Universal Life Insurance.......what am I missing?

I have had a CIGNA group universal life insurance policy for many yrs. Just recently I noticed it has a small cash value that is earning 5% , I think from premiums slightly more than cost. I have never paid more than the billed amount. The last statement had an enclosure saying that I could also add a lump sum into a cash accumulation account that would earn 5% after a 2% charge for a premium tax. The yield supposedly would never be less than 5%. I think that means the 1st yr yield would be 3% but after that it would be 5%. Supposedly I could take the money out any time w/o fees/penalty. The earnings could be tax free if the total withdrawn was less than the sum of all my premiums and contributions.

I understand that these funds would not be insured like a CD in FDIC bank so that would be a major consideration. What else should I be worried about?

added question: I was under the impression that the cash value of a whole life insurance policy was something that was lost when the insured died and only the face value of the policy was paid out. Is this correct? And is the situation different for a universal life policy? The CSR told me that both the cash value and the face value of policy would be paid out
for the universal life policy.

paging InsuranceExpert

First, thanks to germanpope for trying to flag down the expert, and then for the expert for your wisdom.
I appreciate your education......I understand the semantics....it's like not being able to charge more for using
a credit card, but being able to give a discount for cash. Rather like splitting hairs to me but I get it , sort of,
though it might be hard to distinguish which was what in reality.

I recently requalified for an individual 10 yr term policy which cut that premium in half so that the universal life is now costing
me more and will almost double in 3 yrs. I am thinking of using the cash accumulation fund as a 3 yr CD (uninsured)
which, in principle , will pay 5% minimum w/ a 2% load which at the moment is better than CDs esp if it will be tax free.
Was looking for any misunderstanding I might have and any traps the insurance co. might have for the unwary.
They will allow me to put in a lump sum that is much larger than anything I would do. They claim the 5% minimum is guaranteed,
that I can withdraw the funds at any time ($500 min withdrawal) and that there are no fees for withdrawal. I asked for something
in writing so they are sending a certificate of insurance that supposedly contains the info.

I have this "feeling" like InsuranceExpert that something isn't making sense here.

Q1: do you need the insurance?

Q2: do you plan on keeping the policy or just using it as a glorified savings account? (if the latter just walk away)

Q3: is this an "Option B" Universal Life policy?

Q4: did anyone explain what happened to the death benefit if you borrow from the policy?

Universal life is a complex beast and if you take loans out on it it can "implode" on itself requiring you to pay even more premiums down the road.
One thing to remember is that universal life policies basically "count on" the interest gained in the sub-account to pay a portion of the premium - if you borrow cash out - then there is less $ gaining interest and the insurance company can't invest on your (their) behalf. If you borrow, you may be creating a ticking time bomb where the policy collapses on itself.

There may be no fees to "borrow" but interest plays into the equation. This may have been described as a "wash-loan" - that the interest credited/debited from the policy will match but that is likely only in the illustration - I doubt anything guarantees those rates "match" in writing.

Ask for an illustration for your "overfund and then loan" scenario and look what happens down the road given the assumptions. (you won't like what you see)

Another thing is that the "tax advantage" of the accumulated savings only counts if the policy is in force.

As IE said - any of this stuff you were told - get it in writing.

Thanks for the kind words. They are very much appreciated.

You should be able to remove the money without it being a loan.
Will you need the coverage in three years? If so, you may be better off replacing it now than waiting 3 years. There is no guarantee that you will be healthy in three years and any coverage that you buy in three years will be more expensive then.
To the extent that the money that you remove from the policy is less than what you put in, it will be tax free.

Here's the "tax free" part in terms of what he is trying to do:

The COI is $300. He puts in $400. $100 goes into the side fund earning 5%. At the end of the year, he takes out $105. By doing it inside of the life insurance policy, the money that went to pay for life insurance is part of the basis. Thus, the investment part of it can be tax free even when there is a gain. So, instead of this being a $100 investment with a $5 gain, at the end of the year, it will be a $295 investment with no gain. (I'm not advocating for doing this.)

Thanks to both of you again. It is becoming clear to me that I don't know how all this stuff works
so, of course, I won't do anything until I do. The premiums now are about 2K/yr. Suppose I
made a lump sum addition of 20K to the cash accumulation fund. For simplicity, assume no premium tax
(it actually is 2%). I earn 5% so I make 1K/yr (assume simple interest). After 3 yrs , I have 3K in interest
plus the 20K lump I put in. I withdraw that 23K and cancel the policy. I was told that I paid 29K in prior yrs
for the insurance. The 23K is less than the 29K I already paid in premiums (will also pay 6K in next 3 yrs).
I thought since I withdrew less than I paid that it would be tax free.

