Indexed universal life insurance (IUL) is a type of universal life insurance policy that allows you to grow cash while still leaving behind a death benefit for your loved ones. An IUL insurance policy offers permanent coverage, provided premiums continue to be paid. The death benefit is paid out to your named beneficiary or beneficiaries when you pass away. Because there is a cash value component tied to an index, the policy can increase in value during your lifetime.
IUL insurance is often pitched as a cash-value insurance policy that grows based on market gains, all tax-free. While IUL insurance may prove worthwhile to some, it’s important to understand how it works before buying a policy. This article will answer some common questions about IUL, give an in-depth explanation of the pros and cons, and compare IUL policies to other types of common life insurance policies.
What is indexed universal life insurance (IUL)?
An indexed universal life insurance policy is a type of life insurance policy that includes a feature to grow cash. Unlike other universal policies that raise cash value via non-equity earned rates, the money in an IUL account can earn interest based on a stock market index such as the S&P 500 or NASDAQ. The cash value of the policy rises or falls depending on the performance of the index chosen by the issuer of the IUL.
One favorable aspect of an IUL is that funds generally come with an interest rate guarantee. Similar to other universal life policies, once the cash value is high enough, you can use those earnings to lower, or potentially fully pay for your premium, without decreasing the death benefit.
IUL policies offer higher potential cash growth than other forms of life insurance, but they also come with higher risks and extra fees.
How does an IUL policy work?
As a type of permanent life insurance, indexed universal life insurance functions similarly to other universal life insurance policies. As long as premiums are being paid, you will continue to get coverage. There are a couple of distinguishing characteristics of an IUL compared to other life insurance products.
One main difference is the way an IUL builds cash value. IUL cash value can grow based on a stock index instead of through non-equity earned rates. The cash value portion of your policy earns interest based on the performance of a stock market index chosen by the issuer. For example, returns may be linked to the S&P 500 composite price index, which follows the gains or losses of the 500 largest U.S. companies according to market capitalization. As the selected index goes up or down, so does the rate of return on the cash value segment of your policy. There is even the potential of achieving a zero-cost policy by paying premiums with the cash value of the account.
An IUL also includes lifelong death benefit coverage (provided premiums are paid) that’s paid out to a named beneficiary (or beneficiaries) when the policyholder passes away. The IUL death benefit can be adjusted, depending on your policy, to be paid out to a different beneficiary, adding a layer of flexibility.
How is interest calculated for indexed universal life insurance?
As mentioned above, IUL policies can increase cash value by putting a portion of money toward an equity index account like the S&P 500 or NASDAQ. IUL does not have a fixed interest rate but does come with a rate guarantee. Here’s an explanation of those two aspects of the IUL interest rate.
No fixed interest rate
The cash value portion of the indexed account doesn’t earn a fixed interest rate. The insurer of the IUC policy specifies an index and then calculates an interest rate based on that index. This rate will vary based on index performance. (An index tracks the performance of a specific group of investments, such as stocks or bonds.) Credits are then added to the cash value account based on gains or losses of the selected index.
Interest rate guarantee
Policies typically include an interest rate guarantee. This means an IUL policy will continue to grow based on the set minimum interest rate even if the index produces lower returns. On the other side of the coin, interest rates are also subject to a rate cap or upper limit.
What are the pros and cons of an IUL insurance policy?
There are many benefits of an IUL policy, but there are also unfavorable aspects. Before purchasing an indexed universal life policy, make sure to fully understand how this type of policy works, the advantages, and the risks.
Advantages of indexed universal life insurance
As is the case with any kind of life insurance policy, thoroughly research potential firms to make sure you’re getting the right coverage for your financial situation. With that in mind, here’s a breakdown of the principal benefits of incorporating an IUL into your financial plan.
1. Potentially higher returns
These policies take advantage of share option gains to ride upside increases on equity indexes, without the risk of losses when the index goes down. The annual return that you receive with an IUL insurance policy will depend on the performance of the associated index. This aspect of an IUL policy gives it an edge over other policies with a low fixed interest rate.
IUL insurance offers a measure of flexibility. One aspect is allowing policyholders to decide how much risk they would like to take based on the index selection or rate cap. Another measure of flexibility comes with the death benefit. The death benefit amount, who the beneficiary is, and the number of beneficiaries can be adjusted. You can also add a number of policy riders to customize the policy to your individual needs. For example, many policies have a long-term care rider that covers nursing home costs or an accelerated death benefit rider. This allows you to access your policy’s death benefit before you die if you’re diagnosed with a qualifying terminal illness.
