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Understanding Indexed Universal Life (IUL) Insurance

Understanding Indexed Universal Life (IUL) Insurance
Matthew Collister
Updated October 12, 2021
5 Min Read

Indexed universal life (IUL) is a form of insurance that, like other life insurance policies, pays a death benefit to your beneficiaries upon your passing. It can also help you earn money, based on the performance of the stock market, to use while you’re still living. 

Depending on your life insurance needs, your interest in using life insurance as an investment vehicle, and your tolerance for financial risk, an IUL policy may be a good choice for you.

How does indexed universal life insurance work?

IUL is “permanent” life insurance. This means the policy stays in force until your death, and it has what’s known as a cash value feature. It’s also a form of universal life insurance, so you can adjust your death benefit and your premium payment as your needs change. 

When you buy an IUL policy, you and your insurance company agree to a specific dollar figure for your death benefit. This death benefit is paid to your designated beneficiaries (such as your spouse or children) upon your death. The amount of the death benefit drives the cost of your premium — the more the policy pays, the higher your premium. In this way, IUL acts as any other life insurance policy, providing your family with financial protection in the event of your passing.

In addition to the death benefit, an IUL policy can help you earn money through its cash value feature. Cash value works like an investment account. You fund it by making premium payments in amounts beyond what’s needed for the insurance coverage and related fees. The insurance company sets that money aside in an account that grows based on the performance of a stock index of the company’s choosing. Examples of stock indexes are the Dow Jones Industrial Average (DJIA) and the S&P 500.

If the chosen stock index increases in value over a set period (for example, annually), your cash value account earns interest based on the index’s percentage of increase. For example, if your index is the S&P, and it grows at 8% in a given year, then your cash value is multiplied by 8%. The resulting interest is added to your cash value.

This interest is subject to caps and floors. A cap is a limit to how much you can earn. If your account’s cap is set at 10%, and the chosen index grows 13%, the interest paid to your account will only be 10%. The floor, meanwhile, is the lowest amount you can earn. Floors are usually set to 0%. If the index loses 10% in your time period, you simply won’t earn any interest. Caps and floors serve to limit your potential earnings while also limiting your risk. 

How you can use your cash value

You have multiple options as your cash value grows. You can withdraw some of the funds to pay for an emergency, supplement your retirement income, take a vacation, or do whatever you like. Just be aware that any investment gains are considered “taxable income.” You should discuss this with your tax preparer. 

You can also take out a loan against your cash value. The loan amount accrues interest until its paid back in full. If you should pass away while the loan is still outstanding, the balance will be deducted from the death benefit. 

It’s also common to use the cash value to pay the policy’s premium. And if you decide to cancel, or “surrender” the policy, you should get back the cash value minus a surrender charge and any unpaid premiums due.

Of course, you can let the cash value grow and grow, and serve as part of your nest egg as you approach and enter retirement. 

Advantages of indexed universal life insurance

If you’re looking for some flexibility when it comes to your life insurance and have a slightly higher appetite for risk when it comes to investments, an IUL might be right for you. 

With an IUL, you gain some control over your death benefit and payments. If your needs change in the years after you purchase the policy, you can adjust your death benefit and premiums. This is one of the key features of universal life policies.

You also enjoy the opportunity to tie your earnings to the stock market. Because the stock market generally outperforms interest rates for other types of life insurance policies (the average rate of return for the S&P 500 in the past 10 years has been 13.6%, while the DJIA has returned 9.2%, according to Goldman Sachs), an IUL offers the possibility of higher returns.

Disadvantages of indexed universal life insurance

While an IUL policy offers a nice combination of flexibility and earnings, these policies do have some caveats. Any time your money is tied to the stock market, there’s risk involved. During periods of market contraction, your returns may fall short of your goals, or be nonexistent. So if you typically rely on the cash value to cover your premiums, you may find yourself needing to pay extra money to keep the policy in force. 

And while the policy’s floor can help limit your losses, its earnings cap will also prevent you from maximizing your gains. So if the market goes through a particularly bullish period, you won’t be able to fully participate in that growth.

IUL policies also have fees that can be modified at any time by the insurance company. Rising policy fees can eat into your cash value. 

Indexed universal life vs. whole life insurance

If you’re shopping for life insurance, you may be considering either an IUL or a whole life policy. While the two policy types share some features, there are some key differences.

Both policy types are permanent life insurance, meaning the coverage stays in effect until your death (unless you surrender the policy, or the policy is canceled due to non-payment of the premium). Both policy types also have a cash value component, meaning they can be used as an investment tool in addition to insurance. With both, the cash value can be accessed through withdrawal or loan, or can be used to pay the policy premium. 

However, while the interest in an IUL is variable and tied to the performance of stock indices, the interest in a whole life policy is fixed, which may limit both your returns and risk. An IUL also allows you to modify your death benefit and premium if your needs change. This feature is unavailable with a whole life policy, which features a fixed death benefit and premium. 

Is indexed universal life the right choice for you?

If you’re a certain type of investor, an IUL may be right for you. Ask yourself: Are you interested in participating in the stock market, and willing to accept a little more risk than with a whole life policy? If so, are you comfortable not having total control of your investments (remember, the insurance company chooses which stock indexes it ties to your cash value)? And are you willing to see your earnings capped when the markets show strong growth? If you’ve answered yes to these questions, then an IUL might be right for you.

There are many types of life insurance to choose from. Some policy types are fairly simple, while some are much more complex. An IUL is generally considered among the more complex types available.

A combination of features

An IUL provides a combination of life insurance coverage with a cash value feature that’s tied to the performance of the stock market. These policies offer greater flexibility than other types of life insurance, with a bit more risk on the investment side. But if this combination of features meets your needs, then an IUL might be the ideal type of life insurance for you.

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