INDEXED UNIVERSAL LIFE INSURANCE POLICY IUL: How It Works

indexed universal life insurance

If you want the flexibility of universal life insurance with the growth potential of a cash value account, you should look into indexed universal life insurance policy. Indexed universal life insurance, or IUL, allows you to benefit from some of the stock market’s upside while limiting risk.
There are numerous options, fees, and forecasts to consider before purchasing an IUL policy. IUL coverage has more ups and downs than other types of life insurance because it ties cash value to the stock market. However, for a savvy investor looking for a policy with flexibility, indexed universal life may be the ideal solution.

What is Indexed Universal Life Insurance IUL?

Permanent life insurance is a type of indexed universal life insurance. It remains in force as long as you make your premium payments on time or until the maturity date specified in the policy. Many IULs mature when the insured reaches the age of 121.

Indexed universal life insurance includes a cash value component with gains and losses tied to an index such as the S&P 500. While the cash value fluctuates with the index, the insurance company actually invests in securities such as bonds and mortgages.

A policy loan allows you to borrow against your cash value or withdraw cash value. When you die, your beneficiaries will receive a death benefit, but the amount will be reduced by any unpaid loans or withdrawals from the cash value.

Changes to your death benefits and/or premium payments are sometimes possible with universal life insurance, but only within certain limits. The primary distinction between indexed universal life insurance and other universal life insurance policies is the manner in which cash value accumulates.

How Does Indexed Universal Life Insurance IUL Policy Work?

Indexed universal life insurance functions similarly to universal life insurance. You pay a premium in exchange for lifelong coverage and can invest in the cash value account. The cost of insurance (covering your death benefit) and other fees are deducted from your premium payment, and the remainder is deposited into your cash account.

IUL premiums, like universal life premiums, are adjustable. If you decide to skip a premium payment or underpay, the money will be deducted directly from your account. If your needs change, you may be able to adjust the death benefit amount. So, if you apply to increase your coverage, you may be required to take a medical exam.

How IUL cash value accounts function

The cash value account earns money based on the performance of a stock index of your choice. A stock index, such as the S&P 500 or Dow Jones Industrial Average, is a method of tracking a collection of stocks. You can select one or more of these indices from insurance companies. The insurer pays policyholders interest based on the performance of the index; as the value rises, the account earns interest. If the index falls, the account earns less or none at all.

To help minimize large swings in interest payments, the amount you can earn is subject to “floors” and “caps.” The floor is the lowest possible account rate that is usually guaranteed for the life of the policy but is frequently set at 0%. This means that if the market crashes, the account will not suffer losses.

The cap is the highest interest rate that the account can earn, so if the market rises more than the cap, you’ll only be credited for the amount that exceeds the cap. In contrast to the floor, your insurer can change the cap while the policy is still in effect.

As an example, consider an IUL policy with a 0% floor and a 9.5% cap. The cash account money earns interest at the credited rate shown in the last column.

Here are the market changes and the credited life insurance interest rate.

Index changeIndex floorIndex capCredited rate
-4.0%.0.0%.9.5%.0.0%.
21.8%.0.0%.9.5%.9.5%.
8.9%.0.0%.9.5%.8.9%.
3.5%.0.0%.9.5%.3.5%.

You can see how the floor protected the account from losses at first, but how the cap limited the index’s benefit in the following period. The index increased by 21%, while policyholders gained only 9.5%.

Pros of Indexed Universal Life Insurance IUL

As with any type of universal life insurance, thorough research is required to ensure that any potential firms are among the best universal life insurance companies currently in operation. With that in mind, here are some of the primary benefits of including IUL in your financial plan.

#1. Greater Profitability

These policies use call options to gain upside exposure to equity indexes without the risk of losses, whereas whole life insurance policies and fixed universal life insurance policies offer only a small interest rate that may or may not be guaranteed. Of course, the annual return on an IUL insurance policy will be determined by the performance of its underlying index. However, your insurance company may still be able to provide a guaranteed minimum return on your investment.

#2. More adaptability

When putting together a policy to meet your investment objectives, IUL insurance can provide flexibility. Policyholders can choose how much risk they want to take in the market, adjust death benefit amounts as needed, and select from a variety of riders that make the policy tailored to their specific needs. For example, you could include a long-term care rider to cover nursing home costs if they arise.

#3. Capital Gains Are Tax-Free

Unless they abandon the policy before it matures, policyholders do not pay capital gains on the increase in cash value over time, whereas other types of financial accounts may tax capital gains upon withdrawal.

This benefit extends to any loans you may take out against the policy’s cash value. If you want to avoid paying taxes and penalties on an early withdrawal from a 401(k) or IRA, having a ready source of cash to borrow against may be appealing.

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

#4. No effect on Social Security

In retirement, Social Security benefits may be a significant source of income. You can start receiving Social Security benefits as early as age 62 or defer them until age 70. Taking benefits before reaching your full retirement age, as well as working while receiving benefits, can reduce your benefit amount. Before reaching full retirement age, you can only earn a certain amount per year before your benefits are reduced.

The cash value accumulation from an IUL insurance policy, as well as any loan amounts borrowed, would not count toward the earnings thresholds. As a result, you could borrow against your policy to supplement Social Security benefits without reducing your benefit amount.

