Is Indexed Universal Life (IUL) a Good Investment?

Indexed Universal Life (IUL) insurance is a type of permanent life insurance that offers both a death benefit and a cash value component. Unlike term life insurance, IUL provides coverage for an individual’s entire life. The cash value has the potential to grow, influenced by the performance of a market index, combining life insurance security with value accumulation.

Understanding Indexed Universal Life Insurance

The cash value component of an IUL policy has the potential to grow based on the performance of a chosen stock market index, such as the S&P 500 or NASDAQ 100. The policy’s cash value is not directly invested in the stock market; instead, the insurance company credits interest based on the index’s performance. This growth is subject to a cap rate, a participation rate, and a floor rate.

A cap rate represents the maximum interest rate that can be credited to the cash value in a given period, regardless of how well the underlying index performs. For instance, if an index gains 15% but the policy has a 10% cap, the cash value will only be credited with 10% interest for that period.

The participation rate determines the percentage of the index’s gains that will be credited to the policy’s cash value. For example, if an index increases by 10% and the policy has an 80% participation rate, the credited interest would be 8% before applying any cap. Some policies may offer participation rates exceeding 100%.

A floor rate provides a minimum guaranteed interest rate, often 0%, ensuring that the cash value will not decrease due to negative index performance. This protective feature means that even if the chosen index experiences a significant downturn, the cash value will not lose money from market losses.

Cash Value Growth and Death Benefit Mechanics

The insurance company uses options to link the cash value growth to the index while managing risk. Policyholders can access the accumulated cash value through policy loans or withdrawals.

A policy loan involves borrowing money from the insurer, using the cash value as collateral. These loans typically accrue interest, and if not repaid, they reduce the death benefit paid to beneficiaries. The cash value in the policy continues to earn interest, even while a loan is outstanding, though the loan amount might be subject to its own interest rate.

Withdrawals directly reduce the cash value and can also decrease the policy’s death benefit. If a withdrawal exceeds the premiums paid, the excess amount may be subject to taxation. Managing loans and withdrawals is important to avoid unintended reductions in the death benefit or potential policy lapse.

The death benefit in an IUL policy can be structured in different ways. A common structure is a level death benefit, where the payout to beneficiaries remains constant. An increasing death benefit option allows the death benefit to grow, often by including the accumulated cash value.

The interaction between the cash value and the death benefit is dynamic. As cash value grows, it can potentially increase the death benefit if structured that way, or it can be accessed by the policyholder, which would then reduce the eventual death benefit.

Policy Costs and Accessing Funds

Indexed Universal Life policies involve various costs and fees deducted from the cash value, affecting its growth and overall performance. Common charges include mortality and expense (M&E) charges, administrative fees for policy management, and record-keeping. These costs are typically deducted monthly from the cash value.

Surrender charges are fees incurred if the policy is canceled or surrendered, especially within the initial years after policy issuance. This period typically ranges from 10 to 15 years, with charges gradually decreasing over time.

Policy riders, which add specific benefits or features, also come with additional costs deducted from the cash value. These combined charges can significantly impact the cash value accumulation, particularly in the policy’s early years, as they reduce the amount available to earn interest.

Policy loans are generally not considered taxable income as long as the policy remains in force. However, interest is usually charged on these loans. If the loan balance, including accrued interest, grows too large relative to the cash value, it can lead to the policy lapsing.

If a policy lapses with an outstanding loan, the loan amount exceeding the premiums paid into the policy may become taxable.

Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered a return of basis. Any amount withdrawn that exceeds the total premiums paid is typically subject to income tax.

Considerations for Financial Planning

Indexed Universal Life policies offer specific tax implications. The growth of the cash value within an IUL policy is tax-deferred, meaning earnings are not taxed as they accumulate. Taxes are typically only incurred when funds are withdrawn from the policy and exceed the amount of premiums paid.

The death benefit paid to beneficiaries is generally received income-tax-free under Internal Revenue Code Section 7702. However, if the policy is classified as a Modified Endowment Contract (MEC) under Section 7702A due to excessive premium payments, loans and withdrawals may be subject to “Last-In, First-Out” (LIFO) taxation.

Withdrawals before age 59½ may incur a 10% federal income tax penalty. This reclassification can significantly alter the policy’s tax advantages.

IUL policies are designed for long-term financial strategies, and their performance is often illustrated through projections. These illustrations are not guarantees but rather projections based on various interest rate scenarios.

Policy illustrations typically show both guaranteed rates, which represent the minimum performance, and illustrated rates, based on historical index performance and assumptions about future caps and participation rates. Interpreting these illustrations requires careful consideration, as higher illustrated rates may not materialize, impacting actual cash value growth.

An IUL policy can align with several long-term financial objectives. For wealth transfer and legacy planning, the tax-free death benefit provides a method to pass assets to heirs without income tax liability.

The cash value can also serve as a source of supplemental retirement income through tax-free policy loans, helping to manage income streams in retirement. Additionally, IUL can be a tool for wealth accumulation, offering tax-advantaged growth that can complement other retirement savings vehicles.

However, careful planning and professional guidance are recommended to ensure the policy meets individual financial goals.