Indexed universal life (IUL) insurance policies put a portion of the policyholder’s premium payments toward annual renewable term 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. The gains are applied based on a participation rate that’s set by the insurance company, which can be anywhere from 25% to more than 100%.

Key Takeaways

  • Indexed universal life policies provide greater upside potential, flexibility, and tax-free gains.
  • Drawbacks include that there are caps on returns and no guarantees as to the premium amounts or market returns.
  • In general, these policies are best for those with a large upfront investment who are seeking options for a tax-free retirement.

Indexed Universal Life Insurance: How It's Marketed

Indexed universal life 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.

The typical marketing material for an IUL policy can also be instructive. For example, according to Voya Financial:

Indexed universal life insurance provides death benefit protection and the opportunity to build money inside your policy, called cash value, based in part on the increases of market indexes. Even if these indexes dip, you’re still safe with a guaranteed minimum interest rate.

By comparison, AXA puts it this way:

Indexed universal life insurance combines life insurance protection with equity-linked accumulation potential. It has some of the same features as universal life, like premium flexibility, and offers more growth potential, but with potentially less risk than variable universal life insurance.

But while the sales pitch certainly sounds compelling on the surface, critics warn that market returns are far from guaranteed and the term nature of the insurance could make it expensive to maintain the policy later in life when premiums tend to rise sharply.

These policies are generally best for those with a large upfront investment who are planning for tax-free retirement.

Pros of Indexed Universal Life Insurance

1. Higher Return Potential

These policies leverage call options to gain upside exposure to equity indexes without the risk of losses, while whole life policies provide only a small interest rate that may not even be guaranteed.

2. Greater Flexibility

Policyholders can decide how much risk they’d 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.

3. Tax-Free Capital Gains

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.

Cons of Indexed Universal Life Insurance

There are several gotchas associated with indexed universal life 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.

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.

2. No Guarantees

Whole life policies often include a guaranteed interest rate with predictable premium amounts throughout the life of the policy. IUL policies, on the other hand, have variable returns based on an index and have variable premiums over time.