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Kimberly Rotter is a blog editor and owner of a boutique content services firm. She has 25+ years of experience in writing and editing.
Updated July 19, 2024 Reviewed by Reviewed by Anthony BattleAnthony Battle is a CERTIFIED FINANCIAL PLANNER™ professional. He earned the Chartered Financial Consultant® designation for advanced financial planning, the Chartered Life Underwriter® designation for advanced insurance specialization, the Accredited Financial Counselor® for Financial Counseling and both the Retirement Income Certified Professional®, and Certified Retirement Counselor designations for advance retirement planning.
Indexed universal life (IUL) insurance offers the benefit of market gains while building cash value and guarantees beneficiaries a payout upon death. Like other types of universal life insurance, IUL holds a cash value that increases as premiums are paid. You can receive the cash value if you cancel the policy, or you can take out a loan and use the funds for other purposes.
Also known as equity-indexed universal life insurance, IUL insurance puts a portion of the premiums toward annual renewable term life insurance. The remainder is added to the cash value of the policy after fees are deducted. The cash value is credited on a monthly or annual basis with interest based on increases in an equity index. While IUL insurance may prove valuable to some, it’s important to understand how it works before purchasing a policy.
Among the pros of IUL insurance is the potential for higher returns. There are cons, however, such as the fact that higher returns are not guaranteed.
IUL insurance is pitched as a cash-value policy that benefits from tax-free market gains without the risk of loss during a market downturn. Insured parties can link a percentage of the policy’s cash value to a market index, such as the S&P 500 or the Nasdaq 100. As the index moves up and down, the rate of return also moves on the policy. Different policies have different maximum levels for the amount you can invest, up to 100%.
A percentage of the interest income, which is called the participation rate, is added to the cash value of the policy if the indexed account shows gains (usually calculated over a month). This is usually annually or once every five years. So if the gain is 4%, the participation rate is 50%, and the current cash value total is $10,000. This means $200 is added to the cash value (4% × 50% × $10,000 = $200).
If the index falls in value or remains steady, the account nets little or nothing. But there's one benefit: the policyholder is protected from incurring losses.
Although they perform like securities, IULs are not considered investment securities. “The cash value is not [actually] invested in the market or an index,” said Jordan Niefeld, CPA, CFP, of Raymond James & Associates in Aventura, Florida. “The index is just a measuring device to determine the interest crediting rate on the cash value account.”
As with any kind of universal life insurance, it’s important that you do your research to ensure that your insurance provider is a reputable universal life insurance company.
A significant advantage of IUL insurance is the potential for gains in the cash value that can potentially be higher than those on other types of life insurance, such as traditional universal life or whole life insurance policies.
Policyholders also get the benefit of a crediting floor, which is typically 0% or 1%. Having this means the existing cash value is protected from losses in a poorly performing market. “If the index generates a negative return, the client does not participate in a negative crediting rate,” Niefeld said. In other words, the account will not lose its original cash value.
The cash value accumulates tax deferred, and the death benefit is tax-free for beneficiaries. Loans made against the policy are also tax-free in many cases. Premiums are paid with after-tax dollars, so partial and full withdrawals (up to the amount paid in premiums) are also tax-free.
IUL insurance, like other types of life insurance, can provide a death benefit for your loved ones. This money can be used to:
This death benefit can be passed on to your beneficiaries tax-free.
Social Security benefits may be an important source of income in retirement. You can begin taking Social Security as early as age 62 or defer benefits up to age 70. Taking benefits ahead of your full retirement age can shrink your benefit amount, as can working while receiving benefits. You’re only allowed to earn so much per year prior to reaching full retirement age before your benefits are reduced.
Cash value accumulation from an IUL insurance policy wouldn’t count toward the earnings thresholds, nor would any loan amounts that you borrow. So, you could take a loan against your policy to supplement Social Security benefits without detracting from your benefit amount.
A variety of riders, or additional provisions, can make the policy more attractive and more valuable, including guaranteed premiums, guaranteed death benefits, and provisions for long-term care and critical illness.