3. Capital gains are tax-free
The government generally requires you to pay capital gains tax when you sell an asset or an investment for profit. Unlike other types of financial accounts, Indexed universal life insurance policyholders do not pay capital gains tax on the increase in cash value of their policy. This benefit can include any loans that you may take from the cash value of your policy. Having a nontaxable source of cash to borrow against may appeal to you if you want to avoid penalties associated with an early withdrawal from a 401(k) or IRA account.
4. No impact on Social Security benefits
Social Security benefits are an important source of retirement income for many. Before reaching full retirement age, the government reduces benefits if you earn more income than what’s permitted. The cash value accumulation from an IUL policy does not count toward the earnings threshold, nor do any loan amounts that you borrow from your IUL. Therefore, you can take a loan against your policy, without reducing your Social Security benefit amount.
5. Lifetime death benefit
Like other types of life insurance, an IUL policy provides a death benefit for your loved ones. Death benefit funds can be used to pay for funeral and burial costs, outstanding debts such as a mortgage, fund college expenses for grandchildren, or simply to cover everyday living expenses. This death benefit from an IUL policy can be passed on to your beneficiaries tax-free.
Unfavorable aspects of indexed universal life insurance
Although there are many benefits to an IUL policy, there are also several drawbacks. For instance, if someone establishes the policy during a time when the market performs poorly, the premium payments being high may not contribute to the cash value. There is also the potential of the policy lapsing if payments aren’t made on time later in life. This could negate the point of purchasing life insurance altogether.
Here are a few other factors to consider:
1. Return caps
It’s important to understand the limitations of your potential IUL policy gains. Indexed universal life insurance policies have participation rates and caps. This may be as high as 100% or as low as 25%. The participation rate is the actual amount of index gains that your cash value can receive. For example, if the index goes up 20% and you have a participation rate of 50%, you’ll gain 10% in your cash account. Additionally, there’s usually a rate cap set, which is the maximum percentage you can gain no matter how well the index performs.
Owning an IUL policy doesn’t mean that your money is being invested in a particular index. The index is merely a barometer used to calculate interest for cash value gains. The calculation of your gains doesn’t include any dividends that you could have potentially earned if you had invested directly in the index. If you’re looking for higher potential gains, you may be better off investing in the stock market directly or considering a variable universal life insurance policy instead. That being said, your personal risk tolerance and investment objectives are important factors to consider when deciding which choice will be best for you.
2. No guarantees
Because IUL policies offer returns based on an index and have variable premiums over time, there are no guarantees in terms of gains. This requires budgeting for potentially higher premiums and riding out fluctuations in returns when the index is doing poorly.
IUL insurance policies generally come with a host of fees and other costs. Here are some examples of common IUL fees:
- Administrative expenses
- Premium expense charges
- Rider fees
- Surrender charge
The various fees and costs can negate the rate of return that comes with your policy. For example, the fees can threaten to drain your policy’s cash value when the associated index plunges. There’s also the risk of internal costs causing the policy account value to drop to the point that your policy becomes at risk of lapsing.
Here is a list of the benefits and drawbacks to consider.
- Provides higher returns than some other life insurance policies
- Policies can be designed according to your preferred risk level
- Tax-free capital gains
- No reduction of Social Security benefits
- Returns are capped
- Returns are not guaranteed
- Generally higher fees than other policies
What are the differences between indexed universal life insurance policies and other life insurance policies?
A unique aspect of an IUL policy is that the cash value account is tied to a stock market index. This means that returns may vary based on the performance of the specific index. Although the insurance company may offer a minimum guaranteed rate of return, there is also an upper limit rate cap.
How does IUL insurance stack up to other life insurance categories? The following comparison examples can help you to decide which type of insurance policy might be best for you.
Indexed universal life insurance vs. term life insurance
Term life insurance offers a simpler and more economical way to ensure your loved ones are financially protected if the policy is still active when you die. Term life insurance remains in effect for a set term, typically 10, 15, 20, or 30 years. IUL remains in effect your entire lifetime, provided you pay the premiums. With a term life policy, your beneficiaries can make a claim for your death benefit after you die. Because this plan is simpler than an IUL, there are no interest rates or higher premiums associated with the policy.
|Indexed universal life insurance||Term life insurance|
(provided premiums are paid)
|Interest on cash value||In line with current money market rates||No|
depending on the policy
Indexed universal life insurance vs. whole life insurance
If you’re looking for a lifelong insurance policy that’s less complex than an IUL policy, whole life insurance might be the option for you. Although potential gains can be less, whole life insurance also builds cash value. The cash value earned by a whole life insurance policy is based on a predetermined schedule. You don’t need to worry about the market index performance, and the premiums will likely be less costly with fewer fees. On the other hand, there is no flexibility to adjust premiums or achieve a paid-up policy like with an IUL.
