Indexed Universal Life Insurance: Definition, Pros + Cons

Updated

Indexed universal life (IUL) insurance is one of the lesser-known types of life insurance. It doesn’t appeal to many investors, whether they’re more aggressive or conservative. And it often gets confused with regular universal life insurance.

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But IUL has its place for many people who want to combine their life insurance with potential stock market rewards without much risk. 

When considering end-of-life planning, your life insurance plan is an important factor. A universal life insurance policy is a valuable option if you want to pay for your funeral with life insurance and provide financial security for years to come. This article will discuss universal life insurance and what it might look like for you.

What Is Indexed Universal Life Insurance?

Indexed universal life insurance is a form of permanent life insurance. It combines the features of a death benefit for your survivors with a way to accumulate money you can use while living. 

IUL is permanent life insurance

IUL isn’t term life insurance; it’s permanent life insurance. Understanding the difference will help you better understand IUL and life insurance in general.

Term life insurance is like renting as opposed to owning. With term life, you’re only covered by the policy for a specified time period. If you die during that period, your beneficiaries receive a payout from the life insurance company. If you don’t die during that period, the policy expires, and the life insurance company keeps all of the premium payments you’ve made.

Permanent life insurance is like owning your life insurance policy. You’ll have it for your entire life as long as you keep your premium payments current. The most well-known type of permanent life insurance is whole life, but indexed universal life insurance also falls into this category. 

Permanent life insurance not only provides a death benefit to your survivors; it also accumulates cash as the policy’s “cash value.” 

IUL vs. other universal life insurance

Indexed universal life insurance is just one of three types of universal life. The other two are basic universal life insurance and variable universal life insurance. 

Let’s look at how they’re similar and how they differ from each other.

Universal life insurance is permanent life insurance. It pays a death benefit and accumulates cash value. The death benefit is paid to the person you name as the beneficiary in your policy. It’s generally paid to them in a lump sum, and they receive it tax-free.

The cash value is a savings feature of the policy. A portion of every dollar you pay in premiums is deducted for the cost of administration and the life insurance component. The other part goes into the cash value of the policy and accumulates over time. It grows because the insurance company pays you interest on it.

The interest rate is primarily dependent on overall market interest rates, but it has a minimum guaranteed interest rate.

Variable universal life insurance is also permanent life insurance and has the same two components: a death benefit and cash value. The difference between VUL and UL is that VUL’s cash value growth depends on the performance of certain mutual funds, which you select. There are many to choose from, and if the ones you choose perform well, your cash value will typically grow much faster than it would for a UL policy.

However, if your mutual funds don’t fare well, then your cash value can lose value, even to the point where it loses all value, and you have to pay more money into the policy to keep it active.

Indexed universal life insurance falls in between UL and VUL. The cash value portion of an IUL policy is also tied to the market, but not any specific mutual funds. Instead, it’s affected by the overall market’s performance, such as the S&P 500. 

The big difference between VUL and IUL is that IUL has a minimum guaranteed interest rate, meaning you can never lose cash value inside the policy like you can with a VUL policy. You can benefit from market gains but be protected against market losses. 

However, there’s a slight catch. While your interest rate on your IUL policy can never drop below a certain level, it also can’t rise above a certain level because the interest rate is capped. For example, your IUL policy may state that the interest rate credited to your cash value can never drop below 3% but can never rise above 10%. 

Who Typically Buys Indexed Universal Life Insurance?

The typical buyer of IUL is someone who is motivated to buy life insurance protection and wants to grow cash value so they can access that money while they’re alive in the form of loans or withdrawals. They use the cash value for a variety of reasons:

  • Pay off a mortgage
  • Pay for children’s education
  • Provide another source of retirement income
  • Pay for medical expenses
  • Pay for long-term care

The policy owner can use the policy’s cash value in any manner they see fit. If they borrow cash value from the policy, the outstanding loan balance is deducted from the face amount of the policy when they die.

