What Is Indexed Universal Life & How Does It Work?

Indexed Universal Life (IUL) insurance is a type of permanent life insurance that combines a death benefit with a cash value component. This cash value has the potential to grow over time, with its growth linked to the performance of a selected market index. Unlike some other permanent life insurance options, IUL policies offer a unique mechanism for cash value accumulation, providing a blend of protection and potential for growth.

Understanding Indexed Universal Life Insurance

Indexed Universal Life insurance policies divide premium payments into two primary allocations: covering the cost of insurance and contributing to the policy’s cash value. The cost of insurance portion covers administrative fees and keeps the death benefit active. The remaining amount is allocated to the cash value component, where growth potential originates.

A distinguishing feature of IUL policies is the index-linking mechanism, where cash value growth is tied to an external market index, such as the S&P 500. Funds within an IUL policy are not directly invested in the stock market; instead, the index’s performance serves as a benchmark for calculating the interest credited to the cash value. This approach allows policyholders to benefit from market upside while maintaining protection from direct market downturns.

Cash value growth is managed through “floor” and “cap” rates. A floor is the minimum guaranteed interest rate, often 0%, ensuring the cash value will not decrease due to negative market performance. This protects against market losses. A cap is the maximum interest rate credited to the policy’s cash value within a given period, regardless of how high the linked index performs. For example, if an index gains 15% but the policy has a 10% cap, the cash value is credited with 10% interest.

Another element influencing cash value growth is the participation rate, which determines the percentage of the index’s gains credited to the cash value. If an index rises by 10% and the policy has an 80% participation rate, the cash value is credited with 8% interest, assuming it is within the cap. While the floor is typically guaranteed, cap and participation rates can be adjusted by the insurer over time.

IUL policies offer flexibility in premium payments, allowing policyholders to adjust the amount paid within certain limits based on their financial situation. If sufficient cash value has accumulated, it can be used to cover the cost of insurance and other fees, potentially allowing for reduced or skipped premium payments. Policyholders can also adjust the death benefit amount as life circumstances change.

Key Policy Elements

The Cash Value Account within an IUL policy accumulates funds over time. This account serves as a source of potential growth and a reservoir from which policyholders can access funds during their lifetime. The accumulated cash value offers financial flexibility beyond the death benefit.

IUL policies offer various Death Benefit Options that influence how the death benefit interacts with the cash value. Option A, the Level Death Benefit, provides a fixed death benefit amount to beneficiaries; cash value growth does not increase the payout. Option B, the Increasing Death Benefit, pays the stated death benefit plus the accumulated cash value to beneficiaries. This option allows the death benefit to grow with the cash value but typically incurs higher costs of insurance. Policyholders can switch between these options as their financial needs or estate planning goals evolve.

Policy Loans allow policyholders to borrow money against the cash value of their IUL policy. The cash value acts as collateral for the loan, and the policy remains intact, continuing to earn interest on the borrowed amount. Unlike direct withdrawals, policy loans are generally not considered taxable income as long as the policy remains in force. Interest accrues on the loan balance; while repayment is not strictly mandated, outstanding loans reduce the death benefit paid to beneficiaries if not repaid before the insured’s passing.

Withdrawal provisions enable policyholders to take funds directly from the cash value. When a withdrawal occurs, the cash value is reduced by the amount taken, directly impacting the policy’s future growth and the death benefit. Withdrawals reduce the accumulated cash value and can potentially lead to the policy lapsing if the remaining cash value is insufficient to cover ongoing costs. Withdrawals directly reduce the cash value, whereas loans use the cash value as collateral.

Riders are optional provisions that can be added to an IUL policy to customize its coverage and benefits. Common riders include accelerated death benefit riders, which allow policyholders to access a portion of their death benefit early if diagnosed with a terminal illness. Another common rider is the waiver of premium, which waives future premium payments if the policyholder becomes disabled. These features enhance the policy’s utility by addressing specific needs beyond basic life insurance coverage.

Tax Implications of IULs

Premiums paid for Indexed Universal Life insurance policies are not tax-deductible for individuals. The IRS views life insurance premiums as personal expenses, so they do not qualify for tax deductions. Premiums are paid with after-tax dollars.

The cash value growth within an IUL policy accumulates on a tax-deferred basis. Interest and gains credited to the cash value are not taxed annually. Taxes on this growth are postponed until the funds are accessed, such as through withdrawals or policy surrender. This tax-deferred growth allows the cash value to compound, as earnings are reinvested without immediate tax erosion.

The death benefit paid to beneficiaries from an IUL policy is income tax-free. The full amount of the death benefit can be received by beneficiaries without federal income tax liability. This tax-free payout applies whether the death benefit is received as a lump sum or in installments. Any interest earned on the death benefit after the insured’s passing may be taxable.

Policy Loans taken from an IUL are tax-free, provided the policy remains in force and is not classified as a Modified Endowment Contract (MEC). Loans are considered debt against the policy’s cash value, not a distribution of earnings, so they are not treated as taxable income. If the policy lapses with an outstanding loan balance, the loan amount may become taxable.

A Modified Endowment Contract (MEC) is a cash value life insurance policy that has lost some of its tax advantages due to overfunding. A policy becomes an MEC if premiums paid exceed IRS limits established by the “7-pay test” within the first seven years. Once designated an MEC, this classification is permanent and cannot be reversed. Distributions from an MEC, including loans and withdrawals, are subject to less favorable tax treatment. They are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are taxed first, and may be subject to a 10% penalty if taken before age 59½.

Withdrawals from an IUL are tax-free up to the amount of premiums paid into the policy, which is considered a return of the policyholder’s basis. This follows the “first-in, first-out” (FIFO) rule for non-MEC policies. Any withdrawals that exceed the total premiums paid are subject to income tax. If the policy is an MEC, withdrawals are taxed differently, with gains taxed first (LIFO), and may incur an additional 10% penalty if the policyholder is under age 59½.