Thinking twice about variable universal life
These insurance-investment combos sound good. But with their fees and other complications, you should proceed with caution.
NEW YORK (Money) -- QUESTION: I'm single, in my 30s and I'm already maxing out my 401(k) and IRA account. My financial planner is recommending I purchase a variable universal life policy, the rationale being that I have exhausted all of my other tax-advantaged investment opportunities. I trust my adviser, but I don't understand whether a variable universal life policy is really a good deal. What do you think? George K., Hartford, Conn.
RESPONSE: I have no problem with using life insurance as a tool for protecting the financial security of one's family - specifically, to replace the income of a breadwinner who dies. (Clearly, that's not much of a reason for you to buy insurance now since you're single and have no dependents.)
I'm very skeptical, however, about pitches that portray life insurance as a souped-up tax-advantaged investment and retirement account.
Using insurance policies, and particularly variable universal life policies, primarily as tax-sheltered investments can get quite complicated and involve risks that many people don't understand. And these policies usually come laden with fees that make them quite expensive ways to invest.
So at the very least I think you should proceed with extreme caution.
Basically, a variable universal life policy is one that allows you to buy life insurance coverage while simultaneously investing in stock and bond portfolios that are much like mutual funds. Part of the premium you pay goes to buy what is essentially term insurance, while the rest goes into the "cash value" portion of the policy that consists of the mutual fund-like investment accounts.
The big advantage to doing your investing within an insurance policy is that any gains in your "cash value" or investment accounts aren't taxed as long as they remain within the policy. The trick, though, is getting those gains out of the policy. If you simply withdraw them, you will owe tax at ordinary income rates, which can go as high as 35 percent. That's not much of a deal when long-term capital gains you earn outside an insurance policy are taxed at long-term capital gains rates that max out at 15 percent.
But the people peddling these policies will usually point out that there's a way to get at your money without paying taxes. Specifically, they'll note that if you borrow the money from the policy - typically through a low-interest rate loan -instead of simply withdrawing it, the money you receive is considered the proceeds of a loan, and thus not taxable.
Voila! You now have tax-free returns.
So what, possibly, could be wrong with such a sunny scenario?
Well, for one thing, these policies are usually larded with fees that can drag down the return you eventually earn. Many charge upfront sales "loads" or commissions that can range from 5% to nearly 10% of what you put into the policy.
The investment options in the policy also charge annual management fees. No surprise there; so do mutual funds. But unlike mutual funds the investment portfolios in the policy have another layer of insurance fees that can run almost as high as 1 percent per year in the initial years of the policy. The result is that you could end up paying upwards of 2 percent a year in annual costs (that's on top of the sales commission).
And let's not forget that you're also buying insurance protection. Again, no surprise since this is an insurance policy, after all. The rate you pay, however, can be much, much higher than you would pay for a comparable amount of coverage on a basic term policy.
When you combine all these fees, it's not uncommon to find that it can easily take five or more years before your cash value - what you would receive if you cashed out the policy - exceeds the premiums you've paid in. And even if you hold the policy for many, many years, those fees are dragging down your returns.
Of course, the sales person will point out that by borrowing against the policy you sidestep taxes. Which means you're dramatically raising your after-tax rate of return. There's one complication, though. Once you start borrowing against the policy, you've got to keep paying premiums to keep the policy in force. If you let it lapse, you could be in for a horrendous tax nightmare.
So, for example, if you've pulled a hundred grand or more out of the policy during retirement and suddenly find yourself at age 75 or 80 unable to pay the annual premium, the policy could lapse and all the investment earnings you borrowed from the policy over the years would be taxed at ordinary income rates.
In short, you could face one huge tax bill at a time when you're probably least able to handle it.
Given the expenses, the complications and the potential tax headache late in retirement, I'm not a big fan of using variable universal life (or any other type of insurance policy, for that matter) as an investment vehicle to save for retirement.
True, you'll eventually have to pay taxes on any gains in these investments. But if you hold for the long-term, you can postpone most of the tax bill until you sell, at which time most, if not nearly all, of your gains will be taxed at attractive long-term capital gains rates.
And best of all, you won't have to worry about the possibility of being hit with a mammoth tax bill that could make your golden years quite grim.