How Universal Life Insurance Works for Retirement Planning

Universal life insurance is marketed as a flexible financial tool that provides lifelong coverage while accumulating cash value. Unlike term life insurance, which offers protection for a set period, universal life policies allow policyholders to adjust premiums and death benefits. This flexibility makes them appealing for those looking to supplement retirement income, but managing funding, cash value growth, and tax implications requires careful consideration.

Funding Methods

How a universal life insurance policy is funded affects its long-term viability. Unlike traditional policies with fixed premiums, universal life allows flexible contributions within set limits. While useful, this flexibility requires careful management to ensure the policy remains in force and continues to grow.

Premium payments are divided into three components: the cost of insurance (COI), administrative fees, and the cash value portion. The COI covers the death benefit and increases with age, so underfunding early on can lead to significantly higher costs later. Many policyholders contribute more than the minimum premium in the early years to build cash value and offset rising costs.

Overfunding a policy reduces the risk of a lapse and increases the potential for future withdrawals or loans. However, excessive contributions can cause the policy to be classified as a Modified Endowment Contract (MEC), which alters its tax treatment. MECs lose some tax advantages, particularly for withdrawals and loans, which may be subject to income tax and penalties. The IRS applies the “7-pay test” to determine MEC status, comparing total premiums paid in the first seven years to the amount needed to fully fund the policy under IRS guidelines.

Tracking Cash Value

The cash value in a universal life policy grows based on interest credited to the account, which may be determined by the insurer’s declared rate or linked to an external index. Unlike whole life insurance, which offers a guaranteed return, universal life policies typically have a minimum guaranteed rate but can earn more depending on market conditions.

Interest rates fluctuate with economic conditions, meaning periods of low rates can slow cash accumulation. Indexed universal life (IUL) policies tie cash value growth to a stock market index like the S&P 500, but gains are limited by participation rates and caps. While this allows for market-linked growth, returns are not directly tied to stock market performance.

Policy expenses, including mortality charges and administrative fees, are deducted from the cash value. If these costs exceed the cash value, the policyholder may need to contribute additional premiums to prevent a lapse. This becomes more important in later years as insurance costs rise, making regular policy reviews essential.

Tax Factors

Universal life insurance policies offer tax-deferred growth, meaning gains within the policy are not taxed as long as they remain inside the account. This can be advantageous compared to taxable investment accounts where dividends, interest, and capital gains may be taxed annually.

The death benefit is generally income tax-free under Section 101(a) of the Internal Revenue Code. However, if the policy is personally owned and the total estate exceeds federal or state exemption thresholds, the death benefit could be included in the taxable estate. To avoid this, some policyholders place the policy in an irrevocable life insurance trust (ILIT), which removes it from the insured’s estate.

Improper structuring can lead to tax consequences. If a policy is transferred for valuable consideration, the death benefit may become partially taxable under the “transfer-for-value” rule. Additionally, if a policy lapses with outstanding gains, the policyholder may owe taxes on those gains. Regular monitoring and proper structuring help avoid these issues.

Loans, Withdrawals, and Surrender

Policyholders can access funds through loans, partial withdrawals, or full surrender, each with different financial and tax implications. Policy loans allow borrowing against the cash value without immediate tax consequences, provided the policy remains in force. However, interest accrues on the loan, and if unpaid, it reduces both the cash value and the death benefit. Insurers may offer fixed or variable loan interest rates, affecting the cost of borrowing.

Partial withdrawals remove a portion of the cash value. These withdrawals are generally tax-free up to the total premiums paid (cost basis), but amounts exceeding this threshold are taxed as income under IRC Section 72(e). Withdrawals also reduce the death benefit, which may affect estate planning. Some policies impose surrender charges on early withdrawals, particularly in the first 10–15 years.

A full surrender cancels the policy, providing the remaining cash value after fees and taxes. If the surrender value exceeds the total premiums paid, the excess is taxed as ordinary income. Policyholders considering surrender should evaluate the tax impact and potential loss of coverage before making a decision.