What Is Indexed Universal Life Insurance and How Does it Work?


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Key Takeaways

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Indexed universal life insurance (IUL) combines permanent life insurance with a cash value component that grows based on stock market index performance, offering potential upside with downside protection.

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IUL works best for high-net-worth individuals who've maxed out other retirement accounts and want tax-free growth and access to funds, but it comes with high fees and complexity.

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While IUL offers market-linked growth potential and tax advantages, financial advisors point to capped returns, high costs, and better alternatives like 401(k)s for most people.

What Is Indexed Universal Life Insurance?

Indexed universal life insurance (IUL) is a permanent life insurance policy that provides a death benefit and a cash value component. The cash value is tied to a market index, allowing for potential growth.

IUL offers flexibility in premium payments, death benefits and investment options. The policy's cash value grows tax-deferred, and you can access it through loans or withdrawals. The cash value links to a market index, letting you participate in market gains without directly investing in the stock market.

Cash value is the investment portion of your life insurance policy that accumulates over time. Unlike term life insurance, which only provides a death benefit, permanent life insurance policies like IUL build cash value you can borrow against or withdraw during your lifetime.

How Indexed Universal Life Insurance Works

Think of IUL as life insurance with a built-in investment account. Your premiums pay for death benefit protection, and any extra money goes into an account that can grow based on how well the stock market performs. If the market goes up, your account grows. If it goes down, you don't lose money, but you don't gain anything either. You can adjust how much you pay and even borrow from the account while you're alive.

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    Indexing and Interest Crediting

    IUL tracks the performance of a selected market index. Your policy's cash value grows based on how well your chosen index performs.

    Insurance companies determine which indexes are available, offering either a single index or multiple options. You can often choose which index to follow based on your comfort level with risk.

    Common indexes for IULs include:

    • S&P 500: Measures the performance of 500 large companies listed on U.S. stock exchanges
    • NASDAQ-100: Includes 100 of the largest non-financial companies listed on the NASDAQ stock exchange
    • Dow Jones Industrial Average (DJIA): Tracks 30 large, publicly owned companies trading on the NYSE and NASDAQ
    • Russell 2000: Measures the performance of approximately 2,000 small-cap companies
    • MSCI EAFE: Represents large and mid-cap securities across 21 developed markets, excluding the U.S. and Canada

    Interest is added to the cash value based on the chosen index's performance. The structure usually has a cap and a floor, providing potential growth with some protection.

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    Premium Flexibility

    IUL policies offer flexible premium payments. This means you can pay more or less each month depending on your financial situation, unlike traditional life insurance where you pay the same amount every month.

    This adaptability allows you to choose your IUL coverage to meet changing financial needs and goals. This flexibility has considerations and potential consequences.

    Premium payment changes can affect the policy's cash value and death benefit:

    • Reducing premiums: If you reduce or skip premium payments, your policy's cash value may not grow as expected. It might even decrease if the reduced premiums aren't enough to cover the policy's costs.
    • Increasing premiums: Increasing premium payments can boost cash value accumulation, potentially increasing the death benefit.
    • Non-payment: If you stop premium payments entirely without sufficient cash value to cover costs, the policy could lapse, causing loss of the cash value and death benefit.
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    Participation Rates, Caps and Floors

    Your IUL's participation rate determines how much of the stock market's gains you actually get. For example, if the market goes up 10% but your participation rate is 75%, you only get 7.5% growth in your account.

    Caps are the maximum amount your account can grow in a year, even if the market does better. If your cap is 12% and the market goes up 15%, you only get 12%.

    Floors protect you from losing money. Even if the market crashes, your floor (usually 0%) means your account won't lose value, but it won't grow that year.

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    Cash Value Growth and Death Benefits

    Your IUL cash value is like a savings account within your life insurance policy. This account grows based on stock market performance (with the caps and floors mentioned above). You can borrow money from this account or withdraw some of it while you're alive, though this might reduce your death benefit.

    Death benefit is the money your family receives when you die — it's tax-free. Part of your monthly premium pays for this protection, while the rest goes into your cash value account.

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    Tax Implications

    When your IUL policy matures (usually at the end of the policy term or when you reach a certain age), the benefits specified in the contract are paid out.

    In an IUL policy, withdrawals from the cash value are tax-free up to the premiums you've paid. However, any withdrawals beyond this amount may be subject to income tax. Loans against your policy's cash value aren't taxable, but if the policy lapses or is surrendered with an outstanding loan, the loan amount may become taxable income.

    If the policy is classified as a Modified Endowment Contract (MEC), which occurs when premiums paid exceed federal tax limits, loans and withdrawals may be subject to taxation.

