By Thomas R. Kosky, MBA
The following is Part 1 of a two-part series exploring the ins and outs of variable universal life insurance, focusing on its guidelines, structure, and potential advantages and/or disadvantages for physician-investors.
Variable universal life (VUL) is a type of insurance that builds a cash value, which can be invested in a variety of separate accounts, similar to mutual funds. The "variable" component in the name refers to this ability to invest in volatile investments. The "universal" component is a bit of a misnomer that is used to refer to the flexibility the owner has in making premium payments. The premiums can vary from nothing in any given month up to maximums defined by the IRS code for life insurance. This flexibility is in contrast to whole life insurance, which has fixed premium payments.
VUL is considered a type of permanent life insurance, because the death benefit will be paid if the insured dies any time up until the endowment age (typically age 100), as long as there is sufficient cash value to pay the costs of insurance in the policy.
Benefits of this Vehicle
VUL insurance receives special tax advantages in the IRS code. The cash value in life insurance is able to earn investment returns without incurring current income tax as long as it meets the definition of life insurance and the policy remains in force. The tax-free investment returns could be used to pay for the costs of insurance inside the policy.
In one theory, life insurance is only needed to the extent that assets left behind by a person will not be sufficient to meet the income and capital needs of their dependents. In one form of VUL, the cost of insurance purchased is based only on the difference between the death benefit and the cash value (defined as the net amount at risk from the perspective of the insurer). Therefore, the greater the cash value accumulation, the lesser the net amount at risk, and the less insurance that is purchased.
Persons can also put the funds into VUL policies under the gift tax exemption. Those with a net worth high enough to encounter the estate tax give money away to their children to protect that money from being taxed. Often this is done within a VUL policy because it allows tax deferral, provides for permanent life insurance, and can usually be accessed by borrowing against the policy.
The Insured in Control
By allowing the contract owner to choose the investments inside the policy, the insured takes on the investment risk, and receives greater potential return. If the investment returns are very poor this could lead to a policy lapsing. To avoid this, many insurers offer guaranteed death benefits up to a certain age as long as a given minimum premium is paid.
VUL policies have a great deal of flexibility in choosing the level of premiums to pay for a death benefit. The minimum premium is primarily affected by the contract features offered by the insurer. To maintain a death benefit guarantee, that specified premium level must be paid every month. To keep the policy in force, typically no premium needs to be paid as long as there is enough cash value in the policy to pay that month's cost of insurance. The maximum premium amounts are heavily influenced by the IRS code for life insurance. The IRS code section 7702 sets limits for how much cash value can be allowed and how much premium can be paid for a given death benefit. The most efficient policy in terms of cash value growth would have the maximum premium paid for the minimum death benefit. Then the costs of insurance would have the minimum negative effect on the growth of the cash value. The extreme would be a life insurance policy that had no life insurance component, and was entirely cash value. If it received favorable tax treatment as a life insurance policy, it would be the perfect tax shelter—pure investment returns and no insurance cost.
In fact, when VUL policies first became available in 1986, contract owners were able to make very high investments in their policies and received extraordinary tax benefits. To curb this practice, but still encourage life insurance purchase, the IRS developed guidelines regarding allowed premiums for a given death benefit.
Maximum Premiums Allowed
The standard set by the IRS was twofold: a definition of the maximum amount of cash value per death benefit and a definition of the maximum premium for a given death benefit. If the maximum premium is exceeded, the policy no longer qualifies for all of the benefits of a life insurance contract and is instead known as a modified endowment contract (MEC). An MEC still receives taxfree investment returns, and a tax-free death benefit, but withdrawals of cash value in an MEC are on a last-in-firstout (LIFO) basis, where earnings are withdrawn first and taxed as ordinary income. If the cash value in a contract exceeds the specified percentage of death benefit, the policy no longer qualifies as life insurance and investment earnings become taxable in the year the specified percentage is exceeded. To avoid this, contracts define the death benefit to be the higher of the original death benefit or the amount needed to meet IRS guidelines. The maximum cash value is determined to be a percentage of the death benefit ranging from 30% or so for young insureds, declining to 0% for those reaching age 100.
The maximum premiums are set by the IRS guidelines such that the premiums paid within a 7-year period after a qualifying event (such as purchase or death benefit increase), grown at a 6% rate, and using the maximum guaranteed costs of insurance in the policy contract, would endow the policy at age 100 (ie, the cash value would equal the death benefit). More specific rules are adjusted for premiums that are not paid in equal amounts over a 7-year period. The entire maximum premium (greater than the 7-year premium) can be paid in 1 year and no more premiums can be paid unless the death benefit is increased. Because the 7-year level guideline premium was exceeded the policy becomes an MEC.
There is another premium designed to be the maximum premium that can be paid every year a policy is in force. This premium carries different names from different insurers, one calling it the guideline maximum premium. This is the premium that often reaches the most efficient use of the policy.
Thomas R. Kosky and his partner, Harris L. Kerker, are principals of the Asset Planning, Group, Inc, in Miami, Fla. The company specializes in investment, retirement, and estate planning. Mr. Kosky has also taught corporate finance in the Saturday Executive and Health Care Executive MBA Programs at the University of Miami in Coral Gables, Fla. Questions or comments are welcome at 800-953-5508, or e-mail Mr. Kosky directly at ProfessorKosky@aol.com.