What Is Indexed Universal Life Insurance (IUL)?
Indexed universal life (IUL) insurance policies can help you to build wealth while leaving behind a death benefit for your loved ones. These policies put a portion of the policyholder’s premium payments toward annual renewable term life insurance, with the remainder added to the cash value of the policy after fees are deducted. On a monthly or annual basis, the cash value is credited with interest based on increases in an equity index.
While IUL insurance may prove valuable to some, it’s important to understand how it works before purchasing a policy. There are several pros and cons in comparison to other forms of life insurance.
- Indexed universal life (IUL) insurance policies provide greater upside potential, flexibility, and tax-free gains.
- This type of life insurance offers permanent coverage as long as premiums are paid.
- Some of the drawbacks include caps on returns and no guarantees as to the premium amounts or market returns.
- An IUL policy may be canceled if you stop paying premiums.
- In general, these policies are best for those with a large up-front investment who are seeking options for a tax-free retirement.
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Understanding Indexed Universal Life Insurance
IUL insurance is often pitched as a cash value insurance policy that benefits from the market’s gains tax-free—without the risk of loss during a market downturn.
When you purchase an IUL insurance policy, you’re getting permanent coverage as long as premiums are paid. Your policy includes a death benefit, which is paid out to your named beneficiary or beneficiaries when you pass away. But the policy can also increase in value during your lifetime through a cash value component.
The cash value portion of your policy earns interest based on the performance of an underlying stock market index. For example, returns may be linked to Standard & Poor’s (S&P) 500 composite price index, which tracks the movements of the 500 largest U.S. companies by market capitalization. As the index moves up or down, so does the rate of return on the cash value component of your policy.
The insurance company that issues the policy may offer a minimum guaranteed rate of return. There may also be an upper limit or rate cap on returns.
IUL insurance is riskier than fixed universal life insurance policies, which offer a guaranteed rate of return. But it’s less risky than variable universal life insurance, which allows you to invest money directly in mutual funds or other securities.
You may be able to borrow against the cash value accrued in an indexed universal life insurance policy, but any loans outstanding when you pass away would be deducted from the death benefit.
Benefits of Indexed Universal Life Insurance
As is the case with any type of universal life insurance, it’s vital to thoroughly research any potential firms to ensure that they’re among the best universal life insurance companies currently operating. With that in mind, here’s a look at some of the chief advantages of including IUL in your financial plan.
1. Higher Return Potential
These policies leverage call options to gain upside exposure to equity indexes without the risk of losses, while whole life insurance policies and fixed universal life insurance policies provide only a small interest rate that may not even be guaranteed. Of course, the annual return that you see with an IUL insurance policy will depend on how well its underlying index performs. But your insurance company can still offer a guaranteed minimum return on your investment.
2. Greater Flexibility
IUL insurance can offer flexibility when putting together a policy that’s designed to meet your investment goals. Policyholders can decide how much risk they would like to take in the market, adjust death benefit amounts as needed, and choose among a number of riders that make the policy customizable to their needs. For example, you may choose to add on a long-term care rider to cover nursing home costs if that becomes necessary or an accelerated death benefit rider, which can pay out benefits if you become terminally ill.
3. Tax-Free Capital Gains
Capital gains tax applies when you sell an asset or investment for a profit. Indexed universal life insurance policyholders do not pay capital gains on the increase in cash value over time unless they abandon the policy before it matures, whereas other types of financial accounts may tax capital gains upon withdrawal. This benefit extends to any loans that you may take from the policy against your cash value. Having a ready source of cash that you can borrow against may be appealing if you want to avoid triggering taxes and penalties with an early withdrawal from a 401(k) or IRA.
Unlike a 401(k) or traditional IRA, there are no required minimum distributions for cash value accumulation in an indexed universal life insurance policy.
4. No Social Security Impact
Social Security benefits may be an important source of income in retirement. You can begin taking Social Security as early as age 62 or defer benefits up to age 70. Taking benefits ahead of your full retirement age can shrink your benefit amount, as can working while receiving benefits. You’re only allowed to earn so much per year prior to reaching full retirement age before your benefits are reduced.
Cash value accumulation from an IUL insurance policy wouldn’t count toward the earnings thresholds, nor would any loan amounts that you borrow. So you could take a loan against your policy to supplement Social Security benefits without detracting from your benefit amount.
