Indexed Universal Life Insurance
How Indexed Universal Life Insurance Works
Indexed universal life, or IUL, insurance is a type of permanent coverage that offers a death benefit as well as a cash value component. These policies are more flexible than whole life and even regular universal life insurance.
One reason for this is that the IUL policyholder can choose from several different investment or fixed account options for determining how the return on the cash value will be done.
For instance, indexed universal life insurance will track one or more underlying market indexes, such as the S&P 500 or the DJIA (Dow Jones Industrial Average). When the index performs well in a given policy contract year, a positive return will be credited to the cash value—usually up to a preset limit (or “cap”).
But, if the underlying index(es) incurs a loss during a given contract year, no negative credit is credited to the cash value account. Instead, a guaranteed minimum “floor” rate will be provided. Therefore, the principal in the account will not decrease in value—even if the underlying index generates a significant loss.
Further, because there are no losses to make up for, if or when the index performs well again in the future, previous gains may continue to be built upon. This can provide the policyholder with a “win-win” scenario.
When considering an IUL policy, it helps to understand which crediting method(s) are used and how they work. That way, you will know what to anticipate in certain situations. These crediting methods can include one or more of the following:
- Cap
- Spread
- Participation Rate
A cap represents the highest rate of growth that will be credited to the cash value—even if the underlying index (or indexes) has a stellar performance during a given contract year. For example, if an IUL policy has a cap of 6%, and the underlying index generates an 8% return for the year, 6% will be credited to the cash value.
The insurance company sets participation rates. These refer to the percentage of the index’s gain credited to an IUL’s cash value. For instance, if the participation rate is 80%, and the underlying index generates 10% in a given time frame, then the cash value would receive an 8% positive return. This is because 80% of 10% equals 8%.
A spread is also expressed as a percentage. In this case, an amount is subtracted from the return generated from the underlying index(es). For example, if there is a spread of 3%, and the tracked index returns 10% in a given contract year, then 7% will be credited to the cash value because 10% minus a 3% spread equals 7%.
Like other types of permanent life insurance, the growth in an IUL policy’s cash value component grows on a tax-deferred basis. This means that no tax is due on the gain until the withdrawal time. So, over time, the value could grow considerably—especially compared to a taxable account with all other factors being equal.
Tax Deferred versus Taxable Growth
Because of the tax-deferred nature of the cash value, some investors turn to indexed universal life insurance as an additional method of generating tax-advantaged growth, similar to that in IRAs (Individual Retirement Accounts) and employer-sponsored retirement plans (such as a 401k)—but without the annual maximum contribution limitations.
The cash from an indexed universal life insurance policy may be withdrawn and used. However, if this happens, the portion of the withdrawal that is considered gain will be taxed as ordinary income.
In addition, most permanent life insurance policies have a surrender charge period during which a penalty will be incurred if the policy is surrendered (i.e., canceled) or if more than a certain amount is taken out of the account.
On top of that, if these withdrawals occur before the policyholder has turned 59 ½, an additional 10% “early withdrawal” penalty will usually be incurred from the IRS. So, only about half of the amount withdrawn from the policy may be used as spendable cash.
As an alternative, tax-free loans can be accessed from the policy. In this case, there are no surrender charges or added IRS penalties. In addition, because the loan is technically from the insurance company (rather than from the policy’s cash value itself), the borrowed funds will remain in the cash value account—and it will continue to generate growth as if the money was still there.
As an added “bonus,” while the loan may be repaid (with interest), if there is a balance remaining at the time of the insured’s death, the amount that is due will simply be taken from the policy’s death benefit, and any of the remaining funds will be paid out to the beneficiary. Like other types of life insurance proceeds, the beneficiary (or beneficiaries) receives the death benefit funds free of income taxation.
Because indexed universal life is a type of permanent coverage, there is no “time limit” on the policy like term life insurance. So, as long as the premium is paid, the IUL policy will stay in force—even if the insured contracts an adverse health condition in the future.
Pros and Cons of Indexed Universal Life Insurance
| Advantages of Indexed Universal Life Insurance | Disadvantages of Indexed Universal Life Insurance |
|---|---|
| Death benefit coverage (paid income tax-free to the beneficiary) | Limitations on the growth of the cash value (caps, spreads, or participation rates) |
| Low premiums | Surrender charge(s) on withdrawals from the cash value |
| Flexibility | Surrender charge if the policy is canceled during a preset period |
| Tax-deferred gains in the cash value | The premium for the death benefit could go up |
| Opportunity for higher growth than whole life and regular universal life insurance | |
| Principal protection in any type of market environment | |
| No limit on annual contribution to the policy | |
| Ability to access cash via withdrawal or tax-free loan |
How Much Does Indexed Universal Life Insurance Cost?
When a premium is paid into an indexed universal life insurance policy, a portion goes to pay the cost of the insurance protection. Any fees will also be taken from the premium payment, and the remainder will go into the policy’s cash value component.
Several factors are considered when determining the premium for an indexed universal life insurance policy. These typically include the following:
- Amount of the death benefit coverage
- Age and gender of the applicant
- Health history (as well as family health history)
- Prescription medications used
- Smoking status (including cigarettes, cigars, marijuana, and chewing tobacco)
- Occupation
- Marital status
- State of residence
- Other life insurance coverage in force (and the amount)
- Insurance carrier
Who is a Good Candidate for Indexed Universal Life Insurance?
vehicle is not right for everyone. Someone who may be a good candidate for indexed universal life insurance, though, could include an individual who:
- Needs permanent death benefit protection for loved ones or business succession requirements
- Is seeking additional alternatives for generating tax-deferred growth (even if they have “maxed out” the annual contributions to an IRA and employer-sponsored retirement plan)
- Wants the opportunity to generate higher growth than whole life and regular universal life insurance, but who also wants the assurance that principal will be safe—even if the stock market tumbles
- Is in relatively good health (to qualify for the death benefit coverage)
- Wants additional alternatives for tax-free retirement income.
Because not all indexed universal life insurance policies are the same, even if this type of coverage seems like a good fit, it is recommended that you talk with a specialist who can help you narrow down the best plan for your specific needs.
Is Indexed Universal Life Insurance Right for You?
If you have any questions regarding IUL, or you’re interested in getting a quote on this type of coverage, it can help to discuss your needs and objectives with a financial specialist who is also knowledgeable about life insurance planning.
For a no-cost, no-obligation meeting—in-person, over the phone, or online—please feel free to contact us at <phone number> or email us at <email address>. We look forward to talking with you.
