What Is Indexed Universal Life Insurance?

What Is Indexed Universal Life Insurance?

An indexed universal life policy is a type of permanent life insurance, providing lifelong coverage and a death benefit. It also includes a cash value component, which is a savings-style account that grows over time.

With an indexed universal life insurance policy, the cash value earns interest by tracking a bond or a stock index, such as the S&P 500. IUL policies also offer minimum account interest earnings, known as floors, and there may be a cap on the gains you can see in your account.

You can borrow against the cash value, withdraw from it or use it to pay premiums. Any growth is tax-deferred, so you'll pay taxes if you withdraw investment gains before your policy matures—but not as those gains are earned.

How Does Indexed Universal Life Insurance Work?

When you buy an indexed universal life insurance policy, you pay regular premiums in exchange for lifelong coverage. Part of your premiums goes toward insurance costs, like administrative fees and the death benefit, and part goes toward the cash value. The key difference between IUL policies and other types of universal life insurance is how the cash value is invested.

Flexible Premiums and Adjustable Death Benefit

IUL policies offer flexibility because you can use the cash value to cover some or all of your premiums. This gives you the option to underpay or skip payments altogether. You may also have the option of adjusting your death benefit if your needs change over time, though your insurance company may ask you to complete a medical exam before increasing your coverage.

Cash Value

The cash value component grows over time, but you have the option of putting the funds in a fixed-rate account, an indexed account or both. The indexed account tracks the performance of a well-known stock index, such as the Nasdaq or S&P 500. Your investment options depend on what the insurance company offers. The cash value account earns more interest when the index goes up, and less if the index drops.

The amount of interest you earn is subject to a floor on losses and a cap on gains. The floor is the minimum you'll earn on your indexed account. It's often guaranteed for the life of the policy. With a 0% floor, for instance, your account won't suffer losses when an index has a negative return.

The cap is the highest rate the account can earn, often set around 8% to 12%. This feature can be a drawback when the market surges. If your cap is 10% and your index rises by 15%, for instance, you'll only earn 10%. Your insurer can adjust the cap while the policy is in force.

Another feature that can restrict your earnings is the participation rate, which dictates the amount you receive from the cash value earnings. For example, say your cap is 10% and participation rate is 80%. The interest credited to your account would be based on 80% of that return, meaning you'll only earn 8% of the index returns. Like the cap, your insurer can adjust the participation rate during the life of the policy.

Death Benefit

The death benefit is the amount of money your beneficiary receives after you pass away. With IUL policies, the death benefit may be reduced by the amount of any cash value withdrawals or cash value loans you took out but didn't pay back. This death benefit is usually not taxable for your heirs.

Indexed Universal Life Insurance vs. Whole Life Insurance

Whole life insurance and indexed universal life insurance policies share some similarities. They both offer coverage for life and come with a death benefit and cash value component that grows over time.

But whole life provides more predictability because the premiums and death benefit stay the same, and your cash value grows at a fixed rate that won't decline. You may have lower premiums with fewer fees compared to an IUL, though you can't adjust premiums or control the cash value investment.

With an IUL policy, the premiums and death benefit are adjustable. Additionally, your cash value growth depends on a market index. This could be a benefit or drawback depending on the market performance and how you handle the account. Your cash value may decrease if the index loses value, your fees increase or you decide to use the cash value to cover premiums.

Pros and Cons of Indexed Universal Life Insurance

It's important to carefully weigh the benefits and drawbacks of indexed universal life insurance before purchasing a policy.

Pros

• Built-in protections: The floor on the indexed portion of your cash value protects against market swings. And because the policy isn't directly invested in the stock market, your risk is reduced.
• Flexibility: You have the option of adjusting your premiums and death benefit while the policy is in force. You can also allocate your cash value to different sub-accounts and potentially choose where the indexed account invests.
• Tax benefits: The funds in your cash value account grow and aren't taxed the way gains on investments are. Your beneficiaries also receive a death benefit that isn't typically subject to income or estate taxes.
• Easy access: You may withdraw or borrow from your cash value anytime without penalty.
• Unlimited contribution potential: IUL policies don't limit how much you can contribute each year, allowing you to experience more growth if you want to contribute more.

Cons:

• Earnings risk: Your indexed value may not grow at all (assuming a 0% floor) or may offer less growth in a slow market.
• Growth is capped: Caps and maximum participation rates limit the amount of interest you can earn in your indexed account.
• Growth excludes stock dividends: Your insurance company doesn't directly invest in stocks, so you won't benefit from dividends paid to shareholders.
• Management fees: Insurance companies charge fees for managing your account, which can eat into your cash value.
• Potential tax consequences: If you withdraw money that includes investment gains before your policy matures, you may need to pay income taxes on the funds.
• Effort involved: You'll need to monitor your cash value account to track the index performance and decide whether to apply the value toward your premiums.

How Much Does Indexed Universal Life Insurance Cost?

The cost of an indexed universal life insurance policy varies, depending on factors like your age, where you live, your health and the coverage amount you choose. But generally, indexed universal life insurance policies cost more than term life insurance because they include a cash value account and never expire. And because IUL policies offer less of an earnings guarantee than a whole life policy, they're often cheaper than whole life policies.

For example, according to one quote, a healthy, nonsmoking 34-year-old woman may pay between $71 and $96 a month for an indexed universal life policy, assuming $250,000 of coverage. The same person may pay $32 to $44 a month for a term life policy and between $177 and $245 per month for a whole life policy.

Is Indexed Universal Life Insurance a Good Investment?

Indexed universal life insurance might be a good fit if you have expensive assets to protect and your risk tolerance is high. It's also a good option if you think you'll need to adjust your premium and death benefit.

But you might not need a life insurance policy after you've paid off your debts and saved for your big financial goals, like retirement and your kid's college education. In these situations, a term life insurance policy with a separate retirement fund and other savings vehicles might offer what you need, and at a lower price tag.

How to Buy Indexed Universal Life Insurance

You can buy an indexed universal life insurance policy at most insurance companies. An independent agent can walk you through your options to find the right coverage amount for the best price with a reputable insurer. Once you have a few quotes, you should:

1. Compare coverage limits, estimated monthly payments and administrative or management fees that come with each policy.
2. Choose a policy and an insurer.
3. Submit an application. The company may ask you to go through a phone interview or medical exam.
4. Once approved, start paying premiums on a regular basis.

The Bottom Line

Indexed universal life insurance offers permanent coverage with a death benefit and a cash value that grows based on underlying investments. You can either allocate the cash value portion in a fixed account, an indexed account or both. Your earnings are subject to a floor that protects you against market downturns, but the cap and participation rate can limit what you earn.

These are complex policies that may require some oversight, so it's important to work with a financial planner or another certified professional before choosing one. You may also compare IUL policies against other types of life insurance to see what works best for your situation.