What Is Indexed Universal Life Insurance (IUL)?

Reviewed by Thomas J. CatalanoFact checked by Bobby L. Hickman, FLMI CLU Reviewed by Thomas J. CatalanoFact checked by Bobby L. Hickman, FLMI CLU

What Is Indexed Universal Life Insurance (IUL)?

Indexed universal life (IUL) insurance is a type of permanent life insurance that provides a cash value component along with a death benefit. The money in a policyholder’s cash value account can earn interest by tracking a stock market index selected by the insurer, such as the Nasdaq-100 or the Standard & Poor’s 500. If you policy also has a fixed-rate account, you can choose how much you want to go into each account.

Although the interest rate derived from the equity index account can fluctuate, the policy does offer an interest rate guarantee, which limits your losses. It also may cap your gains. These policies are more volatile than fixed universal life policies, but less risky than variable UL insurance policies because IUL does not invest in equity positions.

Key Takeaways

• Indexed universal life (IUL) insurance lets the policyholder decide how much cash value to assign to an equity-indexed account and to a fixed-rate account, if available.
• Indexed universal life is a form of permanent life insurance which (like universal life) allows for flexible premiums and possibly a flexible death benefit.
• IUL insurance policies can track a number of well-known equity indexes, such as the S&P 500 or the Nasdaq-100, to earn interest credits.
• IUL policies usually cap your returns but also guarantee a minimum interest rate.

How Does Indexed Universal Life (IUL) Insurance Work?

As with universal life insurance, IUL policies have adjustable premiums. You can underpay or skip premiums, plus you may be able to adjust your death benefit. What makes IUL different is the way the cash value is invested.

When you take out an indexed universal life insurance policy, the insurance company provides several options to select at least one index to use for all or part of the cash value account segment of your policy and your death benefit. When a premium is paid on the account, a portion pays the cost of insurance based on the insured’s life; any fees are paid; and the rest is added to the cash value.

The total cash value is credited with interest based on increases in an equity index (although your money isn’t directly invested in the stock market). If you own an indexed universal life policy, you can likely borrow against the cash value accumulated in the policy. However, if you don’t pay back your loans, they are deducted from the death benefit.

Key Features

IUL insurance offers these main features, among others:

• Permanent, lifelong coverage when premiums are kept up to date.
• Flexible premiums, and a death benefit that may also be flexible.
• Cash value, along with potential growth of that value through an equity index account.
• An option to allocate part of the cash value to a fixed interest option.
• Minimum interest rate guarantees (“floors”), but there may also be a cap on gains, typically around 8%-12%.
• Accumulated cash value can be used to lower or potentially cover premiums without subtracting from your death benefit.

Some policies may allow the policyholder to select multiple indexes.

Policyholders can decide the percentage allocated to the fixed and indexed accounts. The value of the selected index is recorded at the beginning of the month and compared with the value at the end of the month. If the index increases during the month, interest is added to the cash value. The index gains are credited back to the policy, either on a monthly or an annual basis.

Note

IULs usually offer a guaranteed minimum fixed interest rate and a choice of benchmark equity indexes to track.

People who need permanent life insurance protection but wish to take advantage of possible cash accumulation via an equity index might use IULs as key person insurance for business owners, premium-financing plans, or estate-planning vehicles.

Example of Indexed Universal Life Insurance

Let’s say your selected index for your IUL policy gained 6% from the beginning of June to the end of June. The 6% is multiplied by the cash value. The resulting interest is added to the cash value. Some policies calculate the index gains as the sum of the changes for the period, while other policies take an average of the daily gains for a month. No interest is credited to the cash account if the index goes down instead of up.

The gains from the index are credited to the policy based on a percentage rate, referred to as the participation rate. The rate is set by the insurance company and can be anywhere from 25% to more than 100%. (The insurer can also change the participate rate over the lifetime of the policy.) For example, if the gain is 6%, the participation rate is 50%, and the current cash value total is $10,000, $300 is added to the cash value (6% x 50% x $10,000 = $300).

Important

IUL insurance policies are less risky than variable life insurance because no cash is directly invested in the stock market.

Advantages and Disadvantages of IUL Insurance

While not for everyone, IUL insurance policies are a viable option for people seeking permanent life insurance with a cash component that earns interest plus a death benefit. This type of life insurance is more expensive than term life insurance, but you get permanent coverage and the death benefit paid tax-free to your beneficiaries when you die. The policy may increase in value due to the cash value component and you may be able to borrow from your account. There are a number of pros and cons to consider before purchasing an IUL policy.

