How variable universal life insurance works: Features, pros & cons

Variable universal life (VUL) insurance is a form of permanent life insurance. It combines the main benefit of life insurance—a financial payout to your loved ones when you die—with investment subaccounts. These investment subaccounts can be used to invest the cash value of your policy. If the market performs well, your cash value can grow. Conversely, if the market performs poorly, your policy could lose value. The higher-risk environment of VUL will be familiar to people with other forms of investments.

Among the various types of permanent life insurance, VUL is one of the most feature-packed. With this type of policy, you can expect four primary features:

Your beneficiary (usually a loved one or family member) receives a financial payout when you die. The payout, which is often income tax-free, can help pay for a funeral, ongoing expenses or estate taxes.

The cash value of your life insurance can be placed in variable and fixed subaccounts and should reflect your risk tolerance. If enough money is available, you may be able to take a loan or make a withdrawal.

The cash value inside your policy can grow or decline after you place it in a market-based investment option.

Adjust how much to pay into your policy and when within the limits set by your insurer. There are consequences of adjusting your premium payments, so be sure to read on to the next section.

VUL policies last as long as you pay premiums in full and the contract retains its value. If you research life insurance options, you may see VUL’s close cousins: universal life insurance and variable life insurance. These types of policies share some qualities. Like universal life insurance, VUL has flexibility in premium payment timing and frequency and may allow you to increase or decrease your coverage amount. And, like a variable life policy, VUL allows you to allocate your cash value in investment subaccounts.

“The Internal Revenue Code has set rules concerning life insurance, especially life insurance that builds cash value like variable universal life insurance," says Kevin Foseid, life product consultant at Thrivent. "Using those rules, we have determined how much money you can pay into a life insurance contract, if you stay at or below that level, we will maintain it’s definition of life insurance and you will have certain tax advantages.

High-income earners and retirees often use this policy as part of a complex financial strategy. Expect to pay more for a VUL policy than for term life insurance.

While the primary purpose of life insurance is financial protection for your loved ones, one of the main reasons to consider buying variable universal life insurance is the potential for investment returns. Weigh this pro against the cons of VUL, which include complexity and a high level of risk.

The pros of variable universal life insurance include four considerations. First, there's a death benefit that's often income tax-free. Second, there's the potential to grow your money tax-deferred. Third, you can adjust payment timing and amount within the limits of your contract. And fourth, you may be able to adjust your coverage amount.

An income tax-free death benefit allows you to transfer wealth to your beneficiaries when you die. They can use the funds to help pay for funeral expenses or take time away from work to grieve. In addition to a tax-free death benefit, Foseid explains, "The cash value within a life insurance contract will grow tax-deferred, and depending on how you access the cash value while still alive, and assuming the policy is not a modified endowment contract (MEC), the distributions you take from the policy also can be tax-free."

Other common uses of a death benefit are charitable causes, a memorial fund or paying inheritance tax.

The potential to grow your cash value tax-deferred is why many people sign up for VUL. If the investment options within your policy grow in value, the growth might not be taxed until you take a distribution. Expect the cash value of your policy to fluctuate daily with the market.

The tax laws that govern VUL can be complicated. So make time to talk with a tax advisor about the specifics of your life insurance contract and tax situation.

Flexible payments allow you to change the amount and frequency of your contributions to the life insurance policy. You can slow down or increase contributions within the limits of your contract terms. The changes you make will affect how slowly or quickly you accumulate value. But they’re a good option to have if your income changes.

One thing to note about flexible payment timing and frequency: You’ll want to be mindful if you decide to slow down contributions. When you reduce premium payments, you also may decrease the cash value of your life insurance. Or you may decrease the death benefit available to your beneficiaries. Reducing premium payments can make it take longer to meet your life insurance policy goals. Always talk with a financial advisor before altering planned contributions.

Also, note that adding a large lump sum to your life insurance policy can result in the IRS reclassifying it as a MEC. These contracts have different tax-time rules than standard life insurance.^1,2

You may be able to increase or decrease the size of your death benefit with a VUL policy. Adjust your coverage amount within the limits set by your insurer. Use the flexible payments outlined above to help make this possible. There must be enough money paid into your policy to make a death benefit size increase possible.

Increases and decreases have limitations related to contract size and your age. Increases may require evidence of insurability. Decrease charges may apply to a decrease in coverage.

The cons of variable universal life insurance include complexity, higher cash needs, long time horizons and market risks.

VUL’s complexity can make using it more challenging. VUL policies are more complicated than term and whole life policies. Before buying, be sure to clearly understand the goals you're trying to achieve. Know how this product will support them. Consider talking with a financial advisor or tax advisor about the details. Also, read and consider prospectuses before investing.

Required funding contributions can be higher for VUL than for other types of life insurance. VULs generally have higher contract charges, usually include investment fees and may require more funding to withstand market downturns.

