What is indexed universal life insurance (IUL)?

There are several other features of indexed universal life insurance, according to the American Institute of Certified Public Accountants (AICPA), such as:

• No fixed interest rate
• Interest rate guarantee
• Adjustable death benefit¹
• Access to cash value²

No fixed interest rate

When you purchase indexed universal life insurance, funds in your cash value indexed account don't earn a fixed rate of interest, explains the National Association of Insurance Commissioners (NAIC). Instead, your rate of interest is based on a selected index. This differs from a universal life insurance policy, which earns interest similar to that of a money market account, says the Insurance Information Institute (III). According to the Securities and Exchange Commission (SEC), an index tracks the performance of a specific basket of investments, such as stocks or bonds. Your insurer should provide you with a list of indices to choose from, then calculate an interest rate based on the performance of that index, says the NAIC. The life insurance company then credits that interest to your cash value account. Some indices do have a guaranteed rate, regardless of how the index performs.

Interest rate guarantee

The NAIC also says that policies typically include an interest rate guarantee, so a minimum interest rate is paid even if the index produces lower returns. However, interest rates are usually also subject to a "cap" or upper limit.

Adjustable premium payments (within limits)¹

Your policy will likely specify a planned premium for you. However, if you have enough money in your cash value account, you may be able to use those funds to help pay your premiums.

Adjustable death benefit¹

Death benefits are typically flexible with an indexed universal life policy, and you can usually lower them at any time. However, increasing the death benefit may require you to pass a medical examination.

Access to cash value²

In case of emergency, you may be able to borrow from your indexed universal life insurance policy, although you will likely be charged interest for doing so. You may also be able to make withdrawals from your cash value account. However, doing so may permanently reduce your death benefit. If you don't maintain a large enough balance in your cash value account, withdrawals may also risk causing your policy to lapse.

When you pay for permanent life insurance, some of the money goes to the amount of money your loved ones get when you die, explains Forbes. Some also pays for managing your insurance and the cost of keeping you insured. The rest goes into a savings account that builds up over time (the cash value).

How can I find out my cash value?

There are a few ways you can typically find the cash value of your IUL. You can reach out to your insurer directly or access your account online – many insurance companies allow policyholders to manage their policies via an online portal. You can also check your policy documents and policy statements for information regarding your cash value.

To give you an idea of how cash value works, here’s an example.

So, let's say you have an IUL policy where you pay $100 each month. Out of this $100, $20 may go toward covering the life insurance part, $10 may cover administrative costs and $70 may be put into your cash value account.

After a year, your $70 has grown by 8%, becoming $75.60. And the next year, if the index grows again by 8%, your new balance would be $81.65.

This process continues over the years, and your cash value keeps growing based on the performance of the index. So, if you need money later on, you can withdraw a portion of this cash value. And if something happens to you, your beneficiaries may receive the life insurance benefit, which is separate from the cash value.

Indexed universal life insurance is a complex type of type of life insurance that can come with unique benefits that differ from other life policies and traditional savings accounts. Here are a few of them.

Cash value accumulation

As we’ve mentioned, a portion of the premium you pay goes into a cash value account that you can use later on, like a savings account that grows over time.

Increased potential for returns

An IUL policy’s cash value may be less risky than a traditional savings account, like a 401(k) or IRA in a volatile market, according to Forbes. Policyholders are safeguarded by something called "the floor," typically set at 0%. This means that even if the market drops to -30%, your IUL won’t lose any value but instead will be credited with 0% for that period.

Flexibility

You can adjust your premiums and coverage as your needs change (within the parameters of your policy), giving you more control over your own policy, CNN explains. But that’s not at all. Depending on your specific policy, you may be able to skip premiums and even adjust the benefit and certain cases, adds MarketWatch.

Tax-exempt capital returns

Earnings become subject to taxation only in the event of a policy lapsing before your passing, according to CNN. The money you get from your policy typically isn't taxed, which means more money for you and your loved ones.

Death benefit

If something happens to you, your loved ones get a lump sum of money, called the death benefit, which is generally income tax free and can help them financially.

Limits on percentage gains

Cash value accumulation may be limited by rate caps, says Forbes. Additionally, some insurers, for instance, may set what is called a “participation rate,” which limits how much cash value return you get from the growth of an index.