Advantages

• Flexible premiums: As with standard universal life insurance, the policyholder can increase their premiums or lower them in times of hardship.
• Cash value accumulation: Amounts credited to the cash value grow tax-deferred. The cash value can pay the insurance premiums, allowing the policyholder to reduce or stop making out-of-pocket premium payments.
• Investment flexibility: The policyholder controls the amount risked in equity-indexed accounts and the death benefit amounts can be adjusted as needed. Most IUL insurance policies offer a host of optional riders, from death benefit guarantees to no-lapse guarantees.
• Death benefit: This benefit is permanent, not subject to income or death taxes, and not required to go through probate.
• Less risk: The policy is not directly invested in the stock market, reducing risk.
• Easier distribution: The cash value in IUL insurance policies can be accessed at any time without penalty, regardless of a person’s age.
• Unlimited contribution: IUL insurance policies have no limitations on annual contributions.
• Extended maturity date: Many IUL policies have a later maturity date than other types of universal life policies, with some ending when the insured reaches age 121 or more. If the insured is still alive at that time, policies pay out the death benefit (but not usually the cash value) and the proceeds may be taxable.

Disadvantages

• Caps on accumulation percentages: Insurance companies sometimes set a maximum participation rate that is less than 100%.
• Better for larger face amounts: Smaller policy face values don’t offer much advantage over regular UL insurance policies.
• Based on a variable equity index: If the index goes down, no interest is credited to the cash value. (Some policies offer a low guaranteed rate over a longer period.) Other investment vehicles use market indexes as a benchmark for performance. Their goal normally is to outperform the index. With IUL, the goal is to profit from upward movements in the index.
• Growth does not include stock dividends: Because the insurance company only buys options in an index, you’re not directly invested in stocksm so you don’t benefit when companies pay dividends to shareholders.
• Management fees: Insurers charge fees for managing your money, which can drain cash value.
• Premium calls: Once your policy value grows enough to cover your premiums and other expenses, you can decide to skip or underpay premiums. If so, you should monitor your cash value regularly to make sure the cash value remains to cover those costs. Otherwise, the insurance company can require you to add more funds to prevent the policy from lapsing.
• Tax consequences of loans and withdrawals: If you withdraw money that includes investment gains before your policy matures, you could face income taxes on that funds. Also, if your policy lapses with an outstanding loan, the loan could become taxable.

Is Indexed Universal Life Insurance (IUL) a Good Investment?

An IUL can be a good way to save up money in a cash value account that, connected to a market index, may earn modest returns. However, it is first and foremost a life insurance policy, not an investment vehicle.

Can You Lose Money in an Indexed Universal Life Insurance Policy (IUL)?

It is unlikely you will lose money in an IUL because insurance providers set a guarantee for your principal to protect it against losses in the market. However, there is also often a cap on the maximum amount you can earn.

Is Indexed Universal Life Insurance (IUL) Better Than a 401(K)?

For most people, no, IUL isn’t better than a 401(k) in terms of saving for retirement. Most IULs are best for high-net-worth individuals looking for ways to reduce their taxable income or those who have maxed out their other retirement options. For everyone else, a 401(k) is a better investment vehicle because it doesn’t carry the high fees and premiums of an IUL, plus there is no cap on the amount you may earn (unlike with an IUL policy).

What Are the Cons of Indexed Universal Life (IUL)?

Indexed universal life policies cap how much money you can accumulate, often at less than 100%, and they are based on an possibly volatile equity index. While you may not lose any money in the account if the index goes down, you won’t earn interest. If the market turns bullish, the earnings on your IUL will not be as high as a typical investment account. The high cost of premiums and fees makes IULs expensive and considerably less affordable than term life.

Is IUL Better Than Whole Life?

Not necessarily. IUL insurance policies have an investment element, which can grow and earn interest connected to an equity index. They also have flexible premiums.

Whole life insurance is a more straightforward form of permanent life insurance, with a guaranteed death benefit, fixed premiums, and cash value component that acts like a savings vehicle, rather than an investment account. Whole life is easier to understand but may not provide the upside that IUL can.

The Bottom Line

Indexed universal life (IUL) insurance offers cash value plus a death benefit. The money in the cash value account can earn interest through tracking an equity index, and with some often allocated to a fixed-rate account. However, Indexed universal life policies cap how much money you can accumulate (often at less than 100%) and they are based on a possibly volatile equity index.

Beyond the death benefit offered, IUL policies shouldn’t be considered optimum retirement savings vehicles. A 401(k) is a better option for that purpose because it doesn’t carry the high fees and premiums of an IUL policy, plus there is no cap on the amount you may earn when invested. Most IUL policies are best for high-net-worth individuals seeking to lower their taxable income.

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