What Is an Indexed Universal Life (IUL) Policy?

An Indexed Universal Life (IUL) policy is a type of permanent life insurance designed to provide lifelong coverage. It features a death benefit, which offers financial protection to beneficiaries. IUL policies also include a cash value component whose growth is linked to a chosen stock market index, such as the S&P 500, without directly investing in the market.

Defining Indexed Universal Life Insurance

Indexed Universal Life insurance is a permanent life insurance policy combining a death benefit with a cash value feature. Unlike traditional whole life policies, IUL cash value growth is tied to a specific stock market index. This allows policyholders to potentially benefit from market gains without directly owning securities.

The “universal life” aspect provides flexibility in premium payments and the ability to adjust the death benefit as financial needs change. Policyholders can modify or even skip premium payments if the accumulated cash value covers policy costs. This adaptability distinguishes universal life policies from more rigid permanent life insurance.

The “indexed” component means interest credited to the cash value is determined by an external market index, such as the Nasdaq 100 or S&P 500. The policy does not directly invest in the stock market or index funds. Instead, the insurance company uses the index’s performance as a benchmark to calculate interest credited to the cash value.

Key Components of an IUL Policy

The death benefit is the sum of money paid to designated beneficiaries upon the insured’s death. In an IUL policy, it can often be adjusted over time, allowing policyholders to increase or decrease coverage based on evolving financial obligations and family needs.

The cash value account operates as a savings component within the policy. A portion of each premium payment, after charges, is allocated to this account. It grows over time, accumulating value that can be accessed by the policyholder during their lifetime.

The indexed account dictates how the cash value grows. Rather than earning a fixed interest rate, the cash value’s growth is linked to the performance of a specific market index. The insurance company credits interest to the cash value based on the chosen index’s performance, but policyholders do not directly participate in the market.

IUL policies come with various charges and fees that impact cash value accumulation. These include mortality and expense charges, administrative fees, and surrender charges if the policy is terminated prematurely. These charges reduce the premium available for cash value growth.

How IUL Policy Value Grows

An IUL policy’s cash value growth is determined by indexing methods linking its performance to a market index. Interest credits are calculated based on a chosen index’s performance over a defined period. Common methods include point-to-point, which compares index values at two specific points, and annual reset, which measures performance annually.

A participation rate determines the percentage of the index’s gain credited to the cash value. For instance, a 70% participation rate means if the index gains 10%, the cash value is credited with 7% interest. This rate varies between policies and carriers.

The cap rate represents the maximum interest rate credited to the cash value in any crediting period, regardless of index performance. If the index’s gain, after applying the participation rate, exceeds the cap, only the cap rate is applied. Cap rates typically range from 8% to 12% but fluctuate based on market conditions and insurer offerings.

Conversely, the floor rate provides a guaranteed minimum interest rate, often 0% or 1%, that the cash value earns, even if the linked index performs negatively. This protects against market downturns, ensuring the cash value does not lose principal. The floor prevents losses, distinguishing IUL from direct market investments.

Premium allocation plays a role in cash value growth. When a premium is paid, a portion covers insurance costs, fees, and administrative charges. The remaining amount is allocated to the cash value, which participates in the indexed growth strategy. This process directly impacts the rate at which the cash value accumulates and generates interest credits.

Policyholders can access the cash value through loans or withdrawals. Policy loans allow access without fully surrendering the policy, but the loan balance accrues interest and reduces the death benefit if not repaid. Withdrawals permanently reduce both the cash value and the death benefit. These options provide liquidity but impact the policy’s long-term value and death benefit.

Tax Treatment of IUL Policies

A significant benefit is the tax-deferred growth of the cash value. Interest credited to the cash value accumulates without current income taxes. Taxes on these gains are only incurred if funds are withdrawn from the policy.

The death benefit paid to beneficiaries from an IUL policy is generally income tax-free. This allows the full death benefit to be passed on, providing a financial legacy without tax erosion. This tax-free payout is a characteristic of most life insurance policies.

Policyholders can access their cash value through policy loans or withdrawals on a tax-favored basis. Policy loans are generally tax-free, considered debt against the policy rather than taxable income. Withdrawals up to the policyholder’s “basis” (total premiums paid) are also typically received tax-free.

However, these tax benefits can be altered if the policy becomes a Modified Endowment Contract (MEC). A policy is designated as a MEC if it fails the “7-pay test,” meaning cumulative premiums paid within the first seven years exceed a specific tax law limit. Once classified as a MEC, policy loans and withdrawals are taxed on a “last-in, first-out” (LIFO) basis, with earnings considered withdrawn first and subject to income tax. Additionally, withdrawals and loans from a MEC before age 59½ may incur a 10% federal income tax penalty.

If an IUL policy is surrendered, any gain (amount received above total premiums paid) may be subject to ordinary income tax. Surrender charges, fees deducted by the insurer for early termination, also reduce the net amount received. The tax implications of surrender underscore the importance of long-term commitment.