When it comes to permanent life insurance, one of the most attractive features is the combination of a death benefit that never expires and a tax-favored cumulative cash value. This enables you to safeguard your family today, plan for your legacy in the future, and accrue cash that can be used for any reason at any time in the future. This characteristic characterizes one of the most flexible financial tools accessible, permanent life insurance.
Because your premiums are placed into the insurance company’s general account (after deducting mortality and expense charges), your cash value grows over time with many permanent life insurance policies. Each company manages its general account according to industry standards and its own investment philosophy. In essence, the insurance company is in charge of managing those funds on your behalf.
The investment component of variable life insurance, as well as the favorable tax treatment they receive, are the primary reasons for its popularity. It is not necessary to report the growth of the cash value account as ordinary income. These accounts can be accessed in later years, and if done correctly (i.e., through loans secured by the account rather than direct withdrawals), funds can be acquired without incurring any income tax liability.
A variable life insurance policy, like mutual funds and other types of investments, must be accompanied by a prospectus that details all of the policy’s charges, fees, and sub-account expenses, among other information. In addition, some of the greatest life insurance firms, such as Prudential and New York Life, provide variable life insurance policies to their customers.
Table of Contents
- 1 What is variable life insurance and how it works?
- 2 Cash value of variable life insurance
- 3 Difference between variable life insurance and variable universal life insurance
- 4 How is variable life insurance different from term life insurance?
- 5 Variable life insurance vs. whole life insurance
- 6 Who needs a variable life insurance policy?
- 7 Key risks of variable life insurance policy
- 8 Pros and cons of variable life insurance
- 9 How much does variable life insurance cost?
- 10 How to buy variable life insurance?
- 11 Things to do before you buy a variable life insurance policy
- 12 Exchanging one variable life insurance policy for another
- 13 Alternatives to variable life insurance
- 14 What are the tax benefits of variable life?
- 15 Final words
What is variable life insurance and how it works?
Variable life insurance is a cash value life insurance that remains active throughout your life, making it significantly more expensive than term life insurance. While the cash value feature enables the policy to be utilized as an investment vehicle, this does not necessarily make it a good choice for the majority of individuals, as investment alternatives are extremely limited and there is no assurance of return. It is normally recommended only for individuals who have exhausted all other financial possibilities.
Variable life insurance policies have a guaranteed minimum death benefit that is subject to change over time. The monetary value, on the other hand, is not guaranteed and is subject to market conditions. Variable life, like any permanent life insurance policy, can cost five to fifteen times as much as a term life insurance policy with the same face value.
Variable life insurance is a sort of permanent life insurance that requires you to pay premiums for the remainder of your life. Variable life, like other types of whole life insurance, provides a tax-free lump amount to your beneficiaries in the event of your death. However, it is frequently purchased for its cash value and used as an investment component.
Variable life insurance is distinguished from other types of life insurance by the possibility of investing the cash value in a variety of funds supplied by the insurance provider, including mutual funds and annuities. The performance of your investments will be influenced by broader market developments. While you may earn more income than you would with a whole life insurance policy that guarantees an interest rate, you, the policyholder, may suffer investment risk if the fund underperforms.
Cash value of variable life insurance
The cash value component of a variable life insurance policy is distinct from that of a full or indexed universal life insurance policy. Each variable life insurance comes with a prospectus outlining approximately 20 to 30 investment possibilities for the cash value, and the cash value investment options are comparable to mutual funds in that the money would be invested in a specific selection of securities, such as:
- A stock market index, such as the S&P 500
- A stock portfolio, such as an emerging markets fund.
- Money market mutual fund
Additionally, most variable life insurance contracts have a fixed interest investment option given by the insurer. Whichever option you choose, you will be charged management fees comparable to mutual fund expense ratios. These fees vary by security and can be rather significant if the money is actively invested (meaning a portfolio manager is picking stocks).
Fees for cash value investment management are occasionally expressed in terms of “basis points,” with one basis point equaling 0.01 percent.
This means that if an investment option advertises a historical rate of return of 6% but includes 125 basis points in management fees, investors should factor in a 1.25 percent reduction in returns.