#5. Death Insurance

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

Financial experts frequently recommend having life insurance coverage equal to 10 to 15 times your annual income.

Cons of Indexed Universal Life Insurance

There are several disadvantages to IUL insurance policies, which critics are quick to point out. For example, someone who establishes the policy during a period when the market is performing poorly may end up with high premium payments that make no contribution to the cash value. If the premium payments are not made on time later in life, the policy may lapse, defeating the purpose of life insurance entirely.

Aside from that, keep the following considerations in mind:

#1. Caps on Returns

Insurance companies frequently set maximum participation rates that are less than 100%, and in some cases as low as 25%. Furthermore, during good years, returns on equity indexes are frequently capped at certain levels. Regardless of how well the policy’s underlying index performs, these restrictions can limit the actual rate of return that is credited to your account each year.

In that case, you might be better off investing directly in the market or considering a variable universal life insurance policy. However, it is critical to consider your personal risk tolerance and investment goals to ensure that both are consistent with your overall strategy.

#2. There are no guarantees.

Whole life insurance policies frequently include a guaranteed interest rate as well as predictable premium amounts throughout the policy’s life. IUL policies, on the other hand, provide index-based returns with variable premiums over time. This means you must be willing to accept fluctuations in returns while also budgeting for potentially higher premiums.

#3. Fees

IUL insurance policies can include a slew of fees and other costs, such as:

  • Charges for premium expenses
  • Administrative costs
  • Riders
  • Commissions and fees
  • Charge of Surrender

All of these fees and costs can reduce the rate of return provided by your policy. That’s why it’s critical to research the best life insurance companies so you know what you’re paying for and what you’re getting in return.

Is it a good idea to get indexed universal life insurance?

Keep in mind that IUL policies are more expensive than other types of life insurance due to higher premium costs and potential fees. If you’re thinking about purchasing an indexed universal life policy, consult with a financial advisor who can explain the nuances and provide an accurate picture of an IUL policy’s actual potential. Check to see how the insurer will calculate your interest rate, earnings cap, and any fees that may be assessed.

Term Life Insurance vs. Indexed Universal Life Insurance IUL

Term life insurance is a simpler and less expensive way to ensure that your loved ones are financially secure if you die while the policy is active. As opposed to IUL insurance, term life insurance which lasts your entire life if you pay your premiums lasts for a set period of time, typically 10, 15, 20, or 30 years. If you die while the policy is still in effect, your beneficiaries can claim your death benefit, and there are no interest rates or higher premiums to worry about.

Whole Life Insurance vs. Indexed Universal Life Insurance

Whole life insurance builds cash value on a predetermined schedule and is a less complicated policy to universal life insurance. You don’t have to be concerned about the performance of specific market indexes, and the premium is likely to be lower with fewer fees than an IUL. However, unlike with a universal policy, you will not be able to adjust premiums or achieve a paid-up policy.

Variable Life Insurance vs. Indexed Universal Life Insurance Policy

Variable life insurance is more complicated than an indexed universal life insurance policy because it allows for even more flexibility. Unlike an indexed policy, the cash value of a variable policy may be entirely dependent on the stocks you choose.

While your variable policy may have a fixed minimum death benefit, the performance of your cash value could significantly increase or decrease your beneficiaries’ total payout upon your death. Your premium may also be influenced by how well the variable portion performs, with poor performance resulting in a higher cost. As a result, variable life insurance is regarded as riskier than whole or universal life policies, including IUL.

Is It Possible to Withdraw Indexed Universal Life Insurance?

While you can access your cash value in an IUL policy, there are some instances where doing so is taxable. For example, you can withdraw tax-free up to your basis (the amount you’ve paid into the policy). Any withdrawal that includes a portion of your investment gains before the policy matures, on the other hand, will be subject to income taxes in that tax year.

Borrowing against cash value may also result in a taxable event. If you let the loan interest deplete the current cash value, your policy may lapse, and you will be required to pay taxes on the loan balance.

Is Indexed Universal Life Insurance Policy a Better Investment Than a 401(k)?

Indexed universal life insurance, as well as 401(k) plans, each have their own set of benefits. A 401(k) plan offers more investment options and may include an employer match. An IUL, on the other hand, includes a death benefit as well as additional cash value that the policyholder can borrow against. They do, however, have high premiums and fees, and, unlike a 401(k), they can be canceled if the insured stops contributing to them.

Conclusion

IUL insurance can help you meet your family’s financial protection needs while also accumulating cash value. These policies, however, can be more complicated than other types of life insurance, and they aren’t always appropriate for every investor. Speaking with an experienced life insurance agent or broker can assist you in determining whether indexed universal life insurance is a good fit for you.

Indexed Universal Life Insurance FAQs

Can you lose money in a IUL?

It is unlikely that you will lose money in an IUL because insurance companies guarantee your principal against market losses. However, there is frequently a maximum amount you can earn.

Is Indexed Universal Life Worth It?

An IUL is only a good investment if the stock market falls and your cash value rises faster than the market. When the stock market is booming, an IUL is likely to disappoint.

Does IUL have cash value?

Indexed universal life insurance is a type of permanent life insurance that includes both a cash value and a death benefit.

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