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My Universal Life Insurance Might Be a Rip Off

03/04/2015 12:37 pm ET | Updated May 04, 2015

A much-discussed insurance product lately is the universal index life policy. This type is best for people who need the reassurance of a guaranteed return, and have no place left to shelter income. But high fees and caps on returns are downsides.

How it works: As with most life insurance policies, your premiums go to the insurance company, which then invests the money in bonds, stocks, funds or other investments. The company hopes to make enough from premiums and investments so that it can afford to pay out benefits when you die.

With a universal index policy, part of your premium is invested in a fund that is connected to a particular index -- the Standard & Poor's 500, in many cases. When that index does well, you earn more interest, which goes into your cash value fund; this is a cache you can tap while you are alive.

Many policies allow for a flexible premium, and you can choose to add more to help you build up your cash fund. If you skimp on premiums, the insurer will take the money out of the cash value. But, should the cash shrink too much, the company may cancel the policy.

Pros. One of the biggest advantages of universal index life is the potential for growth, while you receive protection from volatile markets. Most of these policies guarantee that you earn a certain amount of interest each year. This might be a very low number, such as one percent or two percent (or even a guarantee that it doesn't fall below zero). That means at least you don't lose money even when the index goes down,

Your cash value, depending on the state you live in, might enjoy tax advantages and creditor protection -- meaning, if you declare bankruptcy, the cash stash is off limits from debt repayment. Plus, your cash fund usually isn't subject to the same penalties and restrictions that come when you withdraw early from a tax-advantaged retirement account.

Cons. Most of these policies come with fairly high fees. The commissions are often front-loaded. The costs can eat up your returns, so it can take years before your cash fund sees significant growth. Later in life, your premiums might go up, and leave you without enough in your cash fund to keep the policy in force.

Additionally, most of these policies have caps on returns. Many insurance companies only credit a certain percentage of the increase in the market to you. This means that you don't end up growing your cash value as much when the index does really well. In some cases, you might be better off just investing in an index fund on your own, without doing it through an insurance policy.

Overall, I still can see a place where these types of policies make sense. For me, an index universal life policy is an option to defer some tax if you are not able to participate in a Roth individual retirement account -- if perhaps your income is too high. Like any other financial tool, understand its framework and pitfalls.

Jeff Rose, CFP, is the founder of Alliance Wealth Management in Carbondale, Ill., and also is the founder of the website Good Financial Cents and Life Insurance by Jeff.

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