Variable life insurance products provide a greater upside potential than conventional cash value policies, such as whole life insurance, because you can choose from a choice of investment options.
Variable life insurance policies, on the other hand, may not have a guaranteed rate of return or may have a very low rate of return. Additionally, most cash value investing alternatives have a maximum rate of return cap. Your cash value may actually fall in value during difficult years and may perform less effectively than it could during prosperous years.
Difference between variable life insurance and variable universal life insurance
Variable life and variable universal life insurance are both cash-value policies. Fluctuating life insurance policies have set premiums, a guaranteed minimum death benefit, a variable face value, and the option of borrowing against the policy. Variable universal life insurance offers flexible premiums, no guaranteed minimum death benefit, a variable, and adjustable face value, and the ability to borrow money or surrender a portion of the policy.
Variable life insurance policies are intriguing for investors who enjoy watching the market. These products permit the insurance company to invest a portion of the premium, resulting in tax-free earnings for beneficiaries.
Variable universal life insurance products offer the same investment possibility as fixed universal life insurance policies, but with additional benefits. These whole life policies include an investment option for the cash value, as well as adjustable premiums and a variable death benefit.
Investors seeking life insurance coverage have a variety of alternatives, ranging from term to whole life and a variety of other possibilities in between. Insurance needs fluctuate as a result of life changes, which is why it’s critical to re-evaluate your financial strategy following significant life events such as marriage or the purchase of a property.
How is variable life insurance different from term life insurance?
When a permanent life insurance policy — which means it will endure until the policyholder’s death— is linked with a cash-value account that is invested in bonds or stocks, the result is variable life insurance. Term life insurance is a simple product that lasts for a fixed number of years and does not include any investing components.
Variable life insurance vs. whole life insurance
Both of these types of life insurance are considered permanent. Unlike term insurance, which ensures a death benefit payout for a specific length of time, permanent policies give coverage for the remainder of the insured’s life. If you terminate your permanent life insurance coverage, you will receive the cash value of the policy (minus any fees).
Both of these types of life insurance contracts typically have two components: a savings or investment component and an insurance component. As a result, the rates are greater than those for term insurance. Additionally, policyholders can borrow against the policy’s cash value. As a result, permanent life insurance is also referred to as cash-value insurance.
While whole life and universal life insurance policies are comparable in certain ways, they have some significant distinctions. With fixed premiums and guaranteed cash value accumulation, whole life insurance provides constancy. Consumers have freedom in terms of premium payments, death benefits, and the savings component of their plans with universal life insurance.
Who needs a variable life insurance policy?
The high cost of variable life insurance means that it is not the most suitable life insurance or investment choice for the majority of people. In the event that you only want to ensure that your family receives a death benefit payout, a typical term life insurance policy provides more coverage for a cheaper premium. Traditional investments, on the other hand, will yield superior returns for the vast majority of individuals. Individuals who have exhausted all other investing possibilities, on the other hand, may find the cash value of a variable life insurance policy advantageous.
Key risks of variable life insurance policy
No short-term savings: This is not a vehicle for short-term savings. In most cases, a variable life insurance policy is used to give a death benefit or to assist in the achievement of other long-term financial goals.
Policy lapse: There has been a lapse in policy. You may lose your insurance coverage if you do not retain sufficient cash worth to cover your policy fees and obligations. That is, it will expire with no value, and your beneficiary will not get any death benefit as a result of the termination. A considerable proportion of life insurance policies are let to lapse each year.
For example: if your insurance has a present value of $40,000 and fees and expenses totaling $10,000 each year (based on a death benefit of $300,000), your policy may expire within four years if the fees and expenses total $10,000 per year. The possibility of this occurring sooner is increased by poor investment performance, as well as by making a withdrawal or taking a policy loan. Positive investment performance, as well as the payment of additional premiums, can help to lessen the likelihood of lapse.
Policy Fee: Fees and expenses associated with insurance policies. It is possible that policy costs and expenses will be high. It is possible to incur deductions from premium payments, surrender charges, as well as considerable recurring fees and expenses linked with the ownership of a policy.
