J. Brendan Ryan
Enquirer contributor

If you own a universal-life policy, you need to be careful that you do not inadvertently create a problem for yourself.

Do not misunderstand; I think that UL is the best invention since the internal-combustion engine and the flush toilet. But you need to deal with it the right way, or else it may back you into an expensive corner.

I have warned in earlier columns that one should watch the annual reports to be sure that the cash value does not start to shrink. Shrinkage results when outflow (the internal charges) in a given year exceeds inflow (the sum of the interest credited plus the premium paid). A little shrinkage does not do much harm.

But, if it goes on year after year, you may be forced to increase your payments dramatically or else the policy will lapse. And if it lapses, you lose the protection and, if you have borrowed heavily against the policy, have to pay some income tax.

Other dangers lurk, too.

In the early 1980s, soon after universal-life was made available with all its flexibility and tax advantages, interest rates spiked, approaching 20 percent. People flush with cash saw the opportunity to take advantage of the tax law by juicing the policy with a lot of cash while building in little insurance.

Congress, seeing this abuse of the tax benefits of life insurance, now limits the amount of money one can put into a policy of a given size. Two tests are allowed, the guideline premium test and the cash value accumulation test. Though either test can be used in constructing a policy, the premium test is the one typically used by insurers. Once the policy is issued, the choice of tests is irrevocable.

The premium test puts a strict limit on how much one can pay into a given policy and how quickly it can be paid in.

The premium test can create a problem when a person builds up a reasonably strong cash value and then borrows or withdraws a large portion of it. Depending upon how the owner handles the policy after that, he or she may not be allowed under tax law to pay enough to keep the policy going.

For a long time few advisers, if any, knew of this possible outcome (including me). Most insurance companies did not even know it. So no one could project this untoward outcome.

Even when this problem arises, there is a safety provision that allows the owner to pay an amount not to exceed that year's internal charges drawn from the policy. But, no cash value can be built up in this way, and it is the cash value that makes the policy affordable in the later years. Under this safety provision you simply have what amounts to a very expensive term-insurance policy with horrendous, annually increasing future premiums. So, eventually you will probably drop the coverage.

On the other hand, the accumulation test, if used by the insurer when issuing the policy, limits not the amount of deposits but rather the amount of cash that the policy can hold.

One should choose this test in two circumstances:

• When the new policy will receive a large transfer of cash from an existing policy in a tax-free exchange.

• When a large withdrawal is planned down the road.

In this latter case the premium test would likely force taxable income to be distributed to the owner, as discussed above. The accumulation test avoids that.

But overall the accumulation test tends to be more expensive and thus less preferable.

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J. Brendan Ryan is a Cincinnati insurance agent. His column appears every other Saturday. Contact him at 2212 Victory Parkway, Cincinnati 45206; 221-1454; fax 221-3447; or e-mail ryanatpineridge@aol.com