For example: Marvin took out a $100,000 IUL policy. Five years later, he borrowed $5,000 from the cash value and died one year later with an outstanding loan balance of $3,000. The outstanding loan balance was subtracted from the policy's face amount, so the total death benefit paid out to Marvin’s beneficiaries was $97,000.

The typical IUL buyer understands the stock market and knows that there is risk involved. But they are willing to take on that risk because of the guaranteed minimum interest rate paid by the insurer and the fact that, as the buyer, they can never lose their cash value.

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How Much Does Indexed Universal Life Cost?

The cost of IUL falls in between that of term life insurance and whole life insurance. For example, the cost of a $100,000 life insurance policy for a 35-year-old female could look like this:

  • Term life insurance: $32 per month
  • Indexed universal life insurance: $68 per month
  • Whole life insurance: $109 per month

A significant advantage of any type of universal life insurance policy, including IUL, is that the premium can be paid by the policy’s cash value for as long as there is enough money in the account to make those premium payments. 

If the cash value of any type of universal life policy is no longer sufficient to make the premium payments, the policy owner would need to resume paying the premiums until the cash value increases.

What Are the Pros and Cons of Indexed Universal Life Insurance?

Like any financial product, indexed universal life insurance has its benefits and its drawbacks. Here are the pros and cons of IUL.

Pros

There are many benefits for owners of IUL policies. They include:

Unlimited contributions: Traditional retirement accounts like 401(k)s and IRAs have annual contribution limits which can’t be exceeded. An IUL has no such limitations; you can put as much money into the policy as you’d like. 

Tax-free growth and distribution: As the money in the cash value grows each year, no taxes are owed on that growth. And when any amount of cash value gain is borrowed, there are again no taxes owed. 

Use the cash value at any time: Traditional retirement programs won’t let you take money out of the plan without paying a penalty if you’re younger than age 59½. That penalty is in addition to any taxes you would have to pay on the plan's investment gains.

With an IUL policy, you can take out money at any time with no taxes or penalties due, no matter what age you are, similar to a Roth IRA. However, with a Roth IRA, you have to wait until age 59½, or the IRS will penalize you 10% of the amount you withdraw.

Death benefit: The death benefit is tax-free when paid to your beneficiaries. No income tax or estate tax is due on life insurance proceeds.

Loan availability: You can borrow cash value from the policy without penalties, taxes, or credit checks. And, you don’t have to re-pay the loan; it can be deducted from the face amount if you die with an outstanding loan balance.

Cons

Like any type of life insurance policy, there are some drawbacks to IUL:

Earnings caps: Even though the stock market may have had a record year, with IUL, there is a limit on how high the interest rate applied to the cash value can be. Your money earns less than it would have if you were invested directly in the market. Also, the insurance company can change the maximum rate at their discretion.

Taxable income: If the policy is surrendered or lapses, there can be taxes that need to be paid by the policy owner.

As you can see, there seem to be many more advantages than disadvantages with IUL. But still, there are other options to consider.

If Indexed Universal Life Insurance Isn’t a Good Fit, What Are Good Alternatives?

Many of today’s financial gurus believe that everyone should buy term life insurance and invest the difference. They cite that the policy and administrative fees and costs are excessive with permanent life insurance, and people can have their money grow much faster in a retirement or investment account, like a 401(k) or IRA, where there is no limit or cap on the interest rate of the money in the account.

If access to your cash is important to you, permanent life insurance policies like IUL won’t have very much cash value built up during the policy's first five years or so. Investment accounts, like mutual funds, are much easier to get money out of; your entire account balance is always available to you.

Be Sure to Look at IUL When You Buy Life Insurance

It takes some time and effort to find a life insurance policy that’s a good fit for you and your family. When you talk with a life insurance agent or look online, be sure to take a look at IUL as you compare policies. The tax advantages and unlimited contributions make it a nice supplement to any retirement plans you might have maxed out.

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