Indexed universal life insurance (IUL) is a type of permanent life insurance that combines a death benefit with a cash value component, giving policyholders the opportunity to grow their savings with a risk level tied to a market index. IUL policies are complex in nature, with flexibility in premium payments and the potential to adjust death benefits to fit changing life circumstances. Bankrate’s insurance editorial team is committed to helping you make informed financial decisions. This guide explains the basics of indexed universal life insurance and helps you decide if it’s the right choice for your needs.
Definition of Indexed Life Insurance
Indexed universal life insurance is a type of permanent life insurance that has both a death benefit and a cash value component. The cash value grows based on the performance of a selected market index, such as the S&P 500 or Nasdaq Composite.
The premiums you pay are essentially split into two parts. One part goes towards maintaining the death benefit, providing financial protection to your beneficiaries. The other part is allocated to the cash value component, which earns interest based on the index-linked index. Keep in mind that depending on your premium payment structure and the number of years of the policy, the amount allocated to maintaining the policy and the amount allocated to the cash value may differ.
Interest rates are subject to market forces, but IUL policies usually include a minimum guaranteed crediting rate to protect you from market downturns. This is a great benefit, but IULs also have a cap on the maximum return you can earn.
Permanent life insurance like IULs are designed to provide lifetime coverage as long as premiums are paid, but the maximum age for coverage ranges from 95 to 121, depending on the policy. As cash value accumulates, you can borrow against it, but any outstanding loans will reduce your death benefit. You can also withdraw it without having to repay it, but this also reduces your death benefit.
The flexibility of IUL policies allows you to adjust your premium payments and death benefits based on accumulated cash value, providing adaptive financial planning options. These features are discussed in more detail below.
How Index-Based Whole Life Insurance Works
IUL policies are flexible and have the potential to grow through market-linked returns, provide coverage for life, assuming premiums are paid, and have a cash value component that grows based on an index such as the S&P 500. Understanding how IUL policies work can help you determine if this type of insurance fits your financial goals.
Cash Value Component
The cash value component of an IUL policy is a key feature that distinguishes it from other types of life insurance. The policy’s cash value grows based on the performance of a market index you choose. However, IUL policies typically include “caps,” “floors,” and participation rates.
- cap: This is the maximum interest rate you can earn on your policy, even if the index performs well. For example, if your cap is 10 percent and the index rises by 12 percent, your return will be limited to the 10 percent cap.
- floor: This is a minimum interest rate guaranteed by the insurance, and it protects your cash value from a market decline: even if the index performs poorly, your cash value will never fall below the minimum interest rate (usually set at 0 percent).
- Participation rate: The participation rate determines the percentage of the refund paid to the policyholder. It is usually 100%, but insurance companies can lower it. For example, if your limit is 10% and your participation rate is 80%, your policy will pay out 8% of the refund.
Loans and Withdrawals
Once enough cash value has accumulated in your IUL policy, you will be able to access these funds through loans or withdrawals.
- loan: You can borrow against the policy’s cash value at a relatively low interest rate, for any reason. Insurance companies usually lower the interest rate they charge on the portion of the cash value associated with the loan, reducing the total amount the cash value can earn while the loan is outstanding. Furthermore, if you don’t repay the loan during your lifetime, the loan amount plus any accrued interest is deducted from the policy’s death benefit, which is then paid to your beneficiaries.
- drawer: With an IUL policy, you also have the option to withdraw funds directly from the cash value. No interest is charged and you don’t have to pay it back. However, like an outstanding loan, this amount is deducted from your death benefit and the cash value fund left to earn interest is also reduced by the amount withdrawn. Amounts withdrawn are generally tax-free income up to the amount paid in premiums, but any excess may be taxable.
With regard to both withdrawals and loans, if the cash value falls too far — that is, becomes insufficient to cover the costs of the policy and the death benefit — the policy may lapse and be terminated. If you choose to make withdrawals or take out loans against your IUL, it’s important to monitor the performance of your policy.
Flexible premiums
A useful feature of IUL policies is that premium payments are flexible and can be adjusted based on your financial situation.
- Minimum premium: After the first year, you can choose how much to pay – pay only the minimum payment, skip payments, or don’t pay at all, as long as the policy’s cash value covers the cost of maintaining the policy. If the cash value drops too much, your policy may lapse. If you choose to pay only the minimum payment, you may need to pay higher premiums or reduce your death benefit as you get older to keep your policy in place.
- Targeted Premium Strategy: Like whole life insurance, this means you pay set premiums to keep the policy in force until age 95 or 100. However, these target premiums are not guaranteed, and you may need to increase your premiums or reduce your death benefit if the cash value is insufficient.
- Pre-Funding: By making larger payments early on, policyholders can build up cash values more quickly, potentially reducing premiums required later on.
Death Benefit
IUL policies also offer flexibility in how you structure your death benefit.
- Death benefit grades: If you choose this option, your death benefit will remain constant over the life of the policy, just like with whole life insurance.
- Increased Death Benefit: This option offers greater protection, with the death benefit increasing as the cash value grows, but usually at a higher premium. This design pays both the death benefit and the cash value to the beneficiary upon the insured’s death, a unique feature in the world of whole life insurance.