What am I not understanding in simple layman's language if you can. Thanks.

kaneohe said: Thanks to both of you again. It is becoming clear to me that I don't know how all this stuff works
so, of course, I won't do anything until I do. The premiums now are about 2K/yr. Suppose I
made a lump sum addition of 20K to the cash accumulation fund. For simplicity, assume no premium tax
(it actually is 2%). I earn 5% so I make 1K/yr (assume simple interest). After 3 yrs , I have 3K in interest
plus the 20K lump I put in. I withdraw that 23K and cancel the policy. I was told that I paid 29K in prior yrs
for the insurance. The 23K is less than the 29K I already paid in premiums (will also pay 6K in next 3 yrs).
I thought since I withdrew less than I paid that it would be tax free.

What am I not understanding in simple layman's language if you can. Thanks.

you are welcome - I will try to be less technical but will need to throw some numbers around to answer

You are good with the above scenario because your cost basis is way higher than that $3k "gain" - so it would not be taxed

You mentioned before about a term policy
kaneohe said: individual 10 yr term policy which cut that premium in half

Does that mean you can get the same face amount for $1K a year?
if so there goes any $1k/yr "gained" in interest on the $20k as you would pay an extra $1k/yr ($3k total) in insurance - and to do this you to HAVE TO pump in $20k @ 5% for 3 years just to get close to overcoming the additional COI inside the policy

In simpler terms, if you don't put in the $20k you are keeping a policy that is just draining your pocket out of an extra $1k/yr in premium vs the 10 yr term
(this neglects the $400 premium tax for the lump sum so it is in actuality even worse)

In this scenario, over 3 years you would spend $3k in extra COI and the $20k added with that "nice looking 5% rate" just gets you to back to even - yuck!

does that make sense?

also did you ever get an answer about the "Option B Universal Life"?
Say the face amount is $500k and you put in this extra $20k and you do die - you would want your family to get that extra $20k since it is yours right? Not all UL policies would pay out $520k in that scenario...

Well eagle he is still getting insurance for that 1K a year. It isn't quite money down the drain, he is in fact getting something out of it. Assuming there were no other charges and he was going to keep the policy for the coming three years for the death benefit than I'm not really seeing a problem with the OPs strategy. I'll tell you right now that is the highest minimum interest rate credited for a traditional UL I've ever seen, but I haven't analyzed all of them yet though either including that one. (by the way I can tell its Traditional UL).

It would be removal of basis not policy loan, and traditional UL doesn't have wash loans(that I know about).

But clearly you are minimum funding the thing otherwise you wouldn't be experiencing an increase in premiums in a couple years. For future reference, if you intend on keeping a policy forever don't minimum fund it.

And InsuranceExpert I know you are going to recommend 1035ing it into an annuity and surrendering the annuity so that you can harvest loss deductions, but that is only 3K a year and that isn't close to as valuable as the OPs strategy(assuming he needs insurance and was going to pay the 1K for the next 3 years(essentially giving him 3 years of free life insurance)).

My vote is that assuming the OP is going to have life insurance anyway, needs it, there is no additional charges and would otherwise have thrown the money into a CD than his strategy is the right one. Only if all those conditions are met of course. The OP can always get additional insurance on the side right now if he needed to lock in his eligibility, again if he needs it.

OP
1) Assess whether or not you actually need life insurance
2) Determine if you would otherwise keep the policy for the additional 3 years
3) Get everything in writing you assuring that you will not get any additional charges taken out of money put in
4) Make sure you don't MEC the thing(ask about that specifically)
5) That you would have otherwise thrown that money into either a CD, taxable Bond, taxable Bond fund, MMA, or savings account if you weren't going to utilize your strategy.
6) When done with your strategy if you have any useful basis left you can 1035 to an annuity and get a loss deduction with your remaining basis.

If you overfund a life insurance contract to much in a single year your will turn it into a Modified Endowment Contract and it changes the tax status. The biggie is the addition of a 10% penalty like other retirement accounts.

Basis is the sum of all the premiums/contributions you've made on the contract. Any cash value withdrawal up until that amount is tax free. Any withdrawal/surrender in excess of that is taxable at ordinary income. And yes make absolute sure that every cent of the additional money put in minus the premium load isn't touched.

How long do you think you need life insurance for?
How much more expensive will it be in 3 years? (run quotes for your health rating with additional 3 years tacked onto your age)

Thanks again for the education.

eagle:
1) you are correct....5% wasn't special at the start so the 2% premium tax was a turnoff to making additional cash distributions then.
In this environment, tho, it's a bit more attractive.
2) How do you calculate the approximate tax loss..........not sure I need any more after last yr's stock market harvest....the benefits
would be many yrs delayed.....but still curious.
3) How do you get the 3K difference in COI for the UL when the premiums are now similar?

