What Is Indexed Life Insurance and How Does It Work?

Indexed life insurance is a type of permanent life insurance offering lifelong coverage. This financial product combines a death benefit, paid to beneficiaries upon the insured’s passing, with a cash value component that has the potential to grow over time. It aims to provide both financial protection for loved ones and a savings element that policyholders can access during their lifetime. The structure of indexed life insurance seeks to balance growth potential with protection against market downturns.

What is Indexed Life Insurance

Indexed life insurance is permanent life insurance where cash value growth links to a market index, such as the S&P 500. The policy does not directly invest. Instead, growth is credited based on index movement, allowing policyholders to benefit from gains without direct market loss exposure.

The policy includes a cash value accumulation feature, balancing potential market growth with principal protection. This protection comes from a guaranteed minimum interest rate, or “floor,” often 0% or a small positive percentage, ensuring the cash value does not decline from negative index performance.

Policyholders can achieve higher returns than traditional whole life insurance, which offers fixed rates. Growth is subject to limitations like a “cap” on the maximum credited interest rate. This structure provides a more dynamic cash value growth mechanism than fixed-rate policies, offering stability not found in direct market investments.

Core Elements of an Indexed Life Policy

An indexed life insurance policy has several fundamental parts that provide protection and cash value accumulation. Understanding these core components is important for comprehending how the policy operates.

The death benefit is the sum paid to designated beneficiaries upon the insured’s death. It provides financial security, helping cover expenses or replace lost income. Policyholders can often adjust the death benefit amount, subject to underwriting and policy terms.

The cash value component functions as a savings element. It accumulates over time, growing based on the linked market index’s performance and crediting methods. This growth is tax-deferred, with earnings untaxed until accessed. Policyholders can access this cash value during their lifetime via loans or withdrawals.

Premium payments are regular amounts paid to keep the policy in force. They cover costs like funding the death benefit, cash value growth, administrative fees, and mortality charges. Consistent payment keeps the policy active and cash value accumulating.

Understanding Cash Value Growth

Cash value growth in an indexed life policy links to a market index. A market index measures financial market segment performance. The policy’s cash value does not directly invest in index components. Instead, it uses index performance to determine the credited interest rate, providing growth potential without direct market volatility.

A cap rate defines the maximum percentage of index growth credited to the cash value. For example, a 10% cap means only 10% interest is credited even if the index grows more. This limits upside potential during strong market performance. Cap rates range from 8% to 12% annually.

A floor rate protects against market downturns by specifying the minimum interest rate the cash value will earn, even if the index performs negatively. The floor is often 0%, meaning the cash value will not lose money from market declines. Some policies offer a small positive floor, providing a minimal guaranteed return. This rate differentiates indexed life from direct market investments, protecting cash value.

The participation rate determines the percentage of the index’s gain credited to the cash value before any cap. For example, a 70% participation rate means a 10% index growth yields 7% gain for crediting. This percentage is subject to the cap rate. Participation rates vary, and are adjusted annually by the insurer.

Some indexed life policies include a spread or asset charge, a deduction from the index gain before it is applied to the cash value. This charge acts as a fee from the calculated interest credit. This charge influences the credited interest rate.

How to Use Policy Value

Policyholders can access the accumulated cash value within their indexed life insurance policy through several methods, providing financial flexibility. These methods allow liquidity without necessarily surrendering the entire policy. Each approach has unique implications for the death benefit, cash value growth, and taxes.

Policy loans allow policyholders to borrow money against their cash value. The policy remains in force if premiums are paid and loan interest is serviced. Interest accrues on the outstanding balance, 5% to 8% annually. Unpaid loans, plus accrued interest, reduce the death benefit. Policy loans are not taxable income, treated as debt.

Withdrawals involve directly taking money from the policy’s cash value. Unlike loans, withdrawals permanently reduce the policy’s cash value and death benefit. Withdrawals up to premiums paid (the “cost basis”) are tax-free. Any portion exceeding the cost basis is taxable income.

If the policy is a Modified Endowment Contract (MEC) due to exceeding premium limits, withdrawals and loans are subject to different tax rules. For MECs, withdrawals and loans are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are withdrawn first and taxable. Additionally, withdrawals and loans from a MEC before age 59½ may be subject to a 10% federal income tax penalty, similar to qualified retirement plan distributions.

Policy surrender occurs when the policyholder terminates the life insurance policy. Upon surrender, the policyholder receives the accumulated cash value, minus any outstanding loans or surrender charges. Surrender charges are fees imposed if the policy is terminated within a certain period, 10 to 15 years. Amounts received exceeding total premiums paid may be taxable income. Policy surrender ends life insurance coverage and all associated benefits.

Citations

https://www.forbes.com/advisor/life-insurance/indexed-universal-life-insurance/#:~:text=IUL%20is%20a%20type%20of%20permanent,a%200%25%20floor%20and%2010%25%20cap.
https://www.investopedia.com/articles/personal-finance/092215/how-indexed-universal-life-insurance-works.asp
https://www.investopedia.com/articles/pf/08/life-insurance-loan.asp
https://www.irs.gov/pub/irs-wd/0904003.pdf
https://www.investopedia.com/ask/answers/06/withdrawallifeinsurance.asp
https://www.investopedia.com/terms/m/modifiedendowmentcontract.asp
https://www.investopedia.com/terms/s/surrendercharge.asp