Risk of loss: It is possible to lose money when investing in a variable life insurance policy, including the possibility of losing your initial investment.
The following risks are related to investment options:
- The performance of the investment options you select will have an impact on the value of your investment as well as any returns you get.
- Each underlying fund may be subject to a variety of risks that are specific to it. Before making an investment decision, you should read the prospectus for the investment option in question. Regarding each fund option, you should consider a number of factors, including the fund’s investment objectives and policies, management fees and other expenses charged by the fund, the risks and volatility associated with the fund, and whether the fund contributes to the diversification of your overall investment portfolio.
Insurance company risk: It is a risk that the insurance company assumes. Each and every promise, including the death benefit, is backed by the financial stability of the insurance firm that issued the policy. If the insurance business suffers from financial difficulties, it may be unable to fulfill its commitments to you and your family.
Pros and cons of variable life insurance
There are advantages and disadvantages to purchasing variable life insurance. While for the vast majority of people, the disadvantages exceed the advantages, there are some situations in which variable life insurance makes sense.
The advantages of variable life insurance
- In the event of your unexpected death, it protects your family from financial obligations such as mortgages and college loans.
- It allows beneficiaries to receive an inheritance that is free of taxes (applicable to high net-worth individuals whose inheritance will be subject to estate tax).
- It provides coverage for final expenses such as funerals and other end-of-life expenses.
- It allows you to accumulate long-term savings while also having the option to invest in funds supplied by the insurer.
The disadvantages of variable life insurance
- Because it provides the same amount of protection for your beneficiaries as term life insurance, it is significantly more expensive.
- It has a restricted number of investment possibilities for the monetary value that you will accumulate.
- In the event that you are unable to keep up with the high premium payments, your policy may expire, resulting in you being subjected to surrender charges.
How much does variable life insurance cost?
When you get a variable life insurance policy, you will be responsible for a number of costs and expenses. Before you invest, make certain that you understand all of the fees and expenditures. These fees and charges will lower the value of your account and may necessitate you to make further premium contributions to your policy in order to keep the policy from being terminated altogether. Frequently, they will incorporate the following elements:
- Premiums are subject to sales commissions: Sales commissions are calculated as a proportion of the total amount collected. In this case, they reduce the amount of your premium payment that is applied to the insurance policy. Typically, they reimburse the insurance company for the expenses incurred during the sales process.
- Charge of surrender: This amount is charged if you surrender the insurance or withdraw from the contract during the first three years of the term. When you surrender your policy early, the insurance company receives compensation for sales expenses that it would otherwise not be able to recoup. When examining a policy, make sure to pay attention to the length of the surrender charge period.
- Mortality and Expense (M&E) risk fees: They are charged on a per-occurrence basis. These ongoing fees are calculated as a percentage of the amount of your account balance. They contribute to the coverage of the risks that the insurance company assumes in connection with the policy. There are other risks to consider, including the possibility that the policy owner would die sooner than anticipated, that administrative and sales costs will be higher than anticipated, and that policy owner behavior will not meet the insurance company’s expectations.
- Cost of insurance: Insurance premiums are expensive. This continuous price fluctuates for each covered individual depending on a variety of characteristics such as the insured person’s age, gender, health, and death benefit amount. It is intended to reimburse the insurance company for the provision of the death benefit.
- Fees for administration: In addition to covering the insurance company’s costs of issuing and running the policy, these fees also cover the costs of operations such as processing claims, maintaining records, and interacting with you on your behalf. They may be charged in the form of a fixed account maintenance fee or as a percentage of the value of your account.
- Interest on a loan: If your insurance policy allows you to borrow money, you will be charged interest on any money you borrow that remains unpaid.
- Expenses incurred by the underlying fund: Also included are the recurring fees and expenses associated with the mutual funds that serve as the underlying investment possibilities for your variable life insurance policy, which you will pay indirectly. These fees are in addition to the fees imposed by the insurance company, and their impact on the performance of the investment options is reflected in the performance of the investment options.
- The cost of optional features, including fees and expenses: Policies may include a variety of optional features that can be purchased for an additional price, as detailed further in this bulletin. Fees and expenses may differ greatly depending on the type of features offered and/or the specifics of the insured individual.