Pros and Cons of Indexed Universal Life Insurance

Here's a breakdown of indexed universal life insurance pros and cons:

Pros

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Growth potential: IUL offers cash value growth opportunities based on market index performance, providing investment potential

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Flexibility: Adjustable premiums and death benefits adapt to changing financial circumstances

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Tax advantages: IUL provides tax-deferred growth and potentially tax-free access to cash value

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Protection against market losses: IUL offers protection against negative market performance with features like floors

Cons

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Potential costs and fees: Hidden costs, administrative expenses and surrender charges can apply, affecting the policy's overall value

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Limited growth potential vs. direct market investment: IUL policies cap your returns (often at 10-12%), meaning you miss out on full market gains during strong years. Additionally, these policies don't include dividends, which can represent a significant portion of total market returns.

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There are other alternatives: Many financial advisors argue that for most people, a 401(k) is better than IUL because it doesn't carry the high fees and premiums, plus there's no cap on earnings. The consensus is that IUL is mainly suitable for high-net-worth individuals who have maxed out other retirement options.

Who Should and Shouldn't Consider IUL

IUL isn't right for everyone. Consider whether it aligns with your needs, goals and risk tolerance.

You Will Benefit From an IUL Policy If:

  1. 1

    You're a high-net-worth individual

    You've maxed out other retirement accounts like 401(k)s and IRAs and need additional tax-advantaged growth options

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    You want market upside with downside protection

    You're comfortable with capped returns in exchange for protection against market losses

  3. 3

    You're planning for estate transfer

    You want to pass wealth to heirs through a tax-free death benefit

  4. 4

    You want tax-free growth and access

    You value tax-deferred cash value growth and the ability to access funds tax-free through loans during your lifetime

  5. 5

    You can afford higher premiums

    You have the financial capacity to fund the policy adequately and handle potential premium increases over time

An IUL Policy May Not Be Right for You If:

  1. 1

    You're young and just starting out

    You'd benefit more from maximizing employer 401(k) matching and investing in low-cost index funds

  2. 2

    You need guaranteed returns

    You prefer predictable growth without market-related variability

  3. 3

    You want simple, affordable life insurance coverage

    Term life insurance provides more death benefit protection for less money

  4. 4

    You're focused on maximizing returns

    Direct stock market investing offers higher long-term growth potential without caps

  5. 5

    You need short-term access to funds

    Early withdrawals (that you may need for a house or other investment) from IUL policies often come with surrender charges and tax consequences

How to Choose an IUL Policy

When comparing life insurance policies, understand the application and buying process. Although specific rules and requirements may vary by insurance company, common steps are generally involved in acquiring an indexed universal life insurance (IUL) policy.

  1. 1

    Research each provider's reputation

    Research potential insurers' financial strength and customer service ratings before selecting a company.  See our guide to the best universal life companies.

  2. 2

    Consider different policy terms and investment options

    Review each prospective policy's terms, including premium and death benefit flexibility. Inquire about available indexes for linking the cash value

  3. 3

    Work with a financial professional (optional)

    For a more complex policy like indexed universal life, consulting with financial professionals can provide valuable insights and help you navigate IUL complexities

  4. 4

    Review your policy

    Thoroughly read and understand your prospective policy, including fees, caps, floors and potential penalties for changes.

Which Companies Offer IUL?

Many major life insurance companies offer indexed universal life insurance policies and leading providers include:

  • Nationwide: Offers indexed universal life with various index options
  • Pacific Life: Provides IUL policies with multiple crediting strategies
  • Prudential: Features indexed universal life with flexible premium options
  • Northwestern Mutual: Offers IUL with strong financial ratings and comprehensive support
  • Transamerica: Offers IUL with competitive participation rates
  • Lincoln Financial: Provides indexed universal life with various index choices
  • Mutual of Omaha: Features IUL policies with flexible benefit options
  • Allianz: Offers IUL policies with different accumulation strategies
  • American General: Features indexed universal life with flexible benefits

Cost Analysis of Indexed Universal Life Insurance

IUL premiums vary significantly based on your age, health, coverage amount, and the specific policy features you choose. Here are rough monthly cost estimates for a $2 million IUL policy for healthy, non-smoking individuals:

By Age:

  • Age 30: $1,200 to $2,000 per month
  • Age 40: $2,000 to $3,200 per month
  • Age 50: $3,200 to $4,800 per month
  • Age 60: $6,000 to $10,000 per month

Factors That Affect Your Cost:

  • Age: Premiums increase significantly with age
  • Health: Medical conditions can substantially increase costs
  • Coverage amount: Higher death benefits require higher premiums
  • Funding level: Max-funded policies require higher premium payments
  • Index options: Some crediting methods may have higher fees

Remember that IUL policies are flexible, so you can adjust your premium payments based on your financial situation. Most financial advisors recommend funding IUL policies adequately to maximize cash value growth relative to insurance costs. For IUL to work effectively as an investment vehicle, many advisors suggest minimum annual contributions of $10,000 or more.

IUL vs. Other Universal Life Insurance Policies

To choose the right insurance strategy, understand the differences between an indexed universal life policy and other types of life insurance:

Indexed Universal Life Insurance vs. Universal Life Insurance

Key difference: How your cash value grows.

