Indexed Universal Life Insurance: What It Is, How It Works, and Who It’s For

Life insurance can be a valuable source of growth. On top of the usual death benefits, some life insurance policies let you build wealth over time. Indexed Universal Life Insurance (IUL) offers lifelong coverage with cash value growth tied to a market index. Is it for you?

In this guide, we will break down how IUL works, its pros and cons, and who should consider it.

What Is Indexed Universal Life Insurance (IUL)?

Indexed Universal Life Insurance (IUL) is a special type of permanent life insurance. It combines a death benefit with a cash value component and flexible premiums.

What is the difference?

To understand what makes IUL unique, it's essential to know the other main types of life insurance.

Term Life: No cash value, fixed term.

Whole Life: Fixed premiums, guaranteed cash value growth.

Universal Life: Flexible premiums, interest-based cash value.

Compared to the other life insurance types, indexed universal life insurance policies offer flexible premiums with cash value growth linked to a stock market index (e.g. S&P 500).

How Indexed Universal Life Insurance Works

Premium Payments

IULs can offer flexible payment options. It is typically cheaper than whole life insurance.

A portion of your indexed universal life insurance premium payment goes toward insurance, while the rest goes to a cash value account.

Cash Value Growth

The cash value growth of a IUL policy depends on market performance, such as the S&P 500. It is not invested directly.

Participation Rates

The participation rate of an IUL insurance policy is the percentage of index gains credited to it.

Caps and Floors

Caps and floors are the maximum and minimum return rates. For example, you can have a 10% cap and a 0% floor for the return rate. This limits how much you can gain but also mitigates how much you can lose.

Death Benefit Options

Universal life insurance policies have various death benefit options.

Level Death Benefit (Option A): Equal to face amount. More affordable.

Increasing Death Benefit (Option B): Equal to the face amount plus the accumulated value. Can vary based on the growth or decline of the accumulated value.

Both options will decrease if you make a withdrawal or take out a loan.

Policy Loans and Withdrawals

If done correctly, you gain the ability to borrow against the cash value tax-free.

However, loans and withdrawals come with the risk of reducing the death benefit or lapsing the policy.

Key Benefits of IUL

Tax-Deferred Cash Value Accumulation

If you’ve already maxed out your other tax-advantaged accounts, indexed universal life insurance can be an excellent choice for you.

Market-Linked Growth Potential Without Direct Market Risk

Based on your risk tolerance, a IUL could be the best life insurance choice for you. There is less direct risk even though the growth is linked to the market.

Tax-Free Loans and Withdrawals

If structured properly, you would be able to obtain tax-free loans and cash withdrawals from a IUL. Generally, if your policy is in good standing and doesn’t lapse, loans against it do not have to be taxed because they’re considered a debt against the policy, not taxable income.

Flexible Premiums and Death Benefits

IULs have adjustable premiums. If you underpay or skip a payment, the cost is deducted from your policy’s cash value. If you go through a period of financial hardship, the flexibility of an IUL makes it easier to manage.

You can increase or decrease the death benefit amount of your indexed universal life policy. In the case of increasing the death benefit, you might be expected to undergo a medical exam. This flexibility provides you with more control over how much financial protection you can get for your beneficiaries.

Lifelong Coverage

If you are able to comfortably afford the premiums, IUL provides lifelong coverage. This can provide more peace of mind since you wouldn’t have to worry about a lapse in life insurance protection. You also wouldn’t need to go through medical exams unless you’re looking to alter the policy terms.

Potential Drawbacks and Risks

Complexity

Understanding caps, floors, fees, and interest crediting can be difficult. If you are not familiar with economics or life insurance policies, it can be challenging to understand the intricacies. If you have a complex financial situation, budget, or estate, it can also impact the pros and cons of an indexed life insurance policy.

High Fees

The indexed universal life insurance premium is the number one cost you need to consider. The cost of insurance can be hefty if you lose your job or face a financial crisis. Plus, there are often administrative fees and other charges that can add up, making the cost of life insurance greater than just the premium. If you’re unable to maintain continuous payments, you might suffer a lapse in life insurance coverage.

Plus, surrender charges are also a possibility. It can be expensive if you try to surrender.

Market Dependence

While there’s a floor, low market returns may result in slow or halted growth.

Policy Lapse Risk

If not adequately funded, the policy can lapse—especially if loans are taken.

Misleading Sales Tactics

IUL has a bad reputation amongst life insurance policies. Some permanent life insurance policies are sold with unrealistic expectations of returns. These misleading sales tactics can trick those unfamiliar with insurance policies into committing to a IUL policy without truly understanding its terms.

