What Is an IUL Policy and How Does It Work?

Life insurance provides monetary support to beneficiaries upon the policyholder’s death. Indexed Universal Life (IUL) policies are a form of permanent coverage. An IUL policy combines a death benefit with a cash value component. This cash value has the potential to grow over time, with its performance linked to a selected market index.

Understanding Indexed Universal Life Insurance

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, an IUL policy can remain in force for the policyholder’s entire life, provided premiums are paid and the policy maintains sufficient cash value.

IUL policies offer flexibility. Policyholders can adjust their premium payments or modify the death benefit amount as their financial needs change.

The cash value within an IUL policy is linked to the performance of a chosen stock market index. Funds are not directly invested in the market; instead, the insurance company uses the index’s performance to determine the interest credited to the policy’s cash value. This indirect linkage offers growth potential while providing a layer of separation from direct market volatility.

How IUL Cash Value Grows

The cash value component of an IUL policy accumulates through interest credits tied to a selected market index. Key terms influencing growth include the participation rate, cap rate, floor rate, and a spread.

The participation rate determines the percentage of the index’s gain credited to the cash value. For example, if an index gains 10% and the policy has an 80% participation rate, the credited interest would be 8%. This rate can sometimes be adjusted by the insurer.

The cap rate sets the maximum interest rate credited to the cash value, regardless of index performance. If the cap rate is 12% and the index gains 15%, only 12% would be credited. This cap limits upside potential. Conversely, the floor rate is the minimum interest rate credited, often set at 0%. This floor protects against market losses.

Some IUL policies may also incorporate a spread, a deduction from the index’s gain before interest is credited. For instance, if an index gains 8% and there is a 2% spread, the policy would be credited with 6%. The interaction of these rates determines the actual interest applied to the cash value, which grows on a tax-deferred basis, meaning taxes on earnings are not due until funds are accessed.

Accessing Your Policy Value

Policyholders can access the accumulated cash value within an IUL policy through two primary methods: policy loans and partial withdrawals. Both methods have different implications for the policy’s cash value, death benefit, and potential tax liabilities.

Policy loans allow the policyholder to borrow money using the cash value as collateral. These loans are generally not considered taxable income as long as the policy remains in force. Interest typically accrues on the loan, and while there is no strict repayment schedule, unpaid interest can increase the loan balance, potentially reducing the available cash value and the death benefit paid to beneficiaries. If the policy lapses with an outstanding loan balance that exceeds the premiums paid, the unpaid loan amount can become taxable income.

Partial withdrawals directly reduce the cash value and can also decrease the policy’s death benefit. Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered a return of the policyholder’s cost basis. Any amount withdrawn that exceeds the total premiums paid may be subject to income tax. If an IUL policy is classified as a Modified Endowment Contract (MEC) due to excessive premium payments, loans and withdrawals are taxed differently, with earnings potentially taxed first and subject to a 10% penalty if accessed before age 59½.

Costs and Policy Management

Indexed Universal Life policies involve various fees and charges that impact long-term performance and cash value growth. These charges are typically deducted from premium payments or directly from the cash value.

One significant cost is the Cost of Insurance (COI), which covers the death benefit expense. COI is influenced by factors such as the policyholder’s age, health, and the death benefit amount, and it typically increases as the policyholder ages. Administrative fees are also charged for maintaining the policy.

Premium loads, or expense charges, are upfront fees deducted from each premium payment before funds are allocated to the cash value. Additionally, surrender charges may apply if the policy is terminated within a certain period. These cumulative costs can reduce cash value accumulation, especially in the policy’s early years.

If cash value growth is insufficient to cover increasing costs, particularly the rising COI, the policy could lapse. Policyholders may need to make additional premium payments or adjust policy features to prevent a lapse.