When life insurance policy types are listed and described, the focus is usually on two of them: term life and whole life policies. There are more types than those two, though, and they’re typically more complex. They include universal life insurance — and, as a subset, indexed universal life insurance, or IUL. This is an advanced type of policy, where interest on the cash value component is linked to a market index.
In this post, we’ll define IUL, explain how it works, share its pros and cons, and more.
Definition of Indexed Universal Life Insurance (IUL)
First, let’s define universal life insurance. Universal life insurance is a permanent policy, which means that it doesn’t have a set term (say, for 10 or 20 years) and it comes with a cash value. A universal life insurance policy allows policyholders to flexibly adjust premiums and death benefits, though this can have an adverse effect on the policy.
Now, what is IUL? Indexed universal life insurance adds another twist to the equation. This is a type of universal life insurance that doesn’t come with a fixed interest rate. Instead, its growth is tied to a market index. (More about the index soon.)
How Does IUL Work?
After someone buys an IUL policy, they pay premiums, which is similar to other types of life insurance policy structures. Part of that premium covers the insurance costs that, like with other types of life insurance, are based on the insured’s demographics. Remaining fees paid go towards the cash value of policy. Interest paid is calculated in ways that are based on an index (or indexes).
This may sound similar to investing in the stock market, but there’s a key difference. The part of the premium that goes towards the cash value of the policy doesn’t get directly invested in stocks. Instead, the market index(es) is how the interest rate and amount is determined, with a minimum fixed interest rate usually guaranteed.
IULs typically offer policyholders a choice of indexes and allow them to divide the cash value portions of their premiums between fixed and indexed account options.
Explaining the “Index” Feature
A market index represents a broad portfolio of investments with the use of weighted average mathematics to come up with the index figure, which then plays a central role in the amount of interest paid. The three most commonly used market indexes in the United States are the Dow Jones, the S&P 500 and the Nasdaq Composite.
Note that funds invested for the cash portion of the insurance policy do not need to be invested in the index used to calculate the interest. Many times, insurers invest these dollars in bonds rather than stocks.
Benefits and Drawbacks of IUL Insurance
Like other types of life insurance policies, indexed universal life insurance comes with pros and cons. Here is an overview of the benefits and drawbacks of IUL.
Benefits of IUL Insurance
• There’s a death benefit for beneficiaries, as well as the cash value of the policy.
• Withdrawals can be tax-free up to the amount of premiums paid.
• Premiums are flexible — you can pay different amounts each month as long as it’s enough to cover fees and doesn’t go beyond an IRS limit.
• Gains are locked in each year, which means you can’t lose the previous years’ gains, though if the market is down the following year it can decrease unless the policy has a built-in floor.
• Because of the annual reset feature, you never need to make up any losses from prior years.
• No mandatory distributions exist.
• You can explore your tax benefits with your accountant or other financial advisor, and they may be significant for your situation.
• You can borrow against this policy and, if you do, you typically won’t face negative tax consequences.
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Cons of IUL Insurance
• An IUL is complicated and, to get the most benefits from this policy, you’ll need to understand how to maximize its value.
• Although you can pay a minimal premium amount when you want, this can have a negative overall effect on the policy’s cash value.
• Because the cost for the insurance portion depends on your rating, how much is insured and your age, the cost will go up over the years as you get older.
• Although the rate is based on an index, policies come with a cap. So, during high index years, you likely won’t realize the full benefit because of this cap. On the flipside, however, many policies also have built-in floors to offset the cap.
• Fees can take a big chunk out of the policy, causing you to lose much of its value.
• If you don’t keep the policy in force, you may lose the death benefit (which is true of other types of policies), along with the extra money paid into the premiums.
Alternatives to IUL Insurance
Whether you’re not sold on IUL insurance or simply want to know what your other life insurance options are, here are some of the alternatives to indexed universal life insurance:
• Adjustable life insurance: This combines aspects of term life insurance with whole life and provides policyholders with the flexibility to adjust the policy’s amount, term premiums and more. Adjustable life policies also come with a cash value component. A key benefit of adjustable life insurance is that you can make adjustments to your policy without the need to cancel the current policy or buy a new one.
• Variable universal life insurance: Variable universal life is similar to IUL, as it is a permanent life insurance policy that has a cash value and flexible premiums. The investment portion comes with subaccounts and can resemble investing in mutual funds. When the market is doing well, this can benefit the policyholder, but when it’s not, significant losses can occur.
• Standard universal life insurance: Then, of course, there are universal life insurance policies. These come with a fixed interest rate rather than one tied to an index.
• Whole life insurance: Additionally, there’s the more basic whole life insurance policy with standard premiums. There is also a guaranteed death benefit and a cash value component.
• Term life insurance: Then, life insurance at its simplest: term life insurance policies. These don’t come with cash value components or any real bells and whistles. These policies have a term limit (perhaps 10 to 20 years) and are more straightforward and affordable than other options, coming with a death benefit to beneficiaries when the covered individual dies while the policy is paid up and in force.
• Current assumption whole life insurance: Another type of cash value insurance is called current assumption whole life (CAWL), and it has similarities to universal life insurance policies. Premiums are fixed for a certain period of time and, on predetermined dates, premiums are recalculated (and perhaps the death benefit is, as well). Plus, interest is handled in a way that’s similar to universal life.
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Is IUL Insurance Right for Me?
By comparing this overview of indexed universal life insurance with, say, term or whole life insurance, you can see that IUL insurance is quite complex. If, though, you’re earning a high income or want to explore long-term investment opportunities, it can make sense to consider whether the tax benefits associated with an IUL would be worthwhile.
For those who do consider moving forward with exploring indexed universal life insurance, it’s important to compare its pros or cons against those of other types of life insurance. Also take the time to research and compare different life insurance policies.
Although the question of “What is IUL?” is quite short, the answer isn’t. If this type of policy interests you, consider exploring it in more depth to ensure that you’re clear about its complexities.
At Lantern by SoFi, we make life insurance easy to understand and quick to set up. You can conveniently get a quote for a term life insurance policy and apply in just minutes. You can then benefit from flexible coverage for 10 to 30 years, adjustable at any time, in amounts from $100,000 to $8 million.
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