Variable life insurance is a type of permanent life insurance with a varying cash value. The long-term savings, aka investment aspect, of variable life insurance provides a tax-free sum to beneficiaries. The amount of the policy's total death benefit payout goes up or down depending on the performance of underlying securities held in the policy.
The volatility involved with variable life insurance is paired with tax-free benefits. The potential tax savings can be significant as taxes aren't required on distributions.
Of course, there are higher risks involved with owning a variable life insurance policy versus a universal life insurance policy, which has a minimum guaranteed return each year.
It's up to you to decide how much risk you are willing to take over the long-run with the cash value portion of your life insurance. During bull markets, policyholders can expect the returns to be higher than when the markets are down. During bear markets, the opposite is true.
Prospective policyholders who are risk-averse are typically better off with a universal life insurance policy, also known as a standard life insurance policy that has a pre-determined total death benefit amount. The fluctuating nature of variable life insurance's cash value and its more complex structure tend to turn away the average consumer.
However, if you study the stock market performance over the long run, stocks have shown to return 10% on average per year since 1926. Therefore, if you have a long-term time horizon, going the variable life insurance route may perform better.
Think about a variable life insurance policy like investing in stocks and a universal life insurance policy more like investing in bonds. Bonds have returned closer to 5.4% a year since 1926.
Tax Advantages Of Variable Life Insurance
Variable life insurance's main difference from term life insurance is its investment element. Any annual growth in the cash value of the policy isn't considered ordinary income and thus is tax-free.
Policyholders can also access the cash value free of income tax through loans, using the account as collateral, instead of making direct withdrawals. It's important to understand the current tax laws in place before taking out any cash to avoid making a costly mistake.
It's also crucial that you qualify for a low-cost premium if you want to take full advantage of the tax benefits of variable life insurance. Otherwise, paying a costly, high premium will interfere with your policy's performance earnings.
How Variable Life Insurance Works
Here are the basic features.
- Fixed premiums
- Life-long duration
- Guaranteed pre-determined death benefit amount
- Variable cash value component based on a subaccount of investments
And these are the steps that describe how variable life insurance policies work.
- The policyholder pays a monthly or annual premium. The amount of these payments is predetermined before the policy is opened. Premiums are required for the rest of the policyholder's life to prevent the policy from lapsing.
- A portion of the premium payments goes into a tax-deferred savings account every month. This is the cash value of the policy that grows over time. The premium amount that goes towards the cash value each month varies by policy.
- The policyholder chooses how to invest the cash value from a selection of funds provided by the life insurance company. Performance is variable just like any market investment.
- When the policyholder dies, beneficiaries receive both the pre-determined death benefit amount and the variable cash value component.
Before signing any variable life insurance policy, it's important to understand the risks and rewards. Read through the prospectus and find out what fees and expenses are involved. Review the fund investment choices as well.
Active investors may not find the provider's investment selections are sufficient for their needs to reach optimum performance. The dilemma is similar to investing in a 401(k).
If your employer has great, low-cost, fund selections, then you're set. If not, you may want to think about getting an index universal life insurance policy because index funds generally outperform the majority of actively run funds over time.
It all depends on your individual needs, financial goals, and risk tolerance.
Pros Of Variable Life Insurance
Although variable life insurance isn't for everyone, there are several benefits you should know.
- Tax-free inheritance for beneficiaries
- Life-long policy that stays active as long as premiums are paid
- Long-term savings that can be invested in a selection of funds provided by the insurance company
- Provide financial protection to your loved ones when you pass away
The ideal candidate for variable life insurance is someone who wants a permanent life insurance policy and who wants to build wealth in a tax-efficient manner.
From a financial perspective, if you have high cash flow and your net worth is heading towards the estate tax exemption limit per person, a variable life insurance policy may make sense. You are already contributing the maximum to your 401(k) and other tax advantageous accounts. You figure why not build even more wealth tax advantageously through a variable life insurance policy.
From a personal perspective, you may want a variable life insurance policy because you have a pre-existing health condition that may get worse and/or you have dependents who depend on you even as they become adults e.g. a child with cerebral palsy or Down's Syndrome, bless their hearts.
Cons Of Variable Life Insurance
If you want a simple, straightforward life insurance policy that costs less, then go with a term-life insurance policy. Here are some of the disadvantages of variable life insurance.
- More expensive and complex than term life insurance
- Cash value component is exposed to unpredictable market performance
- Investment options are restricted to the provider's fund selections
- Policy will lapse if pricey premiums are not paid
The cost really is the largest con of a a variable life insurance policy. We're talking premiums that can easily be 5-6X higher than a term life insurance policy that pays the same death benefit amount. Remember, the variable life insurance policyholder is not only paying for the death benefit, but also the cash value.
Below is an example of a universal life insurance policy benefit growth chart for a healthy, 42-year-old male. The monthly premium is $958 for a $1,000,000 death benefit. Notice how the cash value grows tremendously over time. The cash value can be used to pay premiums and can be borrowed.
This universal life insurance policy provides a 2% minimum guarantee and is currently offering a 4.25% current interest rate. With a variable life insurance policy, there is no minimum guarantee and the returns are very market dependent.
Get Free Life Insurance Quotes
There are a lot of different options when it comes to purchasing a life insurance policy. The main thing you want to decide is between a term life insurance policy and a permanent life insurance policy like variable life.
Either way, life insurance can provide critical financial relief and help you and your family sleep easier at night. I've personally got a 10-year, $1 million term-life insurance policy I took out in my late-30s. In retrospect, I would have been better off taking out a longer term duration since I have two kids now, or a variable life policy given the stock market has done well since 2009.
Thanks to technology, it’s easier than ever to compare term life insurance policies. The most efficient and free way to get competitive life insurance quotes is to check online with PolicyGenius. They are the #1 life insurance marketplace where qualified lenders compete for your business.
You can quickly search for policies across multiple carriers through PolicyGenius’s online portal for free. I’ve known the founders of PolicyGenius for years and they have truly built a fantastic resource for individuals.