Pros and Cons of IUL Policies
Indexed universal life insurance has a variety of benefits and drawbacks that can influence whether it fits your financial goals. Here’s a breakdown to help you weigh those pros and cons.
| Flexibility: Adjust premiums and death benefits as needed. | Limited growth potential: There is a cap on the maximum interest you can earn. |
| Tax Benefits: Cash value grows tax deferred and there is a tax-free death benefit. | Complex to understand: Knowledge of interest rates, caps, participation rates and how market indexes work is required. |
| Guaranteed Minimum Interest Rate: Protect your cash value from market downturns. | Can be expensive: Fees and premiums are higher than other types of life insurance. |
| Ability to Withdraw Cash Value: You can access your funds without accruing interest. | Possible policy lapse: If the cash value falls too far, your policy may terminate. |
How much does indexed whole life insurance cost?
The cost of indexed universal life insurance varies depending on several factors, including your personal information and the details of your policy. Understanding these factors can help you determine what to expect when considering this type of life insurance. Here are some factors to keep in mind and how they may affect the cost of IUL insurance.
- Personal factors: Your age, health, lifestyle, and gender all play a big role in the cost of IUL insurance. Younger applicants and healthier people usually pay less, but risky behaviors like smoking can make your premiums higher. Also, premiums may differ between men and women.
- Policy details: The amount of coverage and added riders also affect the cost. Higher death benefits require higher premiums, so a $3 million death benefit will cost more than a $500,000 death benefit. Adding riders such as child riders or premium waivers usually increases the price.
- Market factors: A policy’s participation rate, cap and floor play an important role in determining its cost. The participation rate determines how much of the index’s gain is added to your cash value. A higher participation rate means a larger savings amount and potentially lower premiums in the long run. A cap limits the maximum interest that can be added to your cash value, while a floor guarantees a minimum interest, thus protecting your policy from market downturns but also affecting your premiums.
- Premium Flexibility: As mentioned above, IUL policies have minimum premium requirements to remain in effect. If the cash value is too low, additional premiums may be required to prevent lapses, which can increase costs. Some policyholders choose target premiums for consistent payments while aiming for a long-term policy, while others choose prefunding to reduce future premiums.
As you can see, IUL costs can always fluctuate, and to better understand all these nuances, it can be helpful to speak with a qualified agent or use an IUL calculator to narrow down specific costs.
Who is Indexed Universal Life Insurance Right for?
IULs can be a good option for individuals who are comfortable with some risk but don’t want to fully assume the investment risk that comes with variable whole life insurance. Because IUL policies generally offer some guarantee, they are appealing to those looking for a balance between growth potential and safety. This type of insurance is ideal for those who want flexibility in their policy so they can adjust their premium payments and death benefits as life circumstances change.
However, it’s important that policyholders are willing to closely monitor their policies to ensure that their policies don’t lapse due to low cash value. Although IULs do have a cash value component, it’s important to remember that life insurance shouldn’t be thought of as a replacement for a retirement plan like a 401(k) or IRA.
Alternatives to Indexed Whole Life Insurance
Indexed universal life insurance isn’t right for everyone. The insurance market offers a wide variety of life insurance policies. Depending on your individual case, one of the following types of life insurance may better suit your needs and budget:
Term Life Insurance
Term life insurance covers the insured for a specific period of time, usually 10 to 30 years. Term life insurance has a death benefit but does not accumulate cash value. Many term life insurance policies are renewable, allowing the policyholder to extend coverage for another period, usually at a higher rate as they get older. Most term life insurance policies do not return any premiums when the coverage ends and only provide coverage up to a specific age, usually around age 80. Term life insurance is usually the least expensive coverage, especially for those who purchase the policy when they are young and healthy.
Whole Life Insurance
Whole life insurance is a type of permanent life insurance that typically features fixed premiums and a fixed death benefit. Like IUL coverage, whole life insurance builds a cash value component that can be borrowed against. While whole life insurance provides lifetime coverage, it’s important to keep in mind that most policies end coverage at a specific age, usually between 95 and 121 years of age, depending on the terms of the policy. This ensures you’ll remain protected for the rest of your life, as long as you keep paying your premiums.
Variable Life Insurance
Variable life insurance is a type of permanent life insurance that has a death benefit and a cash value component. Variable life insurance allows the insured to control their investments and choose their preferred investment types, such as mutual funds or exchange-traded funds. Variable life insurance offers more investment flexibility than IULs, but it also carries more risk. If investments underperform, the policy’s cash value and death benefit may decrease.
Universal Life Insurance
Universal life insurance works similarly to an IUL, but the cash value is calculated based on the insurance company’s declared interest rate rather than a market index. This type of permanent life insurance also allows the policyholder to adjust the death benefit and premiums.
Variable whole life insurance
Variable whole life insurance is a type of permanent life insurance that combines the features of variable whole life insurance and permanent whole life insurance. With this type of insurance, you have the freedom to invest your savings and change your premiums.
Indexed universal life insurance is a unique type of life insurance, but it shouldn’t be thought of as a retirement savings vehicle. It’s important to remember that while it offers flexibility and growth potential through its cash value component, its primary purpose is to provide a death benefit and financial protection for beneficiaries.
