Indexed Universal Life Insurance: Pros and Cons

Permanent insurance with potential market exposure

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Indexed universal life insurance is life insurance with an investment component. The cash value has indirect exposure to the markets, typically without any downside risk. However, these policies can be extremely complicated. We’ll cover some of the pros and cons of indexed universal life so you can make an informed decision about your insurance needs.

Key Takeaways

  • IUL is a form of cash value life insurance that provides exposure to a market index, such as the S&P 500.
  • Cash value might grow at a favorable rate if the index performs well.
  • Growth (if any) is typically limited, allowing insurers to offer protection against market losses.

What Is Indexed Universal Life Insurance?

Indexed universal life insurance (IUL) is a form of insurance that uses a market index to calculate any cash value growth in the policy. For example, the cash value growth might depend on the movement of the S&P 500 index, excluding dividends. You generally don’t lose money with IUL, but you generally don’t participate in 100% of the gains, either. For example, if the index your policy is tied to returns 7%, your cash value might only be credited 4%, depending on the specifics of how your policy credits interest.

IUL policies are “permanent” insurance policies that can potentially remain in force for your entire life—as long as you continue to pay the costs of insurance. They also allow for flexible premium payments. You don’t necessarily need to make regular payments into the policy, but you need to maintain a cash value that’s sufficient to keep the policy in force.

Pros and Cons of IUL

Every financial product has advantages and disadvantages. While the details vary from insurer to insurer, we’ve highlighted some of the most common features below. Discuss your needs with a licensed insurance agent to get more details.

Pros
  • Index exposure

  • Tax-deferred growth

  • Cash value access

  • Downside protection

Cons
  • Limited upside exposure

  • Returns diminished by fees

  • Other investments may be better

  • Minimal regulatory oversight

Pros Explained

Index Exposure

The growth inside of a life insurance policy is critical, said Noah Schwartz, CFP from Blueprint Financial Strategie via email to The Balance. According to Schwartz, “indexed-linked options may provide a better opportunity than a stated fixed rate, especially in today's interest environment, but buyer beware.”

If the index grows at a favorable rate—and your policy credits most or all of the growth to the cash value—the cash value might grow faster than a whole life or straight universal life policy would. As a result, you might be able to make smaller payments into the policy or build up a substantial cash value to borrow against.

If you borrow from your cash value or take withdrawals, you might end up with a smaller death benefit, or the policy might run out of money. If that happens, your beneficiaries lose coverage, and you could owe taxes.

Tax-Deferred Growth

Growth inside of an insurance contract is typically tax-deferred. For people in the highest income tax brackets, that might be an attractive feature.

Cash Value Availability

A permanent life insurance policy often relies on the cash value to fund the costs of insurance for your entire life. But you can also take withdrawals or loans from your cash value, and you might be able to access those funds tax-free. That could be helpful if you face emergency expenses and don’t have cash available. But if you deplete the cash value or withdraw more than you pay into a policy, you may owe taxes and the policy might fail.

Downside Protection

IUL policies typically eliminate downside investment risk. For example, if the market index loses value, your index-linked investment usually stays the same, minus any applicable policy expenses (it might earn 0% for that period, for example).

Cons Explained

Limited Upside Exposure

While IULs offer some exposure to index movements, you might not benefit from 100% of the growth in the index. Here are some of the most common devices used to limit upside potential:

  • Caps: A cap is a value that represents the maximum amount of gain that can be credited to your policy. For example, if the policy has a cap of 8.5% and the market rises 11%, you would not earn more than 8.5%.
  • Spreads: These features reduce gains by subtracting a portion of any positive index movements before earnings are credited to your account. For example, suppose the indexed account is only subject to a spread, and that spread is 25%. If the index gains 8%, 2% (25% of 8%) would be deducted before being credited to the cash value. In this case, 6% would be credited to the cash value.
  • Participation rates: In some contracts, gains in the index are reduced by a participation rate (and subject to a cap). So if the market rises 10% and you have an 80% participation rate, you’d get up to 80% of that 10% (which is 8%).

Policies may incorporate more than one method of limiting upside potential, such as using both a participation rate and a cap. They may also use alternate methods not discussed here.

