What is indexed universal life insurance (IUL), and how does it work?
Understanding the fundamentals of indexed universal life insurance (IUL) is essential to making informed financial decisions. We'll walk you through the key components, pros and cons and other considerations that come with this complex but potentially rewarding insurance product.
What is indexed universal life insurance (IUL)?
Indexed universal life insurance (IUL) is a permanent life insurance policy offering a death benefit and a cash value component.
It is a hybrid insurance product that combines traditional universal life insurance features with the potential for cash value growth linked to the performance of a stock market index, such as the S&P 500 or Nasdaq 100.
Key features of indexed universal life insurance are:
Death benefit: like other types of life insurance, IUL provides a death benefit that pays out to your beneficiaries when you pass away. This benefit is generally income-tax-free.
Premium flexibility: IUL policies typically allow policyholders to adjust the amount and frequency of premium payments within certain limits. This flexibility can be useful for individuals who want to adapt their policy to changing financial circumstances.
Cash value component: IUL policies build cash value over time, which can be accessed or borrowed against while you're alive. The cash value grows based on the performance of an underlying stock market index, but it is usually protected from market downturns through a minimum guaranteed interest rate.
Indexing and floor protection: the cash value growth is tied to the performance of an index, such as the S&P 500. When the index performs well, the cash value can increase, subject to participation rates, caps and other limitations the insurance company sets. However, IUL policies typically include a floor or minimum guaranteed interest rate, ensuring that the cash value won't go negative even if the indexed market performs poorly. On the other hand, your policy may be capped at, for example, 10%, meaning your cash value will not increase by more than 10% even if the index goes up by more.
Tax Benefits: IUL policies offer potential tax advantages. The cash value grows tax-deferred, meaning you won't pay income tax on the gains as long as the money remains inside the policy. Additionally, withdrawals and loans from the policy can be structured to be tax-free under certain conditions.
How does IUL work?
IUL works by combining elements of traditional life insurance with investment components tied to the performance of a stock market index.
So, how does IUL work?
1. Purchase of the policy: as the policyholder, you purchase an IUL policy from an insurance company. When you buy the policy, you'll typically decide on the death benefit amount (the amount paid to your beneficiaries upon your death) and the premium payments.
2. Premium payments: you make regular premium payments into the policy, which are typically flexible within certain limits. These payments can be monthly, quarterly or annually, and you can adjust the amount of the premium payments as your financial circumstances change.
3. Cash value accumulation: a portion of your premium payments goes toward the insurance cost, and the remainder is allocated to a cash value account within the policy. This cash value account grows over time based on the performance of an underlying stock market index.
4. Growth potential: if your selected index performs well, your cash value can increase, subject to the policy's limitations (participation rate, caps, etc.). This allows your cash value to benefit from potential market gains.
5. Policy flexibility: IUL policies often provide flexibility regarding premium payments and death benefit adjustments. You can tailor the policy to your changing financial needs and goals.
How much does IUL cost?
The cost of an IUL policy can vary significantly based on several factors. We’ve mapped out the key cost considerations below:
Age and health: younger, healthier individuals typically pay lower premiums for IUL coverage. Insurance companies often use medical underwriting to assess your health and risk level. If you have pre-existing health conditions, your premiums may be higher.
Death benefit amount: the higher the death benefit you choose, the higher your premiums will generally be. If you want a larger payout to your beneficiaries, you will need to pay more in premiums.
Riders and features: if you add optional riders or features to your IUL policy, such as a long-term care rider or a disability income rider, your premiums will increase.
Premium payment frequency: the frequency of premium payments (e.g., monthly, quarterly, annually) can affect the total cost of the policy. Some insurance companies offer discounts for annual premium payments.
Policy duration: the length of time you plan to keep the policy in force can impact the cost. Generally, longer-term policies have higher total premiums compared to shorter-term policies.
What are the pros and cons of IUL?
It's essential to carefully consider the advantages and disadvantages of IULs before deciding if an IUL policy is the right financial product for your needs and goals:
Income-tax-free payout: the death benefit is typically paid out to beneficiaries tax-free, providing financial protection for your loved ones.
Tax-deferred growth: the cash value of an IUL policy grows on a tax-deferred basis, allowing you to accumulate savings without immediate tax consequences.
Potential for market-linked returns: IUL policies offer the potential for cash value growth based on the performance of a stock market index, offering the opportunity for higher returns than traditional fixed-interest policies.
Downside protection: your cash value is protected from market losses, meaning it won't decrease in value due to poor market performance, as it has a minimum guaranteed interest rate.
Premium flexibility: IUL policies generally allow you to adjust your premium payments within certain limits, providing flexibility to adapt to changing financial circumstances.
Death benefit and premium adjustments: you can often increase or decrease the death benefit and premium payments to align with your evolving financial goals.
Tax-free withdrawals and loans: you can access the cash value through tax-free withdrawals and loans under certain conditions, providing a source of funds for emergencies or other financial needs.
Higher premiums: IUL policies can have higher premiums than term life insurance due to their investment component and cash value growth potential.
Policy charges: various fees and charges, such as the cost of insurance charges, administrative fees and surrender charges, can reduce the overall returns of the policy.
Complexity: IUL policies can be complex, and understanding their terms, including indexing methods, participation rates and caps, may require financial expertise.
Market dependency: the cash value's growth is linked to the performance of a stock market index. While it offers the potential for higher returns, it also carries the risk of lower or even negative returns in down markets.
Caps and participation rates: many IUL policies have caps on the maximum interest credited to the cash value and participation rates that may limit the full participation in market gains.
Early withdrawal penalties: if you surrender the policy or withdraw cash value in the early years, you may face significant surrender charges, reducing the amount you receive.
The inflexibility of premium payments: while IUL policies offer some premium flexibility, they may require consistent premium payments over the policy's life to maintain coverage.
Is IUL right for you?
With higher associated costs than other life insurance products, an IUL is ideal if you have maximized other tax benefits and want an investment product linked to market conditions. An IUL can complement existing 401(k) plans, allowing you to benefit from market growth while limiting losses and capping gains.
The death benefit is generally income-tax-free, making it a valuable estate planning tool. However, it potentially provides the greatest benefit to high-net-worth individuals looking to minimize taxable income.
The bottom line
An IUL policy can be a suitable option if you’re looking for life insurance coverage combined with the potential for cash value growth, tax advantages and flexibility in premium payments.
However, it's essential to carefully review the policy's terms and conditions, fees, and the specific indexing method used, as these factors can vary significantly between insurance companies and policies. For this reason, consulting with a financial advisor is recommended to determine if IUL is the right fit for your financial goals and needs. Find your perfect financial advisor with Unbiased.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.