner charges you by the service, you don’t need to worry that commissions will sway their recommendation.

Once you’ve purchased universal life coverage, monitoring the policy’s performance is essential. You can request a policy illustration, which projects the policy’s performance based on various scenarios, from your insurer every year. It’s worth revisiting your policy’s performance every few years with a professional, particularly if the policy is underperforming. You may also want to discuss the implications with a financial planner before you change your premiums or take a policy loan or withdrawal.

Universal life offers a lot of flexibility. But that flexibility comes with risks. Be sure you understand the risks before you buy a policy.