Thanks.

My GUESS on what is in your best interest. This assumes that you are healthy and can get decent insurance rates.

1)Get one life insurance policy that has a guaranteed level premium.
2)Do a 1035 exchange of your UL policy into an annuity.

Benefits of doing the above:
1)You'll pay less money for your life insurance.
2)You'll preserve your cost basis.

Ex. Your UL policy has a cash surrender value of $2000 and a cost basis of $20,000. If you do a 1035 exchange into an annuity, the annuity will have $2000 of value and a cost basis of $20,000. This means that your first $18,000 of growth would be tax free. For instance, if the annuity grew to $10,000 and you surrendered it, you would have a $10,000 loss. You also won't have to worry about the pre-59 1/2 penalties for non-qualified annuities because the penalties are only on the gains.

kaneohe said: eagle...........the UL costs 1K/100K face and the 10yr level term costs about 0.8K/100K.
The UL is flat for 3 yrs, then doubles. The 10yr level term is constant for that term.

it sounds like a given that the "holding" pattern should be 3 years - max - with the UL

since we are comparing 10yr level term to a UL policy that has rate tiers in it, that brings the equation closer for these three years only

- if you go to 10 years it would be seriously in favor of the term + investing externally

@ 200k face amount we are talking $400 a year cheaper with the term initially, year 4+ it would be a $2400/yr difference (UL @ 4k - Term @ 1.6k)

considering the 20k investment that $400 year amounts to an effective 2% return, by doing something outside the UL policy

you can either think of the $400 as a "drag" to the UL policy or as an "enhancement" to something external - I will attempt to illustrate the "drag" because to me it is a negative factor paying $400/yr more for insurance because you want this "nice" 5% rate-of-return (let's leave the future rate hike out of it for now)

keeping this UL policy for three years you will make 3% (5%-2% premium tax) + 5% in each of years 2 and 3 - but you sacrifice $400 cash a year to do so because of the premium difference
to again oversimplify the interest calculations you would only "net" 1% + 3% + 3% because of the opportunity cost of the $400/yr (-2%/yr)

ditching the UL and doing the term policy you keep $1200 in your pocket and can still invest in something like a fixed annuity - I think IE posted something about a 4% first year and 2%+ in future years as a going rate in a different thread

you'll likely end up slightly better with this Term + FA strategy in the 3 years, but one thing can't be overlooked - in 3 years you still have a term policy with fixed premiums for 7 more years - with the UL route after 3 years you already know you don't want to keep because of the rate jump - you would have to prove insure-ability again if you wanted a different policy

say something did happen to your health and you kept the UL - then you are stuck paying the $4k/yr or not having insurance - to me that is not the best of both worlds

kaneohe said: eagle......appreciate the detailed analysis. Will have to pick a time when the old brain is receptive to think and review in more detail.
Still intrigued by that 1035 strategy which I've never heard of before so lots of homework to do. Thanks again. I'll have to copy this thread to my
e-mail so it doesn't get lost.

you're welcome

1035's are actually a quite common way to "ditch" a policy/annuity that might be based off of life expectancy tables that are outdated (had you dying way earlier than is statistically realistic in today's world)

think of it this way - the insurance company predicted the average life expectancy was 65 when you bought the policy but now says 75 - the premium charges for the first policy are higher because the insurance company thought they were more likely to pay out earlier on a claims (for them that means less time, on average, to have policyholder money to save/invest)

I recently saw an annuity that pays out five percent(don't know about the fees though), came from an unlikely source. I don't believe the 5% is a minimum though, its subject to drop, but with interest rates expected to rise I doubt it would fall.

So you are currently 65? Or are you saying that you're younger but you'll just keep renewing it until your 95?

Do you need life insurance for your entire life for a particular reason?
Do you think your going to die with more than a couple million dollars in assets?(estate planning issues)
If you didn't buy permanent life would you spend the difference or invest the difference? I.e. does buying permanent insurance cut into to your discretionary spending or your money invested?
What tax bracket are you in? Approximate ballpark of income?
Your risk tolerance in investing? (Ultra conservative, ultra aggressive, a little more of one than the other, or a mixture of both)
*What exactly would you do with the money if you didn't put it into permanent insurance.

My bet is that you wont need permanent insurance, but maybe you'll answer one of those questions in an interesting way and that could change things.

Policy loans are pretty much withdrawals. You put money into the a bond fund and you want it so you sell some shares and get some money. You put money into a life insurance policy and you want some money and so they issue you a policy loan. The only problem is that a lot of Whole Life will be giving you lets say 5% on your money and they will be charging you lets say 6% interest on it. Its very common for you to be running negative 1% on policy loans and so the performance of the death benefit can lag a little after someone starts using policy loans.