Longer time horizons mean this policy isn’t right for everyone. VUL contracts are designed to meet long-term financial goals. They aren’t meant for short-term investing. If you don’t think you’ll be able to fund this policy long-term, don’t sign up.

It’s the nature of stocks and bonds to fluctuate in value. If you invest the cash value of your life insurance in investment subaccounts, that cash value will be subject to market cycles and investment risks. If your investments perform poorly, you could lose your gains and initial investment. There’s the added risk that you could lose your life insurance as well—including the death benefit you initially bought it for.

A jam-packed feature list sets variable universal life insurance apart. It has one of the widest ranges of choices available among life insurance products. The extras contribute to the higher cost of this policy. VUL insurance usually costs more than term or whole life. There are other notable differences between VUL and its peer life insurance policies as well.

Term life insurance is generally the most common life insurance option. It provides a basic death benefit and coverage for a set number of years. Differences between VUL and term life insurance include:

• VUL has no 10-, 20- or 30-year cap on coverage.
• VUL policies have cash value potential, while term life insurance does not.
• VUL policies have market-based investment options. Term life insurance does not.
• VUL premium payment amounts and timing can be adjusted. Term life premiums usually cannot be changed.
• In exchange for these extra features, VUL typically costs more than term life.

Whole life insurance is another common type of life insurance after term insurance. Whole life provides a basic death benefit, plus cash value. Here’s how VUL compares to whole life insurance:

• Both VUL and whole life insurance are permanent life insurance.
• Both VUL and whole life insurance have cash value.
• VUL provides the option to invest cash value in investment subaccounts, while whole life usually does not. Whole life policies accumulate cash value at a flat credited rate set by your insurer.
• VUL premium payment amounts and timing can be adjusted. Whole life premiums usually cannot be changed.
• VUL coverage amount may be adjustable. Whole life coverage amount is usually not adjustable.
• In exchange for these extra features, VUL usually costs more than whole life.

Universal life insurance is similar to VUL. The main difference is that universal life generally lacks a self-directed investment component. It accumulates cash value through credited rates set by the insurer.

• Both VUL and universal life insurance are permanent life insurance.
• Both VUL and universal life insurance have cash value.
• VUL provides the option to invest cash value in stocks and bonds, while universal life usually does not. Universal life policies usually accumulate cash value through a money market interest rate.
• Both VUL and universal life have adjustable premium payments.
• Both VUL and universal life have coverage levels (death benefits) that you may be able to adjust.

Variable life insurance is also closely related to VUL. The main difference between VUL and variable life is that variable life has less premium payment flexibility. With variable life, contributions are made at a set rate, on a set schedule.

• Both VUL and variable life insurance are permanent life insurance.
• Both VUL and variable life insurance have cash value.
• Both VUL and variable life provide the option to invest cash value in investment subaccounts.
• VUL premium payment amounts and timing can be adjusted. Variable life premiums usually cannot be changed.
• VUL has a coverage level (death benefit) that you may be able to adjust. Variable life coverage is not as adjustable.

With both variable policy types, you make investments through your life insurance. Those investments are governed by U.S. federal securities laws. According to the SEC, “Substantial fees, expenses, and tax implications generally make variable life insurance unsuitable as a short-term savings vehicle.” The same is true for VUL, too. So if you don’t think you can fund this policy long-term, don’t sign up.

Whether variable universal life insurance is a good choice depends on your financial goals, risk tolerance, time horizon and strategy. If you have a high-risk tolerance and the idea of a death benefit is appealing, a VUL policy might be a good option for you.

First and foremost, VUL is life insurance. It provides your loved ones with money when you die, as long as your contract retains value. Additionally, this policy’s investment options are a way to potentially grow cash value while you’re still living. You may be able to wait to pay taxes on growth until you withdraw money from the account later on.

As you weigh your decision, consider the risks of VUL in addition to the benefits. If the VUL investment options you selected perform poorly, you could lose your gains. But there’s the added risk that you could also lose your life insurance—and the death benefit you initially bought it for. Likewise, smaller declines in the investment options you selected could mean reductions in the life insurance’s cash value and death benefit. Like all life insurance, VUL contracts include charges to cover insurance and the cost of doing business.

A variable universal life insurance policy can expire if you do not provide enough funding to keep the contract from lapsing without value. A policy is without value when there is not enough cash value to cover the contract’s fees and charges. VUL could also expire if you take a loan or make a withdrawal from the policy that’s significant enough to leave it underfunded.

Remember that the cash value of a VUL policy is allocated to the investment options you select. That means if the market performs poorly, your policy could lose all its value. If your policy loses all value, it won’t have any money left in it to keep the life insurance coverage active. It could terminate if you don’t make extra payments to help keep it active.

