Indexed universal life insurance is a mouthful to say, which is why it’s frequently referred to simply as an “IUL” policy.
But behind the technical name of the policy is a life insurance plan that provides a wide range of flexibility not offered with other life insurance policy types.
During the course of the policy, it’s possible to change the premiums you pay, the face value of the death benefit, and even the amount of the cash value that accumulates in the policy.
Indexed universal life insurance isn’t the right policy choice for all consumers, or even most. But, if you’re looking for the specific qualities offered by this type of life insurance policy, it can be a perfect addition to your overall financial situation.
That’s because, in addition to the flexibility it offers, it also comes with both the death benefit and a cash value accumulation feature.
Think of it as a whole life insurance policy with flexible terms.
What is Indexed Universal Life Insurance?
IUL insurance looks a whole lot like a whole life insurance policy. But, it has enough variation in the basic terms to make it a completely separate policy type.
Much like whole life insurance, it does offer both permanent life insurance coverage as well as cash value accumulation. But, that’s about where the similarities end.
Perhaps the biggest difference between whole life and IUL insurance is in the way the cash value is handled. Just like whole life insurance, a percentage of your IUL policy premium will go into the cash value. But where a whole life policy functions more like a bank account, paying a fixed rate of interest, an IUL policy offers investment options.
While you can choose to invest your money in a fixed income option, similar to a whole life insurance policy, you can also direct your cash value into insurance funds based on certain underlying investment indexes. For example, you can choose to have some or all your cash value invested in a fund tied to the S&P 500 index.
There’s an important distinction here. Funds invested in equities are not invested directly in equities, but rather in indexes tied to those particular equity sectors. You’ll be paid interest on your equity portion, rather than dividends or capital appreciation. Regardless of the source, the income you receive on your cash value is considered interest.
But apart from investment flexibility, you can also adjust your death benefit. That’s because an IUL policy is primarily an investment account that offers a life insurance death benefit.
In general, the majority of your premium will go into the investment portion of your policy. But, you have the ability to adjust the death benefit either higher or lower.
If you increase the death benefit, less money will go into your investment account. If you decrease it, more funds will go into the investment provision. That’s an excellent option to have since the need for life insurance fluctuates throughout the course of your life.
Much like whole life insurance, you can also borrow against your policy. The funds can even be borrowed without tax consequences or even the need to make monthly repayments. Any outstanding loan balance will be payable out of your death benefit upon your death.
And while this provision has some technical limitations, you may be able to take distributions from your investment provision that will be at least partially tax-free. Much like a Roth IRA, the portion of your withdrawal that represents your actual contributions can be taken without creating a tax liability.
How Does an IUL Policy Work?
Let’s start this discussion with the investment provision, since that’s the core feature of indexed universal life insurance.
Investment Provision of IUL
Once again, you have a choice to invest in fixed income investments, equity investments tied to an index, or a combination of both.
If you invest in equity investments, there will be a cap on how much you can earn on those investments. However, there’s also a floor that prevents you from losing money.
If you have some of your investments held in an index based on the S&P 500, the IUL may permit a maximum annual return of 9%. If the index rises by 15% for that year, your return will be limited to the 9% cap. The remaining 6% return will be retained by the insurance company.
But that limit is a positive feature. While your gains are capped, your losses are also limited.
For example, the policy may have a minimum return of 0%. That means if the S&P 500 index were to fall by 15%, you wouldn’t lose any money.
For investors who want to participate in equities, but are fearful about the potential losses—particularly in a crash or a bear market—an IUL policy can be an ideal way to invest in equities without facing the potential for catastrophic losses during uncertain market conditions.
Insurance Provision of IUL
The insurance provision of an IUL is also more complicated than it is for a whole life insurance policy.
That’s because the insurance provision is an annual renewable term policy. As such, the cost of that coverage will increase as you age.
This could lead to the insurance portion eating up an increasingly larger percentage of your annual premium as you get older.
The alternative will be to reduce the amount of the death benefit provision.
Pros and Cons of Indexed Universal Life Insurance
- Flexibility. You can adjust the amount of your death benefit, which will also change the allocation of your policy premiums. Not only will this give you the ability to increase contributions to your investment provision, but it can also better reflect the changing needs for life insurance throughout your life. For example, when you’re young and have dependent children, you may want a larger death benefit. But as you get older, and your financial situation reaches the point where you are almost completely self-insured, you may want to reduce the death benefit to a minimal level. With an IUL policy, you’ll have that option.