There are several potential drawbacks associated with IUL insurance policies. For instance, someone who establishes the policy over a time when the market is performing poorly could end up with high premium payments that don’t contribute at all to the cash value. The policy could then potentially lapse if the premium payments aren’t made on time later in life, which could negate the point of life insurance altogether.
We've highlighted some of the potential downsides below.
Increases in the cash value are limited by the insurer. Insurance companies often set maximum participation rates of less than 100%. In addition, returns on equity (ROE) indexes are often capped at certain amounts during good years. These restrictions can limit the actual rate of return that’s credited toward your account each year, regardless of how well the policy’s underlying index performs.
In that case, you may be better off investing in the market directly or considering a variable universal life insurance policy instead. But it’s important to consider your personal risk tolerance and investment goals to ensure that either one aligns with your overall strategy.
The insurer makes money by keeping a portion of the gains, including anything above the cap.
The crediting rate cap may limit gains in a bull market. If the investor’s money is tied up in an insurance policy, it can potentially underperform other investments. Depending on how the market performs, the insured may realize no gains at all.
The potential for a greater rate of return is one advantage to IUL insurance policies compared to other life insurance policies. However, larger returns are not guaranteed. Returns can in fact be lower than returns on other products, depending on how the market performs. Policyholders have to accept that risk for potentially higher returns.
Costs and fees associated with an indexed universal life insurance policy can also affect profits.
As with any product tied to equities, IUL does include risks. IUL insurance carries greater risk than standard universal life insurance, but less risk than variable life insurance policies (which do actually invest in stocks and bonds). Also, depending on the policy, the premiums could potentially rise if the measuring index performs consistently below the anticipated rate.
In the event of death with outstanding loans against the policy, the outstanding loan funds may be subject to regular income tax. In the event of policy cancellation, gains become taxable as income. Losses are not deductible.
Fees are typically front-loaded and built into complex crediting rate calculations, which may confuse some investors. Fees can be high. Costs vary from one insurer to the next and depend on the age and health of the insured.
These fees can include:
Canceling or surrendering a policy can lead to more costs. In that case, the cash surrender value may be less than the cumulative premiums paid.
Unlike other types of life insurance, the value of an IUL insurance policy is tied to an index tied to the stock market. This means that the returns may vary, depending on the performance of the underlying index.
There are many other types of life insurance policies, explained below.
Now that you know the basics of indexed universal life insurance, you're probably wondering whether it's the right choice for you. If you're mulling over this kind of policy, it's a good idea to take the following into consideration:
Keep in mind, though, that if there's anything you're unsure of or you're on the fence about getting any type of insurance, be sure to consult a professional. This way you'll know if it's affordable and whether it fits into your financial plan.
The cost of an indexed universal life policy depends on several factors. Like any insurance product, the premiums are higher as you get older. So a 50-year-old pays a higher premium than someone in their 30s. Premiums also vary based on your gender and health conditions, so if you're a smoker, you'll end up paying more. Other considerations that factor into your premiums include additional fees like commissions, expense fees, and administrative costs, which may be added to the beginning of your policy. Be sure to check with your insurance agent for the exact premiums and associated fees.
You can typically withdraw the cash value of a whole life insurance policy on a tax-free basis up to the amount of premiums you’ve paid. You can also borrow against a cash value, use a cash value toward premium payments, or cancel the policy to receive the cash value. Unlike with a traditional 401(k) or individual retirement account, you do not have to wait until you are 59½ years old to use the funds.
You can sell your indexed universal life insurance policy and stop making premium payments. However, you will lose the death benefit named in the policy.
Indexed universal life insurance and 401(k) plans all have their own advantages. A 401(k) has more investment options to choose from and may come with an employer match. On the other hand, an IUL comes with a death benefit and an additional cash value that the policyholder can borrow against. However, they also come with high premiums and fees, and unlike a 401(k), they can be canceled if the insured stops paying into them.
Indexed universal life insurance can help you meet your family’s needs for financial protection while also building cash value. However, these policies can be more complex compared to other types of life insurance, and they aren’t necessarily right for every investor. Talking to an experienced life insurance agent or broker can help you decide if indexed universal life insurance is a good fit for you.