Most variable universal life insurance policies offer flexible premium payments. Your premium payments contribute to your death benefit, build cash value and pay operational costs. Like with other types of life insurance policies, your premiums aren’t tax deductible.

The premium flexibility for variable universal policies usually comes down to two things: flexibility in when you pay and how much you pay.

Some VUL policies allow you to change the dates that your life insurance premium is due. There will be limits on the timing that is allowed. You may have the option to set up regular payments or pay whenever you choose. Make sure you learn about the consequences of adjusting your premium payments if you haven’t done so already.

Flexible premiums also allow you to change the dollar amount due in a premium bill (within limits). For example, let’s say it’s October and you’re planning to buy a new car this month. You may be able to pay a lower insurance premium in October, so you have more money to use for the car purchase. Then, next month, you would pay a higher premium to compensate. There would be no penalty for doing so because the two payment amounts are equal to the total amount you owed in life insurance premiums for that period.

VUL insurance policies should be monitored regularly to make sure there’s enough funding to keep the contract active for the future.

When you pay the premium for permanent life insurance, the money goes to three places: the death benefit, the cash value and the insurer’s cost of doing business.

Charges to cover the costs of providing your life insurance (including mortality costs) and contract fees come out of your premium payment first. Then, the remaining premium payment goes toward building the policy's cash value.

The cash value of VUL insurance can usually be directed to one of two places: a variable subaccount or a fixed subaccount. Variable subaccounts consist of investment options. Fixed accounts have a set (fixed) interest rate. Allocate funds in the accounts that best fit your risk tolerance.

Expect your VUL policy’s cash value to change every business day based on your investment portfolios’ subaccounts. Or cash value could change based on the amount of interest credited to your fixed account.

Making sufficient payments can increase your life insurance’s cash value. On the flip side, charges and withdrawals decrease cash value. When and how much you pay into the policy will influence how your life insurance performs. The choices you make directly impact your policy’s tax status, how long it remains active and the amount of cash available for use.

Life insurance premiums are not tax deductible for most individuals and families. As of 2023, they are considered a personal expense by the IRS. Therefore, they do not qualify for a tax deduction.

If you make a large contribution to your life insurance all at once, it could cause your contract to become a modified endowment contract. This will affect how distributions from your life insurance are taxed. The IRS limits how much can be paid into life insurance. Always talk with a financial advisor and tax advisor about how to reach your goals with VUL.

You will choose how to allocate your life insurance’s cash value when applying for a VUL policy. You will likely have a spectrum of subaccounts to choose from—some riskier than others. Once a VUL contract is active, you may be able to revise your allocation choices. You may also be able to make occasional transfers between subaccounts.

Usually, you’re allowed at least a few transfers from the fixed account to the subaccount for free. It may be one per month. Additional transfers, past your contract’s limit, usually come with a fee. There may also be a minimum transfer amount.

Often, the investment funds available are overseen by the insurance provider’s own investment managers. These managers may oversee one or more of your investment subaccounts.

Choices for where to invest through VUL may include:

• Mutual funds (the most common type of VUL investment offering)
• Index funds
• Bond funds
• Money market funds

Fees and expenses vary by insurer. Always read your policy and investment prospectuses before signing up. Common fees and expenses include:

• Yearly contract fees.
• Ongoing contract charges.
• Administrative and operational expenses (including the cost to provide your life insurance).
• Investment management fees, including expense ratios.
• Charges for insurance riders (optional extra coverage for occurrences such as a terminal illness or the onset of a disability).
• Premium loading—an additional premium charged on top of your standard premium.

Variable universal life insurance is worth considering if it might support your financial goals. To learn what tools could support your financial strategy, we recommend evaluating your options. Compare types of life insurance against each other. Then compare investment vehicles. You’ll need to decide what’s right for you. You may also want to talk with a financial advisor to gain clarity on what’s available and how it could serve your personal priorities.

Two questions to ask yourself are: Are you a high-income earner or retiree with disposable income? If you answered “yes,” are you developing a complex financial strategy? Remember that many people looking to invest may see a similar or greater return from a retirement account that’s separate from their life insurance.

Before buying variable universal life insurance, it’s a good idea to ask questions. You’ll meet with a financial advisor or insurance broker to buy a VUL policy. Prepare for your meeting by writing down the following questions. They’re intended as a starting point. Feel free to add any others that come to mind.

• How will this policy help me meet my insurance needs?
• How will this policy help me meet my investment goals?
• How does it compare to other options?
• What will it cost including premiums, fees and expenses?
• How will it impact my taxes?
• What questions do I have about the prospectus and policy documents?

If you haven’t read your prospectus or policy documents yet, ask to have them printed or emailed to you. These are the documents that contain the details of your policy. Do not skip reading them—even when working with someone you trust. These contractual documents are specifically designed to eliminate misunderstandings about what’s included with your VUL insurance.

Ready to learn more about your life insurance options? Connect with a financial advisor near you.