- Investment provisions. Unlike a whole life insurance policy, where you have only a fixed income option, an IUL policy will give you both a fixed income option and participation in indexed equity funds. This holds the potential for much greater long-term growth of your investment provision than you can ever get in a whole life insurance policy.
- Investment earnings are tax-deferred. Similar to retirement plans, investment earnings accumulate in the plan and are not taxable until they are withdrawn.
- Can be an excellent retirement savings supplement. Virtually all retirement plans limit your contributions. For example, the most you can contribute to a 401(k) is $19,500 per year, or $26,000 if you are 50 or older. The most you can contribute to a traditional or Roth IRA is $6,000 per year, or $7,000 if you are 50 or older. If you’ve reached those limits, and you want to contribute more toward your retirement—perhaps because you want to retire early—there’s no limit on how much you can put into an IUL policy. It can be a valuable additional investment account to supplement what you have in your retirement plans.
- No downside loss potential. Because IUL policies impose a floor on investment earnings, you won’t lose any money on your investment account even in the worst market conditions.
- Potential tax-free withdrawals. You can make withdrawals from your plan either by taking a loan or by making withdrawals of amounts you have contributed to the plan.
- You may do better investing on your own. The average long-term return on stocks has been 10% per year going all the way back to the 1920s. If your IUL policy caps your investment earnings at 10%, and sets a floor of 0%, you may average just 5% per year. That being the case, you would do better simply investing in an index fund based on the S&P 500 on your own, and get the benefit of full returns over the long run.
- Premiums paid to your IUL are not tax-deductible. This is generally true of most types of life insurance. But, since an IUL is primarily an investment account, the lack of tax deductibility could be a problem, particularly for anyone who does not customarily max out his or her formal retirement plan contributions.
- High fees. This isn’t a topic insurance agents are fond of discussing, but policies that include an investment provision typically include high fees. Complicating the issue is the fact that the amount of those fees is not always apparent. And since a life insurance policy is essentially a contract, it contains a lot of legal provisions that are not easily understood by the average consumer. If you do take such a policy, you may want to have it reviewed by an insurance attorney before formally accepting the policy.
- Tax consequences may apply if your plan withdrawals exceed your contributions. If your withdrawals from your policy exceed the value of your contributions, you may incur a tax liability on the excess amount withdrawn.
- Your policy proceeds may be taxable if you surrender your policy or allow it to lapse. If you have borrowed against your policy or taken withdrawals that exceed your contributions to the plan, and you allow the policy to lapse, the shortfall may be taxable.
Should You Buy an Indexed Universal Life Insurance Policy?
Indexed universal life insurance is on the high end of the life insurance complications spectrum.
This is a sophisticated insurance investment plan, very similar to annuities. It’s best suited for consumers who are familiar with the policy type, or who have professional counsel, such as an attorney or a CPA, who can clearly explain the many provisions the policy contains.
But, if you meet that qualification and you’re looking for either a way to combine an investment provision with your life insurance, or you’re looking to “top off” your retirement savings, an IUL policy may be right for you.
For most other consumers, the best strategy will be to go with term life insurance, not the least of which because you can buy a large death benefit policy with the smallest possible premium. You can then invest your money in index funds, and get the benefit of the full return those funds will provide.
Where To Get An Indexed Universal Life Insurance Policy
I hope you got a clear picture that indexed universal life insurance is a complex financial plan, and one you should not enter lightly.
Many life insurance companies offer IUL plans, and there are many variations. This is especially true with regard to policy details, like administrative fees and caps and floors on your investment income.
If you’re going to buy such a policy, the best way to do it is to work with an independent life insurance broker. Since we work with many companies, we are not limited by the policy restrictions of a single insurance company.
Instead, we can look for the IUL policy that will work best for your specific needs and preferences. We may even suggest going an alternate route, if we feel that will be in your best interest. That’s the advantage of being independent.
Just complete the Get a Free Life Insurance Quote box to the right of this article and let us get to work helping you get the best coverage at the lowest possible premium.*While we make every effort to keep our site updated, please be aware that "timely" information on this page, such as quote estimates, or pertinent details about companies, may only be accurate as of its last edit day. Huntley Wealth & Insurance Services and its representatives do not give legal or tax advice. Please consult your own legal or tax adviser.