Indexed Universal Life Insurance (IUL) Meaning and Pros and Cons

Indexed universal life (IUL) insurance policies can assist you in accumulating wealth while providing a death benefit to your loved ones. After fees are deducted, a portion of the policyholder's premium payments are applied to annual renewable term life insurance, with the remainder added to the policy's cash value. The cash value is credited with interest based on increases in an equity index on a monthly or annual basis.

While IUL insurance may be beneficial to some people, it is critical to understand how it works before purchasing a policy. In comparison to other types of life insurance, there are several advantages and disadvantages.

Understanding Indexed Universal Life Insurance

IUL insurance is frequently marketed as a cash value insurance policy that benefits from market gains tax-free while eliminating the risk of loss during a market downturn.

When you buy an IUL insurance policy, you get permanent coverage as long as you pay your premiums. When you die, your policy's death benefit is paid out to your named beneficiary or beneficiaries. However, the policy's value can rise over time due to a cash value component.

Your policy's cash value earns interest based on the performance of an underlying stock market index. Returns, for example, could be linked to the Standard & Poor's (S&P) 500 composite price index, which tracks the movements of the 500 largest companies in the United States by market capitalization. The rate of return on the cash value component of your policy fluctuates with the index.

The policy's issuing insurance company may offer a minimum guaranteed rate of return. Returns may also be subject to an upper limit or rate cap.

IUL insurance is more risky than fixed universal life insurance policies that provide a guaranteed rate of return. However, it is less risky than variable universal life insurance, which allows you to invest in mutual funds or other securities directly.

Benefits of Indexed Universal Life Insurance

As with any type of universal life insurance, thorough research is required to ensure that any potential firms are among the best universal life insurance companies currently in operation. With that in mind, here are some of the primary benefits of including IUL in your financial plan.

  1. Higher Return Potential

These policies use call options to gain upside exposure to equity indexes without the risk of losses, whereas whole life and fixed universal life insurance policies offer only a small interest rate that may or may not be guaranteed. Of course, the annual return on an IUL insurance policy will be determined by the performance of its underlying index. However, your insurance company may still be able to provide a guaranteed minimum return on your investment.

  1. Greater Flexibility

When putting together a policy to meet your investment objectives, IUL insurance can provide flexibility. Policyholders can choose how much risk they want to take in the market, adjust death benefit amounts as needed, and select from a variety of riders that make the policy tailored to their specific needs. You can, for example, add a long-term care rider to cover nursing home costs if necessary, or an accelerated death benefit rider to pay out benefits if you become terminally ill.

  1. Tax-Free Capital Gains

When you sell an asset or investment for a profit, you must pay capital gains tax. Unless they abandon the policy before it matures, indexed universal life insurance policyholders do not pay capital gains on the increase in cash value over time, whereas other types of financial accounts may tax capital gains upon withdrawal. This benefit extends to any loans you may take out against the policy's cash value. If you want to avoid paying taxes and penalties on an early withdrawal from a 401(k) or IRA, having a ready source of cash to borrow against may be appealing.

  1. No Social Security Impact

In retirement, Social Security benefits may be a significant source of income. You can start receiving Social Security benefits as early as age 62 or defer them until age 70. Taking benefits before reaching your full retirement age, as well as working while receiving benefits, can reduce your benefit amount. Before reaching full retirement age, you can only earn a certain amount per year before your benefits are reduced.

The cash value accumulation from an IUL insurance policy, as well as any loan amounts borrowed, would not count toward the earnings thresholds. As a result, you could borrow against your policy to supplement Social Security benefits without reducing your benefit amount.

  1. Death Benefit

Like other types of life insurance, IUL insurance can provide a death benefit to your loved ones. This money can be used to pay for funeral and burial expenses, outstanding debts such as a mortgage or co-signed student loans, college costs for children, or simply to cover day-to-day living expenses. This death benefit can be tax-free passed on to your beneficiaries.

Drawbacks of Indexed Universal Life Insurance

There are several disadvantages to IUL insurance policies, which critics are quick to point out. For example, someone who establishes the policy during a period when the market is performing poorly may end up with high premium payments that make no contribution to the cash value. If the premium payments are not made on time later in life, the policy may lapse, defeating the purpose of life insurance entirely.

Aside from that, keep the following considerations in mind:

  1. Caps on Returns

Insurance companies frequently set maximum participation rates that are less than 100%, and in some cases as low as 25%. Furthermore, during good years, returns on equity indexes are frequently capped at certain levels. Regardless of how well the policy's underlying index performs, these restrictions can limit the actual rate of return that is credited to your account each year.

In that case, you might be better off investing directly in the market or considering a variable universal life insurance policy. However, it is critical to consider your personal risk tolerance and investment goals to ensure that both are consistent with your overall strategy.

  1. No Guarantees

Whole life insurance policies frequently include a guaranteed interest rate as well as predictable premium amounts throughout the policy's term. IUL policies, on the other hand, provide index-based returns with variable premiums over time. This means you must be willing to accept fluctuations in returns while also budgeting for potentially higher premiums.

  1. Fees

IUL insurance policies can include a slew of fees and other costs, such as:

  • Premium expense charges
  • Administrative costs
  • Riders
  • Fees and commissions
  • Surrender charge

All of these fees and costs can reduce the rate of return provided by your policy. That's why it's critical to research the best life insurance companies so you know what you're paying for and what you're getting in return.

Indexed Universal Life Insurance vs. Other Life Insurance Policies

Unlike other types of life insurance, the value of an IUL policy is linked to a stock market index. This means that the returns may vary depending on how well the underlying index performs.

There are numerous other types of life insurance policies, which are discussed further below.

  • Term life insurance provides a fixed benefit if the policyholder dies within a specified time period, which is typically between 10 and 30 years. Although there is no cash value accumulation, this is one of the most affordable and straightforward types of life insurance.
  • Whole life insurance is more permanent, and the policy lasts the policyholder's entire life as long as premiums are paid. The policy grows in value on a set schedule, and there are fewer fees than with an IUL policy. They do not, however, provide the option of adjusting premiums.
  • Variable life insurance has more flexibility than IUL insurance, but it is also more complicated. The cash value of a variable policy may be affected by the performance of specific stocks or other securities, and your premium may also change. As a result, variable life insurance is regarded as riskier than other types of life insurance.

The Bottom Line

IUL insurance can help you meet your family's financial protection needs while also accumulating cash value. These policies, however, can be more complicated than other types of life insurance, and they aren't always appropriate for every investor. Speaking with an experienced life insurance agent or broker can assist you in determining whether indexed universal life insurance is a good fit for you.