5. Death Benefit
IUL insurance, like other types of life insurance, can provide a death benefit for your loved ones. This money can be used to pay funeral and burial expenses, cover outstanding debts such as a mortgage or co-signed student loans, fund college costs for children, or simply pay for everyday living expenses. This death benefit can be passed on to your beneficiaries tax-free.
Financial experts often advise having life insurance coverage that’s equivalent to 10 to 15 times your annual income.
Drawbacks of Indexed Universal Life Insurance
There are several drawbacks associated with IUL insurance policies that critics are quick to point out. For instance, someone who establishes the policy over a time when the market is performing poorly could end up with high premium payments that don’t contribute at all to the cash value. The policy could then potentially lapse if the premium payments aren’t made on time later in life, which could negate the point of life insurance altogether.
Aside from that, keep in mind the following other considerations:
1. Caps on Returns
Insurance companies often set maximum participation rates of less than 100% and as low as 25% in some cases. In addition, returns on equity indexes are often capped at certain amounts during good years. These restrictions can limit the actual rate of return that’s credited toward your account each year, regardless of how well the policy’s underlying index performs.
In that case, you may be better off investing in the market directly or considering a variable universal life insurance policy instead. But it’s important to consider your personal risk tolerance and investment goals to ensure that either one aligns with your overall strategy.
2. No Guarantees
Whole life insurance policies often include a guaranteed interest rate with predictable premium amounts throughout the life of the policy. IUL policies, on the other hand, offer returns based on an index and have variable premiums over time. This means that you have to be comfortable riding out fluctuations in returns while also budgeting for potentially higher premiums.
IUL insurance policies can come with a slew of fees and other costs, including:
- Premium expense charges
- Administrative expenses
- Fees and commissions
- Surrender charge
All of these fees and various costs can detract from the rate of return offered by your policy. That’s why it’s important to research the best life insurance companies so you understand what you’re paying for in coverage and getting in return.
Indexed Universal Life Insurance Pros and Cons
Provide higher returns than other life insurance policies.
Policies can be designed around your risk appetite.
Allows tax-free capital gains.
IUL does not reduce social security benefits.
Returns are capped at a certain level.
No guaranteed returns.
IUL may have higher fees than other policies.
Indexed Universal Life Insurance vs. Other Life Insurance Policies
Unlike other types of life insurance, the value of an IUL policy is tied to an index tied to the stock market. This means that the returns may vary, depending on the performance of the underlying index.
There are many other types of life insurance policies, explained below.
- Term life insurance offers a fixed benefit if the policyholder dies within a set period of time, usually between 10 and 30 years. This is one of the most affordable types of life insurance, as well as the simplest, though there's no cash value accumulation.
- Whole life insurance is more permanent, and the policy lasts for the entire life of the policyholder as long as premiums are paid. The policy gains value according to a fixed schedule, and there are fewer fees than an IUL policy. However, they do not come with the flexibility of adjusting premiums.
- Variable life insurance comes with even more flexibility than IUL insurance, meaning that it is also more complicated. A variable policy's cash value may depend on the performance of specific stocks or other securities, and your premium can also change. For this reason, variable life insurance is considered riskier than other life insurance policies.
Is Indexed Universal Life Insurance (IUL) a Good Investment?
While an indexed universal life insurance policy can provide a good way to provide for your loved ones, it's typically not an appropriate investment strategy for most people. High premiums and additional fees mean that an indexed policy may be hard to maintain over the long term, and you may lose the money already spent if your policy lapses. While this may be suitable for some people, others may be better off with stocks or bonds.
How Does an Indexed Universal Life Insurance (IUL) Policy Work?
An indexed universal life insurance policy includes a death benefit, as well as a component that is tied to a stock market index. The cash value of the policy rises or falls, depending on the performance of that index. These policies offer higher potential returns than other forms of life insurance, as well as higher risks and additional fees.
Is Indexed Universal Life Insurance Better Than a 401(k) Plan?
Indexed universal life insurance and 401(k) plans all have their own advantages. A 401(k) has more investment options to choose from and may come with an employer match. However, an IUL comes with a death benefit and an additional cash value that the policyholder can borrow against. However, they also come with high premiums and fees, and unlike a 401(k), they can be canceled if the insured stops paying into them.
The Bottom Line
IUL insurance can help you meet your family’s needs for financial protection while also building cash value. However, these policies can be more complex compared to other types of life insurance, and they aren’t necessarily right for every investor. Talking to an experienced life insurance agent or broker can help you decide if indexed universal life insurance is a good fit for you.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a financial professional to determine a suitable retirement savings, tax, and investment strategy.