Pros and Cons of Indexed Universal Life Insurance
Indexed universal life (IUL) insurance offers the benefit of market gains while building cash value and guarantees beneficiaries a payout upon death. Like other types of universal life insurance, IUL holds a cash value that increases as premiums are paid. You can receive the cash value if you cancel the policy, or you can take out a loan and use the funds for other purposes.
Also known as equity-indexed universal life insurance, IUL insurance puts a portion of the premiums toward annual renewable term life insurance. The remainder is added to the cash value of the policy after fees are deducted. The cash value is credited on a monthly or annual basis with interest based on increases in an equity index. While IUL insurance may prove valuable to some, it’s important to understand how it works before purchasing a policy.
Among the pros of IUL insurance is the potential for higher returns. There are cons, however, such as the fact that higher returns are not guaranteed.
How Indexed Universal Life Insurance (IUL) Works
IUL insurance is pitched as a cash-value policy that benefits from tax-free market gains without the risk of loss during a market downturn. Insured parties can link a percentage of the policy’s cash value to a market index, such as the S&P 500 or the Nasdaq 100. As the index moves up and down, the rate of return also moves on the policy. Different policies have different maximum levels for the amount you can invest, up to 100%. A percentage of the interest income, which is called the participation rate, is added to the cash value of the policy if the indexed account shows gains (usually calculated over a month). This is usually annually or once every five years. So if the gain is 4%, the participation rate is 50%, and the current cash value total is $10,000. This means $200 is added to the cash value (4% × 50% × $10,000 = $200).
If the index falls in value or remains steady, the account nets little or nothing. But there’s one benefit: the policyholder is protected from incurring losses.
Although they perform like securities, IULs are not considered investment securities. “The cash value is not [actually] invested in the market or an index,” said Jordan Niefeld, CPA, CFP, of Raymond James & Associates in Aventura, Florida. “The index is just a measuring device to determine the interest crediting rate on the cash value account.”
Advantages of Indexed Universal Life Insurance
Higher Return Potential
A significant advantage of IUL insurance is the potential for gains in the cash value that can potentially be higher than those on other types of life insurance, such as traditional universal life or whole life insurance policies.
Policyholders also get the benefit of a crediting floor, which is typically 0% or 1%. Having this means the existing cash value is protected from losses in a poorly performing market. “If the index generates a negative return, the client does not participate in a negative crediting rate,” Niefeld said. In other words, the account will not lose its original cash value.
Tax Advantages on Capital Gains
The cash value accumulates tax deferred, and the death benefit is tax-free for beneficiaries. Loans made against the policy are also tax-free in many cases. Premiums are paid with after-tax dollars, so partial and full withdrawals (up to the amount paid in premiums) are also tax-free.
Death Benefit
IUL insurance, like other types of life insurance, can provide a death benefit for your loved ones. This money can be used to:
Use for funeral expenses
Cover outstanding debts such as a mortgage or co-signed student loans
Fund college costs for children
Pay for everyday living expenses
This death benefit can be passed on to your beneficiaries tax-free.
Disadvantages of Indexed Universal Life Insurance
There are several potential drawbacks associated with IUL insurance policies. For instance, someone who establishes the policy over a time when the market is performing poorly could end up with high premium payments that don’t contribute at all to the cash value. The policy could then potentially lapse if the premium payments aren’t made on time later in life, which could negate the point of life insurance altogether.
We’ve highlighted some of the potential downsides below.
Limited Gains
Increases in the cash value are limited by the insurer. Insurance companies often set maximum participation rates of less than 100%. In addition, returns on equity (ROE) indexes are often capped at certain amounts during good years. These restrictions can limit the actual rate of return that’s credited toward your account each year, regardless of how well the policy’s underlying index performs.
In that case, you may be better off investing in the market directly or considering a variable universal life insurance policy instead. But it’s important to consider your personal risk tolerance and investment goals to ensure that either one aligns with your overall strategy.
The insurer makes money by keeping a portion of the gains, including anything above the cap.
No Guarantees for Returns
The potential for a greater rate of return is one advantage to IUL insurance policies compared to other life insurance policies. However, larger returns are not guaranteed. Returns can in fact be lower than returns on other products, depending on how the market performs. Policyholders have to accept that risk for potentially higher returns.
Costs and fees associated with an indexed universal life insurance policy can also affect profits.
As with any product tied to equities, IUL does include risks. IUL insurance carries greater risk than standard universal life insurance, but less risk than variable life insurance policies (which do actually invest in stocks and bonds). Also, depending on the policy, the premiums could potentially rise if the measuring index performs consistently below the anticipated rate.
Taxes
In the event of death with outstanding loans against the policy, the outstanding loan funds may be subject to regular income tax. In the event of policy cancellation, gains become taxable as income. Losses are not deductible.
Fees and Costs
Fees are typically front-loaded and built into complex crediting rate calculations, which may confuse some investors. Fees can be high. Costs vary from one insurer to the next and depend on the age and health of the insured.