Growth doesn’t include stock dividends

Stock dividends are the portion of profits companies pay to shareholders, says Time Magazine. An IUL insurance provider may buy stock options in an index but doesn’t invest in stocks directly.

Risk of lapsing coverage

If your cash value is drained too much, your policy runs the risk of lapsing, warns Forbes. In which case your premiums would go up just to keep your policy active. This may be particular risky in volatile markets, and if the policy is underfunded, policyholders may be required to contribute more money into their accounts.

May not be a good retirement investment

Compared to a traditional retirement account, like a Roth IRA, IUL insurance is can be complex and have high costs that may not be budget-friendly, depending on your financial situation, says the L.A. Times. All of the money in a Roth IRA would go toward retirement – simple and zero risk. Money in an IUL, however, is split between paying the premium and covering administrative fees, plus being tied up in the cash value account.

Shaky government regulations

The U.S. Securities and Exchange Commission (SEC) regulates things like stocks and options. They don’t, however, regulate IULs, according to Forbes. Brokers and certain financial advisors are required to go pass licensing exams to sell securities or derivative products.

Expensive costs

IUL policies, like others permanent life policies, can be expensive (especially if you are in poor health or advanced age), according to Bankrate. They provide not only a death benefit and also a savings account, which requires insurance companies to calculate premiums around the insurance policy and its investment vehicle.

Permanent life insurance may be a good option if you need lifelong coverage and want to build your cash account over the long term, suggests the III.

The NAIC points to the fact that indexed universal life insurance offers both potential for growth based on the market, as well as protection from losing value if the market falls. If these features are appealing, you might consider indexed universal life insurance. Your insurer can help you make an informed decision about whether indexed universal life insurance is right for you.

Your beneficiaries likely won’t have to pay estate or income taxes on a payout, explains MarketWatch, but there may be instances where it is taxable. Interest may accumulate on payout installments, which might be taxed. A policy that lapses before repaying a loan you took out may also be taxed.

In certain types of life insurance, like whole life, universal life and others, the money you earn from your policy grows without being taxed right away, MarketWatch adds. This is called tax-deferred growth. It means you don't pay taxes on the money you make from the policy until you take it out. It lets you build up savings without worrying about taxes. It's especially good if you're in a higher tax bracket because you could avoid paying a lot of taxes on your earnings.

There are multiple types of life insurance and each may differ in multiple ways as far as policy terms, payouts, coverage specifics and the cash value (or lack thereof) go. Here we’ll compare and contrast IUL insurance with other common types of life insurance policies.

IUL vs whole life insurance

Both IUL and whole life insurance are types of permanent life insurance policies that guarantee beneficiary payouts provided policy terms are met, and both have a cash value component, according to Bankrate. The cash value of whole life insurance, however, has a fixed growth rate, says Forbes, whereas IUL’s cash value component is tied to the performance of the stock market and therefore doesn’t have a fixed rate of growth.

IUL vs term life insurance

Unlike IUL, term life is not a permanent life insurance policy, according to Bankrate. Nor does it have a cash value component. Term life insurance policies typically cover you for no more than 30 years, and beneficiaries are only paid if you die before the policy ends. For example, term life insurance is often suitable for parents, so they can provide financial coverage for their children.

IUL vs variable life insurance

Similar to IUL, variable life insurance is a type of permanent coverage that features a cash value component, according to U.S. News.

In a variable life insurance policy, the cash value can change based on how well certain investments do, like stocks or bonds. So, if the investments do well, the cash value can go up, but if they do poorly, it can go down. This means the cash value isn't guaranteed. IUL policies often have a floor to guard against bad returns.

As mentioned previously, in an IUL policy, the cash value is linked to a specific index, like the S&P 500. If the index goes up, the cash value grows, but if it goes down, the cash value might stay the same or not grow as much. There's usually a minimum guaranteed interest rate, so the cash value won't go below that.

While IUL insurance has benefits like potential for higher returns and flexibility, it also has drawbacks like limits on gains and costs. It's important to understand how IUL works and compare it with other types of life insurance before deciding if it's right for you. If you're unsure, talking to an insurer or financial representative can help you make an informed decision.