Indexed Universal Life Insurance: Pros and Cons

Indexed universal life insurance (IUL) is a financial tool that offers both a death benefit and a cash value component tied to a market index. With benefits such as flexibility in premium payments, steady cash value growth and lifelong coverage, IUL may appeal to individuals seeking a combination of life insurance and investment opportunities.

However, it may not be suitable for everyone. The cap on potential growth, inherent market risk, higher fees and the need for active management are factors to consider. Understanding the features of IUL can help you determine if it aligns with your specific financial goals and risk tolerance.

Indexed universal life insurance (IUL) is a type of permanent life insurance that lasts the policyholder's entire life. Unlike traditional life insurance, IUL features a cash value component tied to a market index such as the S&P 500, NASDAQ Composite and Dow Jones Industrial Average.

IUL offers a death benefit to beneficiaries and a cash value that can build over time. The interest on the cash value is linked to an index, providing potential growth opportunities. This connection to market indices sets IUL apart from other life insurance policies.

Understanding how IUL works is important when considering this type of policy. Here's a breakdown of its key components:

• Premium Payments and Death Benefits: The policyholder must pay regular premiums. If premium payments stop, the insurer will cancel the policy. The policy's beneficiaries receive a death benefit upon the policyholder's death.

• Cash Value Accumulation: The cash value of an IUL policy builds over time. You can borrow against this cash value or use it to pay premiums. Its growth is tied to an index, and floors, caps and participation rates govern it.

• Floors, Caps and Participation Rates: These elements control the growth of the cash value. A floor protects it from severe losses. The cap limits potential gains. Participation rates determine the portion of the index's return credited to the account.

Understanding these key components will help you actively manage your IUL insurance.

IUL offers several advantages that make it an attractive option for some consumers:

• Flexibility: One of the main pros of IUL is its flexibility in adjusting death benefits and premiums. This adaptability allows policyholders to tailor the policy to their financial needs. The policyholder can increase or decrease the amount paid to beneficiaries upon their death to align with changes in financial obligations, such as paying off a mortgage, or changes in family dynamics, like the birth of a child. Similarly, you can also adjust premiums to fit your current financial situation.

• Steady Cash Value Growth: IUL provides the ability to grow cash value steadily, taking advantage of market growth without significant risk due to the protection of floors. Floors ensure that even if the market performs poorly, the cash value will not decrease below a certain level, often set at 0%. Cash value growth is also tax-deferred, meaning no taxes are due on gains as long as the policyholder does not withdraw them, allowing the cash value to compound over time. You can also use the cash value for various purposes, such as supplementing retirement income, paying premiums or even borrowing against it for financial needs.

• Lifelong Coverage: As long as you pay premiums, IUL offers lifelong coverage, ensuring that beneficiaries are provided for. The death benefit is generally tax-free, and your beneficiaries can use it for various purposes, such as paying off debts, covering funeral expenses, providing income replacement, funding education or preserving the family's standard of living.

Considering how these benefits apply to you and your family's financial planning is worthwhile.

While IUL has its benefits, there are also drawbacks to consider:

• Growth Limitations: The cap on potential growth means that policyholders may miss out on significant market gains. Despite the protection of floors, there is still inherent risk in tying a life insurance policy to a market index.

• Higher Fees: IUL policies often come with higher fees compared to other life insurance products, like term life insurance. These costs can eat into the cash value, especially in the policy's early years, and may reduce the overall return on investment.

• Active Management: Managing an IUL policy requires active involvement and understanding of the market conditions, participation rates and other factors. Some policyholders may find this need for active management demanding and may require the assistance of a financial professional.

An IUL may not be for you if the higher fees or active involvement required for the policy would be difficult to maintain.

The cost of IUL varies widely based on several factors that can influence the overall expense of the policy:

• Insurer: Different insurance companies may offer different pricing structures for similar IUL products.

• Age and Health of the Policyholder: These personal factors can significantly influence the premium rates.

• Administrative Expenses: These include the costs of managing the policy, such as record-keeping and other operational expenses.

• Sales Fees and Commissions: Fees paid to agents and brokers for selling the policy can add to the overall cost.

• Investment Management Fees: These are fees associated with managing the investment component of the IUL policy.

• Riders and Additional Benefits: Adding extra features or riders to the policy can increase the cost.

Understanding these factors can help you make an informed decision that aligns with your financial goals and budget constraints.

IUL offers tax advantages, such as the tax-free death benefit provided to beneficiaries. This means that the death benefit is generally not subject to federal income tax, as outlined by the Internal Revenue Service (IRS).

The tax treatment of the cash value component is different. While the cash value grows tax-deferred within the policy, certain withdrawals or loans against the cash value may create taxable events. For example, if a withdrawal exceeds the total premiums paid into the policy, it may be subject to income tax.

If not managed properly, policy loans can lead to tax liabilities. Policy loans that cause a policy to lapse may result in taxable income.

IUL has specific features that set it apart from other common types of life insurance. It offers opportunities and protections that other policies may not provide. Here's a quick comparison with other common types of life insurance:

• IUL vs. Term Life Insurance: Unlike term life insurance, which provides coverage for a specific period, IUL offers lifelong coverage. While term life is generally more affordable, IUL includes a cash value component tied to market indices, offering potential growth opportunities.

• IUL vs. Whole Life Insurance: Whole life insurance also provides lifelong coverage but with guaranteed cash value growth. IUL, on the other hand, links cash value growth to market performance, which can lead to higher growth potential but also introduces more risk.

• IUL vs. Variable Universal Life Insurance (VUL): Both IUL and VUL offer investment opportunities within the policy. However, IUL's investment is tied to market indices with caps and floors, providing some protection against market downturns. VUL allows direct investment in sub-accounts, similar to mutual funds, and may have higher growth potential but also higher risk.

• IUL vs. Traditional Universal Life Insurance: Traditional universal life insurance offers flexible premiums and a death benefit, but its cash value growth depends on a fixed interest rate. IUL's cash value growth correlates to market indices, which may offer more growth potential but also more complexity.

We recommend researching the life insurance policies available to you and considering how they fit in with your financial goals.

Below are some frequently asked questions about indexed universal life insurance.