IUL vs Other Cash-Value Life Insurance

IUL vs Whole Life

Unlike IULs, whole life insurance does not have flexible death benefits or premiums. Whole life insurance also tends to be more expensive.

The upside to whole life insurance is that its cash value doesn’t decline. The fixed rate of earnings is more predictable than IULs‘ stock and bond indexes.

IUL vs Variable Universal Life (VUL)

Like IUL, variable universal life offers flexible premiums, accumulated cash growth, and tax treatment. The main difference is in how the variable universal life policy handles the funds of the accumulated cash.

VUL allows you to invest the cash value directly in securities, such as stocks and bonds. Unlike IUL, VUL has no cap rates or floors, and no participation rate. IUL has better market protection while VUL has the risk and reward of direct investments.

IUL vs Traditional Universal Life

The main difference between IUL and universal life is that IUL has indexed returns. Traditional universal life insurance has fixed interest returns.

Who Should Consider Indexed Universal Life Insurance?

Not everyone should purchase an indexed universal life insurance policy. Let’s review the general best and worst candidates for IULs.

Ideal Candidates

The individuals who tend to benefit most from indexed universal life insurance policies are:

• High-income earners looking for tax-advantaged strategies
• People with long-term financial planning goals seeking a tax-free retirement income or a better estate plan
• Those passing on general wealth
• Those who’ve maxed out other retirement accounts (e.g. 401(k) or IRA)

Who May Want to Avoid IUL

Just like how whole life insurance isn’t for everyone, IUL isn’t for everyone.

Individuals needing only simple or short-term coverage may find term life insurance policies to be much more cost-effective. Those with tight budgets may struggle with the long-term funding requirements of IUL. IUL can be worse than other life insurance policies for those who do not have a steady source of income because of this.

People looking for guaranteed investment returns may benefit more if they invest in stocks or other opportunities instead of IUL.

How to Evaluate an IUL Policy

Understand the Illustration

It’s important to review the IUL policy’s illustration, which shows the projections of your policy’s cash growth. The projections rae based on predicted interest rates, the participation rate, fees, and other factors.

No matter how realistic the projections are, they are only estimates. Look also at the guaranteed values, such as the death benefit and floor, for a more secure idea of how each IUL will perform.

Review Participation Rates, Caps, and Floors

Participation rates and caps can both be detrimental to your IUL policy potential.

Participation rate: The rate that determines how much of your index gain is credited to your policy.

Caps: IUL policies have capped (maximum) returns, which can limit upside participation in markets.

Floors: Most IUL policies offer a “floor”, which is essentially a guaranteed percentage of 0%. That way if there is significant market volatility, you can mitigate risk.

Check the Fees and Charges

There might be fees and charges associated with your indexed universal life insurance policy. IUL coverage fees can increase over time, possibly eating into your payments.

Check Insurer Reviews

Every insurance company has its own way of underwriting policies, processing claims, and handling customer issues. It’s a good idea to check out customer testimonials and the life insurance carrier’s history. An IUL insurer with bad reviews should likely be avoided since they may not have the right financial reliability, claims process, or policy coverage.

Work with a Fiduciary or Independent Agent

Unbiased, expert advice can go a long way. Our guide is a good starting point for what is IUL insurance and its pros and cons, but we can’t give specific financial advice. A fiduciary or independent agent can help you figure out what is best for you based on your finances, age, and other factors.

Common Uses for IUL in Financial Planning

Many financial planners look at life insurance options to maximize benefits and financial protection. IUL can be a useful part of your financial plan because of the following factors.

Supplemental Retirement Income

If you need to take out a loan for your retirement, such as to go on vacation at a luxury resort, tax-free loans from IULs could be a good choice. An IUL can help you obtain supplemental retirement income that is tax-free.

Estate Planning and Wealth Transfer

IULs can be helpful for estate planning, especially if you want to pass on generational wealth. Speaking with a professional estate planner is an excellent choice for seeing whether an indexed universal life insurance policy is optimal for you.

Business Uses

You can protect your business using life insurance policies. Key person insurance, executive bonus plans, and other policies all play a role. IUL may be something worth considering in case you want to financially support your business even if you pass away.

College Funding

If you want to fund your child or children’s college tuition, life insurance can be an alternative or supplementary option to 529 plans. Death benefits are more flexible because your loved ones can quickly receive them upon your death, allowing the money to be used for any purpose if you pass away prematurely, including tuition.

If you need extra cash to pay for tuition, you can also fund college for your child while alive using an IUL.

Conclusion

IUL’s main features are:

• Flexible death benefits and premiums
• Market-linked growth with floors and caps
• Tax advantages

IULs are powerful tools best for those who have maxed out other tax-advantaged accounts. Consult with a licensed financial advisor or insurance professional to see whether IULs align with your long-term financial strategy.