- Fees for transactions: These charges are for the services you have requested. For some transactions, such as shifting money between investment alternatives, making partial withdrawals, increasing or decreasing the face value, or giving supplementary reports, certain insurance plans charge a fee (such as policy illustrations).
There may also be additional fees and charges to consider. You should request that your financial expert explains to you all of the fees and charges that may be applicable. In addition, the prospectus for any variable life insurance policy that you are considering will include an explanation of the costs and charges.
How to buy variable life insurance?
In order to obtain a variable life insurance policy, you’ll need to speak with a life insurance broker that also holds an investing license, as variable life insurance is more suitable as an investment than as a simple life insurance policy. To qualify for variable life insurance coverage, you’ll most likely need to go through the standard underwriting process and demonstrate your insurability to the insurer.
Things to do before you buy a variable life insurance policy
- Understand how it works. Make a note of any essential terms that you aren’t familiar with. Prepare to ask your financial professional a few questions about whether or not the coverage is a good fit for your needs and circumstances.
- Figure out how much it will cost to do so. Inquire about the fees and expenses involved.
- Find out the specifics. Different policies have a variety of characteristics. Inquire with your financial expert for a copy of the policy prospectus, which will provide a detailed description of the insurance policy you’re contemplating. Read the prospectus carefully and ask questions if you have any queries regarding anything you do not understand.
The prospectus is available at no cost to the public. It contains vital information about the variable life insurance policy, such as fee and additional charges, investment alternatives, death benefits, and other features, as well as important information about the policy itself.
Things to remember
- Purchasing variable life insurance is only recommended for people who have specific life insurance protection requirements. Variable life insurance is generally considered unsuitable for short-term savings vehicles because of the high costs, expenses, and tax implications.
- You will be expected to pay a specific number of premiums or maintain a particular amount of cash value in order to meet the fees and expenditures associated with your policy. Loans and bad investment performance can both have an impact on your financial value. The failure to maintain a suitable cash value may result in the lapse and termination of your insurance coverage.
- Investment risks are inherent in variable life insurance, just as they are in mutual funds. If the investment options you selected for your policy perform poorly, you may incur financial losses, including the loss of the money you initially invested.
- The amount of insurance you purchased and the number of fees you would be required to pay are not specified in the prospectus. As a result, you should also read any supplemental information that was sent to you when you purchased your insurance policy.
- Your insurance premiums may be applied toward the remuneration of your financial advisor. This means that they may receive a bigger commission for selling some insurance policies or financial products than they do for selling others.
Things to consider
- You should take into account your insurance requirements, investing objectives, and tax position.
- Learn about the different types of insurance policies and other investment options that can match your specific needs.
- Take into consideration whether you can afford the insurance. It is possible that the costs and expenses linked with the insurance coverage may be substantial. If you are unable to pay those costs and expenses, your insurance coverage may be canceled.
- Take into account how the policy will fit into your overall financial situation.
- If you decide that variable life insurance is the best option for you, take the following factors into consideration:
- The quantity of insurance you require, as well as the length of time you require the insurance.
- A large part of the value of your investment, as well as any returns you receive, will be determined by the performance of the investment alternatives that you select. It is possible that you will suffer a financial loss.
- Fees and expenditures are determined by your individual features… (such as age, gender, health, and family history). Make certain that you take into account the complete actual expenses associated with your individual policy. Furthermore, the fees connected with certain insurance policies may rise over time as well.
- Other unique features supplied by the policies may be more suitable for your requirements, and those features may be obtained at a lower cost by purchasing them separately.
- It is critical to consider the financial strength of the insurance business.
- Insurance providers or your financial expert may make personalized illustrations available for specific policy characteristics, depending on the coverage. It may be advisable to seek and review these examples prior to making a decision. In this case, they can assist you in understanding how your policy will operate in your particular situation.
What if you change your mind?
You may cancel your policy without penalty within a short period (often at least 10 days) of receipt. You will normally receive a refund of your premiums upon cancellation. The return amount may be increased or decreased in accordance with the success of your investment selections. The duration of the free look period varies by state in which you submitted your application.
