What Is Equity Indexed Life Insurance?

Equity Indexed Life Insurance (EIL) is a type of permanent life insurance, offering both a death benefit and a cash value component. It provides financial protection for beneficiaries and a savings element that can grow over time. The interest credited to the cash value is linked to the performance of a market index, such as the S&P 500, without directly investing in the market. EIL policies offer potential for growth tied to market performance, often including a guaranteed minimum return.

Core Elements of Equity Indexed Life Insurance

Equity Indexed Life Insurance policies consist of two components: a death benefit and a cash value account. The death benefit provides financial protection to beneficiaries upon the policyholder’s death. This sum is generally paid as a lump sum and is typically received by beneficiaries free of income tax.

Premiums contribute to building a cash value account. This cash value accumulates within the policy. The growth of this cash value is a distinguishing feature of EIL, as it is tied to the performance of an external market index.

The cash value can be accessed by the policyholder during their lifetime. As the cash value grows, it can impact the net death benefit over time, depending on the policy’s structure.

Understanding the Indexing Mechanism

The growth of an Equity Indexed Life Insurance policy’s cash value is tied to the performance of a stock market index, such as the S&P 500 or NASDAQ 100. Policyholders do not directly invest in the index; rather, the interest credited to the cash value is calculated based on the index’s movements.

A key factor is the participation rate, which determines the percentage of the index’s gains that are credited to the policy’s cash value. For instance, if an index gains 10% and the policy has an 80% participation rate, 8% of that gain would be credited to the cash value. This rate can vary between insurance providers and may sometimes be guaranteed to be 100%.

Another element is the cap rate, which sets the maximum percentage of index gains that can be credited to the cash value in a given period. Conversely, the floor rate guarantees a minimum interest rate, often 0% or a small positive percentage, ensuring the cash value does not decline due to market losses.

Some policies may also incorporate a spread or asset fee, which is a percentage deducted from the index gains before applying the participation rate or cap.

Common indexing methods include annual reset, also known as annual point-to-point, where gains are locked in annually by comparing the index value at the beginning and end of each year. Another method is point-to-point (term-to-term), which measures performance from the start to the end of a longer, predetermined period, such as five or ten years. High-water mark uses the highest point of the index during a period for calculation.

Policy Structure and Accessing Cash Value

Equity Indexed Life Insurance policies offer flexibility in death benefit structure. Policyholders can choose between a level death benefit, where the payout remains constant, or an increasing death benefit, which includes the accumulated cash value in addition to the initial face amount. The choice impacts both premium costs and the potential payout to beneficiaries.

Policyholders may also add various optional riders to their EIL policies. These riders can include accelerated death benefit provisions, allowing access to a portion of the death benefit for terminal illness, chronic illness, or long-term care. Other riders, such as guaranteed insurability, permit future increases in coverage without further medical underwriting.

One common method to access cash value is a policy loan, where the cash value acts as collateral. These loans are generally tax-free as long as the policy remains in force, though interest accrues on the loan balance. An outstanding loan balance will reduce the death benefit paid to beneficiaries if not repaid.

Policyholders can also access cash value through withdrawals. Withdrawals are generally treated as a return of premium first, which is tax-free, and any amount exceeding the premiums paid becomes taxable income. Withdrawals reduce the policy’s cash value and can also decrease the death benefit.

A third option is a full surrender of the policy, where the policyholder receives the cash surrender value, which is the cash value minus any surrender charges or outstanding loans. Surrendering the policy ends the life insurance coverage and any gains above the premiums paid may be subject to income tax.

Costs, Charges, and Taxation

Equity Indexed Life Insurance policies involve various costs and charges. These typically include mortality charges associated with providing coverage, and administrative fees. Expense charges or sales charges may be deducted, often in initial years, covering issuance and commissions. Surrender charges are fees incurred if the policy is terminated within a specified initial period.

The death benefit paid to beneficiaries is generally received free of income tax. However, if the death benefit is paid in installments, any interest earned on the unpaid balance may be taxable.

Cash value growth within an EIL policy is typically tax-deferred. When accessing the cash value through withdrawals, amounts up to the total premiums paid are generally considered a tax-free return of principal. Any withdrawals exceeding this amount are taxed as ordinary income.

Policy loans are generally not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the premiums paid can become taxable. A key consideration is whether the policy becomes a Modified Endowment Contract (MEC). A policy is classified as a MEC if it is overfunded. Once a policy becomes a MEC, withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis. Additionally, withdrawals or loans from a MEC may be subject to a 10% income tax penalty.