What is indexed universal life insurance (IUL)?
Key points
- Indexed universal life insurance (IUL) is a type of permanent life insurance that includes a death benefit and a cash value account whose growth is tied to a particular index, often with a minimum guaranteed interest rate.
- IUL policies offer flexibility, allowing adjustments to premiums and death benefits (within limits), and provide access to cash value through loans or withdrawals, though these can reduce benefits or risk policy lapse.
- Potential benefits include cash value growth with downside protection, tax‑deferred growth, and an income tax‑free death benefit, but returns may be limited by caps and participation rates.
Indexed universal life insurance is a type of permanent life insurance, which means it has a cash value component in addition to a death benefit. The money in your cash value account can earn interest based on a market index chosen by your insurer, such as the S&P 500 or the NASDAQ Composite. Funds allocated to the index account don't earn a fixed rate of interest but instead earn a rate tied to the index, as well as IUL's often include an interest rate guarantee and a fixed account.
What are the key features of indexed universal life insurance?
There are several other features of indexed universal life insurance, such as:
- Interest rate guarantee
- Adjustable death benefit¹
- Flexible premium
- Access to cash value²
Does indexed universal life insurance have a 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. 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. 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. The life insurance company then credits that interest to your cash value account. Some indices do have a fixed account and guaranteed rate, regardless of how the index performs.
Is there an interest rate guarantee?
Policies typically have a minimum cap rate, but most policies do not offer a minimum rate guarantee.
Can you adjust premium payments (within limits)¹?
One of the key benefits of an IUL policy is flexible premium payments. While your policy may include a planned premium, you can often adjust how much and how frequently you pay including the option to pay more, less, or even skip payments. To keep your policy in force, you’ll need to maintain enough cash value to cover the cost of insurance and policy charges.
Is the death benefit¹ adjustable?
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.
Can I access 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. IUL isn’t designed for cash access until the policy has been in force for many years, typically at least 15.
How does IUL insurance work?
When you pay your premium, a portion goes toward the cost of insurance and policy fees. The remainder goes into your policy’s cash value, which can grow over time based on market performance. This cash value helps support the death benefit your loved ones receive.
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 should check your annual statement to ensure you policy is working as designed.
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.
What are the benefits of IUL insurance?
Indexed universal life insurance is a complex 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 cash value grows tax deferred over time while in the contract.
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. 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. 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.
Tax-exempt capital returns
Earnings become subject to taxation only in the event of a policy lapsing before your passing. 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.
What are the drawbacks of IUL insurance?
Limits on percentage gains
Cash value accumulation may be limited by rate caps. 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. 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. In which case your premiums would go up just to keep your policy active. This may be particularly 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 life insurance first, whereas IRA is designed for retirement savings first. IUL may also grow slower than IRA’s due to their caps. 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. Brokers and certain financial advisors are required to 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). 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.
Who is indexed universal life insurance right for?
Permanent life insurance may be a good option if you need lifelong coverage and want to build your cash account over the long term.
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.
What about taxes?
Your beneficiaries likely won’t have to pay estate or income taxes on a payout, 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. 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.
How does IUL compare to other types of life insurance?
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.
What’s the difference between IUL and whole life insurance?
IUL has premium flexibility but whole life insurance is a fixed payment schedule. 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. The cash value of whole life insurance, however, has a fixed growth rate, whereas IUL’s cash value component is tied to the performance of the market index and therefore doesn’t have a fixed rate of growth.
What’s the difference between IUL and term life insurance?
Unlike IUL, term life is not a permanent life insurance policy. Nor does it have a cash value component. Term life insurance policies typically cover you for no more than 40 years, and beneficiaries are only paid if you die before the policy ends. For example, term life insurance is often a lot more affordable and suitable for parents, so they can provide financial coverage for their children.
What’s the difference between IUL and variable life insurance?
Similar to IUL, variable life insurance is a type of permanent coverage that features a cash value component.
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.