Exchanging one variable life insurance policy for another
If you are thinking about switching from one life insurance policy to another, here are some things to think about:
- As you become older, the cost of insuring you is likely to rise, making it more expensive to purchase new insurance. Make sure to compare the prices connected with an existing policy to the costs associated with a new policy before purchasing.
- Generally speaking, surrender charges are higher in the first few years of owning a life insurance policy. Depending on the circumstances, you may be subject to a surrender fee on your previous policy as well as a new surrender charge period on the new policy if you trade policies.
- Make sure to evaluate the characteristics of the old and new policies to determine which coverage is more appropriate for your needs.
- Consider the tax ramifications of any policy transaction you may be considering.
- Wait until your new policy takes effect before canceling your current policy in order to ensure that there is no coverage gap in your insurance coverage.
- Inquire with your financial adviser about a policy illustration that compares your current and previous policies.
- Take into consideration the financial motivations that your financial professional may have for recommending that you exchange one insurance coverage for a different one.
Alternatives to variable life insurance
Whole life insurance: Whole life insurance is the most fundamental type of permanent life insurance because the death benefit is assured and fixed. Whole life insurance provides insurance coverage to beneficiaries while progressively reducing the insurer’s financial commitment as the policyholder’s cash value grows over time. The interest on the cash value is calculated at a preset rate set by the insurer and is compounded monthly.
Universal life insurance: Universal life insurance is similar to whole life insurance in that it provides the policyholder with adjustable death benefits and flexible premiums that allow buyers to use the cash value to pay for premiums. It is also similar to whole life insurance in that it allows the policyholder to use the cash value to pay for premiums. Despite the fact that there is still a guaranteed death benefit with universal life, the interest rate that the cash value earns is subject to fluctuation, whereas it is fixed with whole life insurance.
Universal Life Insurance: Insurance with variable rates and asset possibilities is similar to universal life insurance in that it includes flexible premiums and asset alternatives, but it differs in that it does not have the same asset options as Universal Life Insurance. The assets in which you invest your premiums with a variable universal life insurance policy are entirely up to you; there is no guaranteed minimum death benefit or guaranteed cash value with this type of policy.
What are the tax benefits of variable life?
Under the correct circumstances, variable life insurance can provide favorable tax status while also providing the opportunity to profit from market fluctuations without having to pay taxes.
First and foremost, you must be eligible for a reduced premium. It will be difficult for you to grow your income flow if the expense of insuring you is prohibitively expensive.
Second, this product is treated as a security under the law, which is entirely appropriate. As with any investment, you must manage risk and reward, take into account expenses, remain on top of asset allocation, and take any other steps necessary to achieve optimum performance in the long run. If you are not prepared to accomplish this on your own, make sure you have a trusted counsel who can help you through the process.
In addition, you must grasp how to operate within the confines of existing tax regulations. When it comes to growing wealth within life insurance and taking it out, there are good and wrong ways to do it. Mistakes can be extremely expensive.
The growth of the cash value account is not taxable in the same way that ordinary income is. If monies are drawn from the accounts in the following years in the correct manner (for example, through loans using the account as collateral rather than direct withdrawals), they may be received without incurring any income tax liability.
Variable life insurance is neither a decent life insurance policy nor a viable investment vehicle for the vast majority of people who purchase it.
In comparison to a variable life insurance policy, there are much better alternatives to invest – less expensive techniques with higher growth potential that are not entangled in a convoluted life insurance policy. Many buyers decide to avoid purchasing permanent insurance plans altogether and instead choose to purchase a term life insurance policy and invest the remainder of their savings in a retirement account such as an IRA or 401(k).
Depending on your situation, variable life insurance could be beneficial due to its tax-deferred nature. However, even in such situations, there are other options that may be a better fit.
For the vast majority of people, variable life insurance will not be of use, and a far simpler and less expensive term life insurance policy will suffice. The combination of insurance with an investment or savings component should be avoided in most situations. It’s best to consult a financial professional or tax expert when attempting to build together an investment portfolio with a long-term outlook that incorporates several different types of investments.