Returns Diminished by Fees

An IUL policy is an insurance policy, but some people focus on the investment aspect. When viewed that way, it’s crucial to remember that you pay life insurance charges and other expenses inside of the policy. Those fees can eat into the cash value, and you might be able to invest with lower fees elsewhere.

Other Investments May Be Better

While IUL offers some upside exposure, there’s no such thing as a free lunch. “If a client doesn't demonstrate a need for a permanent life insurance policy like an IUL, the money is likely better invested elsewhere,” said Jeff McDermott, CFP from Create Wealth Financial Planning, LLC. The caps, participation rates, and spreads in an IUL typically mean you won’t keep up with standard investment portfolios in rising markets. And if you assume that markets will rise over the long term, you might prefer to fully participate in any growth.

When your primary goal is to grow your money, you need a good reason to pursue growth inside of an insurance policy. Schwartz said “it takes a unique set of circumstances for someone to make the case to me that a permanent insurance policy is appropriate.” Remember that investment vehicles like IRAs and workplace retirement plans also offer tax benefits, and you might be able to arrange for tax-free withdrawals from those accounts.

Minimal Regulatory Oversight

IULs are often sold as investment products because of the upside potential, but they are not regulated as investments. The U.S. Securities and Exchange Commission (SEC) does not supervise the sale of these products, so salespeople only need to follow state insurance laws. While those rules offer some consumer protection, a salesperson only needs an insurance license to sell IUL; they do not need to provide SEC-required disclosures or pass an exam that demonstrates their knowledge regarding investments.

Alternatives to IUL

Term Life Insurance

If you only need insurance for a limited time, term life insurance might be a reasonable alternative. Instead of paying relatively high premiums to build up a cash value that supports the policy for your entire life, you can buy pure insurance that lasts for a specific number of years (20 or 30, for example). Term insurance pays a death benefit that is typically tax-free for beneficiaries, and it provides financial protection for families and others.

Considering the lower premiums that come with a term policy relative to a permanent one, you can invest the difference for long-term growth. Eventually, you may end up with a pool of money that can be used for any purpose—or you could pass the assets on to your heirs after your death. McDermott said, “Most people's need for life insurance declines as they get older. When the mortgage gets paid off, the kids are moved out of the house, and the client is retired, there is no future income to protect. Investment assets fill in the gap that life insurance once covered.”

Whole Life Insurance

If you need a policy with cash value but you’re uncomfortable with the unpredictable growth in an IUL policy, whole life insurance might be appropriate. Whole life policies have fixed rates that provide for a guaranteed death benefit and cash value in any future year. However, you lose some flexibility with whole life, as you typically need to pay premiums on a regular schedule to prevent the policy from lapsing.

Is IUL Right for You?

If you need permanent life insurance coverage and the cash value crediting inside of an IUL contract appeals to you, this product could make sense. For example, you might prefer a policy that has exposure to limited upside growth but won’t lose money when markets fall. Premiums are flexible, which allows you to pay when you have free cash flow, although other universal life policies also offer flexible premiums.

If you don’t understand some of the drawbacks of an IUL policy, it may be wise to pause before buying. These policies are complicated, and it’s easy to focus on the potential benefits. If a policy doesn’t grow as fast as expected, you may need to pay more into the policy to keep it in force. As a result, these policies might not work well for those on a tight budget. Plus, if your need for life insurance is temporary, term insurance could be a better fit.

Frequently Asked Questions (FAQs)

What happens if you stop paying IUL insurance premiums?

When you stop paying premiums on a universal life insurance policy, the policy continues to deduct expenses from the cash value. As long as the cash value is sufficient to support the policy, coverage remains in place. However, if you deplete the cash value, your policy may lapse.

What is the maximum amount you can contribute to an IUL policy?

The IRS sets guidelines on how much you can pay into a life insurance policy without triggering tax consequences. If you pay in enough to make the contract a modified endowment contract (MEC), you may have to pay taxes on loans and distributions. A skilled insurance agent can design a contract that avoids MEC treatment while pursuing other goals.

Can you lose money in an IUL policy?

When the expenses in a policy exceed the growth (if any) plus premium payments, the cash value in an IUL may decline. That said, IULs typically do not participate in stock market downturns. However, it’s critical to read all of your policy disclosures to understand how a given policy works. Finally, if an insurer goes out of business, your funds may be at risk, so it’s best to work with financially strong insurers.