IUL Pros and Cons: Should You Buy an IUL?

An indexed universal life (IUL) policy is a type of permanent life insurance that builds cash value based on the performance of a stock market index, usually the S&P 500. Your money isn't invested directly in the market. Instead, the insurer credits interest to your cash value based on how the index performs.

Three features determine how much your cash value grows:

• Floor: Most IULs have a 0% floor, so your cash value won't lose value because of a negative market year. If the S&P 500 falls 20%, your account is credited 0% instead of a 20% loss.
• Cap rate: Most policies cap annual returns at 8% to 12%. For example, with a 10% cap, a 28% market gain still credits only 10%.
• Participation rate: Some policies credit only a percentage of the index's return. A 90% participation rate means a 10% market gain becomes a 9% credit before any cap is applied. Other policies use a spread, subtracting a fixed percentage from the index return instead.

Together, the floor, cap and participation rate determine how much your cash value can grow each year.

An IUL combines permanent life insurance with tax-advantaged cash value growth. Its biggest advantages are downside protection, flexible policy features and the ability to supplement retirement income for the right buyer.

Most IUL policies have a 0% floor, which means your cash value won't lose value because of a negative market year. If the index falls, your account is credited 0% instead of a loss.

This protection helps preserve long-term growth, but it comes with a trade-off. Your gains are limited by the policy's cap rate, so you give up some upside in strong market years.

Cash value grows tax deferred, so you don't pay income tax on annual interest credits. You can also access your cash value through policy loans without paying income tax, as long as the policy stays in force and isn't classified as a modified endowment contract (MEC).

Keep in mind that unpaid policy loans reduce your death benefit and can create a tax bill if your policy lapses.

Unlike whole life insurance, IUL policies let you adjust your premiums over time. You can contribute more in high-income years or reduce payments when cash flow is tight, provided the policy has enough cash value to cover its costs.

You can also adjust the death benefit as your needs change. Lowering it can reduce insurance costs, while increasing it requires new underwriting.

An IUL provides lifelong coverage instead of expiring after a set term like with a term life insurance policy. As long as your policy remains funded, your coverage continues regardless of changes to your health.

Permanent coverage can be valuable for estate planning, supporting lifelong dependents or providing business succession funding.

Many high-income earners use a max-funded IUL to build cash value for retirement. By contributing the maximum allowed without creating a MEC, you can accumulate cash value and later access it through policy loans that are income tax free.

This strategy works best when your policy is consistently funded over many years. Before buying, ask your insurer to show projections using both the illustrated crediting rate and a lower rate so you can see how different market outcomes affect your retirement income.

IUL policies have downside protection and tax advantages, but they also come with important trade-offs. Limited returns, rising costs and changing policy terms can reduce long-term performance if you don't plan carefully.

IULs don't earn the full return of the stock market. Most policies limit growth through cap rates and participation rates.

For example, if your policy has a 10% cap and a 90% participation rate, a 30% market gain would still credit only 9%. Over time, these limits can greatly reduce growth compared with investing directly in the market.

IUL policies include insurance charges, administrative fees and premium loads that reduce how much of your premium builds cash value.

The biggest expense is the cost of insurance (COI), which increases as you age. If your policy isn't funded adequately, these rising costs can slow cash value growth or put your policy at risk of lapsing.

Policy illustrations show projected results, not guaranteed outcomes. Actual performance depends on future market returns, policy costs and the cap and participation rates set by your insurer.

Before buying, ask for illustrations using lower assumed returns, such as 4% to 5%, to better understand how the policy could perform under less favorable conditions.

Unlike whole life insurance, an IUL's cap and participation rates aren't fixed. Insurers can lower them over time based on market conditions and other business factors.

Before purchasing a policy, ask about the insurer's minimum guaranteed cap rate and whether it has reduced cap rates on existing policies in recent years.

If you don't contribute enough to keep up with rising policy costs, your IUL can lapse. When that happens, any outstanding policy loans may become taxable, creating a large and unexpected tax bill.

Review your policy regularly and be prepared to increase your premiums if cash value growth falls behind expectations. Consistent funding is one of the most important factors in keeping an IUL in force over the long term.

Use this checklist to decide whether an IUL is a good fit for your financial situation.

An IUL can be a valuable financial tool, but it's the right choice for only a small group of buyers.

• Choose an IUL if you've already maxed out your retirement accounts, need permanent life insurance, are in a higher tax bracket and can consistently fund the policy for 20 years or more. It can work well for estate planning, business succession or creating tax-advantaged retirement income.
• Choose whole life insurance if you want permanent coverage with guaranteed cash value growth and more predictable costs.
• Choose term life insurance if your primary goal is affordable coverage for a temporary need, such as income replacement or paying off a mortgage.
• If you haven't maxed out your 401(k) or IRA, prioritize those accounts first. They generally offer lower costs and stronger tax advantages than an IUL.

Before buying, review your policy illustration carefully. An IUL's returns, costs and future cap rates aren't guaranteed, so understanding the trade-offs is essential.