  • IUL: Your cash value growth is tied to a stock market index (like the S&P 500). You get market-linked returns with caps (maximum gains) and floors (minimum losses, usually 0%). This means potential for higher returns but more complexity. Universal Life: Your cash value grows at a fixed interest rate set by the insurance company. You get steady, predictable growth without market risk, but lower return potential.

Variable Universal Life Insurance vs. Indexed Universal Life

Key difference: How much market risk you take.

  • Variable Universal Life (VUL): You directly invest your cash value in mutual fund-like accounts. You can potentially earn higher returns but can also lose money if investments perform poorly. No downside protection. IUL: You get market-linked returns without direct market exposure. The floor (usually 0%) protects you from losses, but caps limit your maximum gains. More protection, less upside potential.

Alternatives to Indexed Universal Life Insurance

While IUL offers benefits, it isn't right for everyone. Here are other life insurance options: 

  • Whole life insurance offers guaranteed cash value growth and fixed premiums. Cash value growth is guaranteed and premiums stay constant, offering predictability and security but often at a higher cost.
  • Term life insurance provides pure life insurance protection without cash value. It covers a specific term, such as 10, 20 or 30 years, and is generally more affordable than other options. It suits those seeking temporary protection without investment considerations.
  • Investment accounts: Separate investment accounts, such as mutual funds or individual retirement accounts (IRAs), provide investment opportunities without linking them to life insurance. This approach allows for targeted investment strategies and diverse options without life insurance's combined benefits.

Types of IUL Strategies

Different IUL strategies offer various options with specific advantages and challenges:

Max-funded IUL optimizes cash value growth by maximizing premium payments up to the limits without turning the policy into a Modified Endowment Contract (MEC). This approach quickly builds cash value, creating a substantial financial asset accessible during the policyholder's lifetime.

Max-Funded IUL

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Pros
  • Maximizes tax-deferred growth of cash value
  • Potential for higher long-term returns
  • Increases potential death benefit
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Cons
  • Higher upfront premiums required
  • Risk of becoming an MEC if overfunded
  • Potentially less liquidity due to higher initial costs

A compound interest IUL account leverages compound interest to increase the policy's cash value over time. This account is typically linked to a favorable interest crediting method. By reinvesting earned interest, the cash value grows exponentially over time, enhancing the policy's overall financial yield.

Compound Interest IUL

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Pros
  • Accelerates cash value growth through compound interest
  • Can substantially increase the policy's value over time
  • Provides long-term financial benefits for retirement
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Cons
  • Dependent on consistent market performance
  • Longer time needed to realize substantial benefits
  • Complexity in managing and understanding crediting rates

Fixed-indexed universal life insurance provides a stable growth rate by linking the cash value to a fixed index rather than more volatile equity markets. This conservative strategy offers predictable returns and less risk, which suits policyholders seeking stability over speculative gains.

Fixed-indexed Universal Life Insurance

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Pros
  • Provides stable and predictable growth
  • Lower risk than other market-linked options
  • Suits conservative investors
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Cons
  • Capped growth potential; may not capture full market upswings
  • Not ideal for those seeking aggressive growth
  • Potential for underperformance compared to other indexes

Equity-indexed universal life insurance links cash value growth to equity market performance, offering higher returns but introducing more risk. Protective floors mitigate losses by setting a minimum interest crediting rate (typically 0%), but exposure to volatile equity markets means the policy's value can fluctuate substantially.

Equity-Indexed Universal Life Insurance

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Pros
  • Higher potential returns linked to stock market performance
  • Floor guarantees protect against market downturns
  • Offers a balance of growth potential and protection
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Cons
  • More exposure to market volatility
  • Caps on returns can limit growth
  • Requires more active management and understanding of market movements

Indexed Universal Life Insurance: FAQ

Answers to frequently asked questions about IUL to help you understand this coverage and determine if it benefits you.

What is an IUL policy?

Is IUL insurance a good investment?

Is IUL good for retirement?

Is IUL insurance worth it?

How do I open an IUL account?

Where can I open an IUL account?

Is IUL tax-free?

How do IUL loans work?

When can you withdraw from an IUL?

Can you lose money in an IUL?

Do IUL premiums increase?

Can you have whole, term and IUL life insurance?

What Is Indexed Universal Life Insurance Policy: Related Articles

About Mark Fitzpatrick


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Mark Fitzpatrick, a Licensed Property and Casualty Insurance Producer, is MoneyGeek's resident Personal Finance Expert. With over five years of experience analyzing the insurance market, he conducts original research and creates tailored content for all types of buyers. His insights have been featured in publications like CNBC, NBC News and Mashable.

Fitzpatrick holds a master’s degree in economics and international relations from Johns Hopkins University and a bachelor’s degree from Boston College. He's also a five-time Jeopardy champion!

Passionate about economics and insurance, he aims to promote transparency in financial topics and empower others to make confident money decisions.


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