Indexed Universal Life Insurance: Pros and Cons

Indexed universal life (IUL) insurance policies can help you to build wealth while leaving behind a death benefit for your loved ones. These policies put a portion of the policyholder’s premium payments toward annual renewable term life insurance, with the remainder added to the cash value of the policy after fees are deducted. On a monthly or annual basis, the cash value is credited 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.

KEY TAKEAWAYS

Indexed universal life (IUL) insurance policies provide greater upside potential, flexibility, and tax-free gains.
This type of life insurance offers permanent coverage as long as premiums are paid.
Some of the drawbacks include caps on returns and no guarantees as to the premium amounts or market returns.
In general, these policies are best for those with a large up-front investment who are seeking options for a tax-free retirement.

Indexed Universal Life Insurance: How It Works

IUL insurance is often pitched as a cash value insurance policy that benefits from the market’s gains tax-free—without the risk of loss during a market downturn.

When you purchase an IUL insurance policy, you’re getting permanent coverage as long as premiums are paid. Your policy includes a death benefit, which is paid out to your named beneficiary or beneficiaries when you pass away. But the policy can also increase in value during your lifetime through a cash value component.

The cash value portion of your policy earns interest based on the performance of an underlying stock market index. For example, returns may be linked to the Standard & Poor’s (S&P) 500 composite price index, which tracks the movements of the 500 largest U.S. companies by market capitalization. As the index moves up or down, so does the rate of return on the cash value component of your policy.

The insurance company that issues the policy may offer a minimum guaranteed rate of return. There may also be an upper limit or rate cap on returns.

IUL insurance is riskier than fixed universal life insurance policies, which offer a guaranteed rate of return. But it’s less risky than variable universal life insurance, which allows you to invest money directly in mutual funds or other securities.

You may be able to borrow against the cash value accrued in an indexed universal life insurance policy, but any loans outstanding when you pass away would be deducted from the death benefit.

Pros of Indexed Universal Life Insurance

As is the case with any type of universal life insurance, it’s vital to thoroughly research any potential firms to ensure that they’re among the best universal life insurance companies currently operating. With that in mind, here’s a look at some of the chief advantages of including IUL in your financial plan.

1. Higher Return Potential

These policies leverage call options to gain upside exposure to equity indexes without the risk of losses, while whole life insurance policies and fixed universal life insurance policies provide only a small interest rate that may not even be guaranteed. Of course, the annual return that you see with an IUL insurance policy will depend on how well its underlying index performs. But your insurance company can still offer a guaranteed minimum return on your investment.

2. Greater Flexibility

IUL insurance can offer flexibility when putting together a policy that’s designed to meet your investment goals. Policyholders can decide how much risk they would like to take in the market, adjust death benefit amounts as needed, and choose among a number of riders that make the policy customizable to their needs. For example, you may choose to add on a long-term care rider to cover nursing home costs if that becomes necessary.

3. Tax-Free Capital Gains

Policyholders do not pay capital gains on the increase in cash value over time unless they abandon the policy before it matures, whereas other types of financial accounts may tax capital gains upon withdrawal.1 This benefit extends to any loans that you may take from the policy against your cash value. Having a ready source of cash that you can borrow against may be appealing if you want to avoid triggering taxes and penalties with an early withdrawal from a 401(k) or IRA.2

Unlike a 401(k) or traditional IRA, there are no required minimum distributions for cash value accumulation in an indexed universal life insurance policy.

4. No Social Security Impact

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.34

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.

5. Death Benefit

IUL insurance, like other types of life insurance, can provide a death benefit for your loved ones. This money can be used to pay funeral and burial expenses, cover outstanding debts such as a mortgage or co-signed student loans, fund college costs for children, or simply pay for everyday living expenses. This death benefit can be passed on to your beneficiaries tax-free.5

Financial experts often advise having life insurance coverage that’s equivalent to 10 to 15 times your annual income.

Cons of Indexed Universal Life Insurance

There are several drawbacks associated with IUL insurance policies that critics are quick to point out. 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.

Aside from that, keep in mind the following other considerations:

1. Caps on Returns

Insurance companies often set maximum participation rates of less than 100% and as low as 25% in some cases. In addition, returns on equity 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.

2. No Guarantees

Whole life insurance policies often include a guaranteed interest rate with predictable premium amounts throughout the life of the policy. IUL policies, on the other hand, offer returns based on an index and have variable premiums over time. This means that you have to be comfortable riding out fluctuations in returns while also budgeting for potentially higher premiums.

3. Fees

IUL insurance policies can come with a slew of fees and other costs, including:

Premium expense charges

Administrative expenses

Riders

Fees and commissions

Surrender charge

All of these fees and various costs can detract from the rate of return offered by your policy. That’s why it’s important to research the best life insurance companies so you understand what you’re paying for in coverage and getting in return.

The Bottom Line

IUL 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.