|Indexed universal life insurance||Whole life insurance|
(provided premiums are paid)
|Interest on cash value||In line with current money market rates||N/A|
Indexed universal life insurance compared with other types of universal life insurance
Guaranteed universal life insurance (GUL)
GUL is typically the cheapest of the three universal life insurance types. Keep in mind GUL has little or no cash value. The basic goal of a GUL policy is to provide lifelong coverage, similar to a whole life policy. These no-lapse style policies promise to stay in force for life. There is a catch, though; if a payment is missed or late, the policy can still terminate.Since there’s usually no cash value account associated with a GUL policy, there’s no money to borrow from. Also, although IUL policies are riskier and have higher premiums/fees than GUL policies, an IUL policy’s cash value account gives it an edge over its GUL counterpart.
Variable universal life insurance (VUL)
Similar to IUL policies, VUL policies also allow you to vary premium payments and the death benefit amount within a predetermined limit. Different from an IUL, a VUL generally requires active management. The policyholder is the one who selects the sub-accounts associated with the cash value investment. This allows a VUL policy to offer the potential for better returns on your cash value (if you’ve invested wisely) while making it possible to maintain a level of control over your investments. That being said, your cash value could become depleted if investment choices bottom out. This makes a VUL policy riskier compared to an IUL policy.
|Guaranteed universal life||Indexed universal life||Variable universal life|
|Cash value||Potentially minimal cash value||Gains and losses tied to an index||Gains and losses tied to sub-accounts that can contain stocks and bonds|
|Ability to adjust premiums and death benefit||No||Yes||Yes|
|Limitation||Might lapse if you miss a payment||Rates are capped on market growth||If sub-accounts are not monitored, cash value can be lost|
Should I get an IUL insurance policy?
If you’re wondering whether an indexed universal life policy is right for you, it may be wise to speak with a financial advisor. An advisor can explain the unique aspects of the various IUL policies to determine if they will meet your financial objectives. Ask how the insurer will calculate your interest rate, your returns cap, and which fees will be charged to the account. You can also use our comparison tool to research on your own.
An IUL insurance policy can build cash value while still meeting your family’s need for financial protection. All in all, someone who wants the flexibility to make changes to their death benefit and premiums but who is comfortable with higher investment risks and fees may find an IUL policy is the right choice for them.
Is indexed universal life insurance better than a 401(k) plan?
One advantage of a 401(k) account is the option for greater investment possibilities. There is also an employer match option that comes with a 401(k) account which can increase your vested balance faster.
On the other hand, IUL policies come with more than just potential growth to cash value accounts associated with the policy. An IUL also comes with a death benefit, as well as potential riders that can be added to the policy based on your financial needs.
The downsides though of an IUL are generally higher premiums and fees, as well as the potential for the IUL policy to be canceled if the insured stops paying premiums. You’ll need to weigh the pros and cons of an IUL compared to a 401(k) in light of your individual financial needs and overall investment goals to determine which is the right choice for you personally.
Is indexed universal life insurance a good investment strategy?
While an indexed universal life insurance policy provides a death benefit that loved ones can use to care for expenses after you’re gone, it’s typically not the right investment approach for most. High premiums, fees, and capped interest rates significantly reduce the overall growth potential of an IUL cash account. While an IUL may be suitable in some situations, if you’re merely looking to invest money, there are definitely better investment strategies out there.
- Indexed universal life insurance policies (IUL) provide growth potential, flexibility, and tax-free gains.
- As long as premiums are paid, there is lifetime, permanent coverage.
- IUL policies include some disadvantages, such as caps on returns and no fixed premium amounts or market returns.
- An IUL policy coverage can lapse if you stop paying premiums.
- IUL policies work best for those with a large upfront investment who are seeking tax-free retirement options and who are looking for a policy that allows for potential growth without downside market risk.
View Article Sources
- Life Insurance – Center for Insurance Policy and Research
- How to choose the right type of life insurance – Insurance Information Institute
- Life Insurance Basics – Insurance Information Institute
- Insurance Information – National Association of Insurance Commissioners
- Life Insurance: Understand Your Choices – American Institute of CPAs
- Is It a Good Idea to Convert Your Term Life Insurance to Whole Life Insurance? – SuperMoney