Indexed universal life insurance (IUL) is a type of permanent life insurance policy that comes with a cash value that earns interest, as well as the standard death benefit. With IUL products, the cash value grows based on a stock market index, such as the S&P 500. Like with other universal life insurance policies, you can eventually use your cash value to pay your policy premiums.
IUL is more expensive and more complex than other life insurance products, such as term life insurance. That’s one of the reasons many people prefer to buy a traditional policy and put the difference in a traditional investment account instead.
How does indexed universal life insurance work?
Indexed universal life insurance works similarly to other types of permanent life insurance — the life insurance policy stays in effect for your whole life as long as the premiums are paid (as opposed to a term policy, which expires after a set amount of time).
Permanent life insurance policies are typically split into two parts: the death benefit and a cash value that can grow over time. With universal policies, you can adjust the death benefit within set limits, and use gains from the cash value to pay your premiums.
What makes indexed universal life insurance unique is the way the cash value grows.
IUL policies have a floor of 0% (so you won’t lose money), but the interest rates aren’t fixed.
Instead, they’re based on a market index chosen by the policyholder.
The insurer chooses which index funds are available in the IUL product, but ultimately the policyholder chooses how the money is allocated with the help of their advisor.
A market index is essentially a group of investments like stocks or bonds. [1] The S&P 500 and the Nasdaq 100 are examples of market indexes. The insurer doesn’t directly invest in the market, but uses the interest rate and performance of a specific index to set the interest rate for your policy.
Pros of indexed universal life insurance
Permanent policies like IUL can help with estate planning and provide an additional investment vehicle if you’ve already maximized contributions to traditional investment accounts, like a 401(k).
IUL can help pay off large estate costs or pass a tax-free inheritance if other assets are large enough to trigger estate taxes.
You can see larger cash value growth with IUL than with other permanent policies, depending on your index investment performance and cap rate.
You also have the advantage of a flexible death benefit and premium payment plan if needed, meaning you can increase or decrease the size of the death benefit (within limits) as your coverage needs change, and use the cash value you’ve gained to pay your premiums. However, you may have to take a medical exam if you want to increase coverage — it depends on the parameters of your policy.
Cons of indexed universal life insurance
IUL policies are generally more expensive and more complex than term life insurance policies. But the primary downside of indexed universal life insurance is the complications and nuances associated with the market index used as a reference and the growth of the cash value.
The earnings may be capped. If the S&P 500 earns 8% but your policy is capped at 4%, you won’t see the full growth reflected in your cash value.
IUL policies don’t take into account dividend yields, which creates another situation in which the growth rate credited wouldn’t match the index growth — dividends are usually paid out quarterly or annually to the policyholder if the insurance company overperforms financially.
Your growing cash value may come with fees that are built into the cap rate. If you want to use your cash value, you’ll encounter restrictions and taxes if you withdraw more money than you’ve paid into the policy.
The policyholder takes on much more investment risk than they would with other life insurance products. If the stock index doesn’t perform well, you’ll have to pay more into your policy to prevent it from lapsing, and it can become difficult to afford.
With IUL, you need to spend a lot of time studying your index options or be very comfortable with the guidance of the company from which you're buying to make an informed insurance choice.
Indexed universal life insurance vs. whole life insurance
Indexed universal life insurance and whole life insurance are both types of permanent policies, but they have differences related to the death benefit, cash value, premiums, and market risk. Most notably, the cash value of an IUL policy grows based on a market index, and the cash value of a standard whole life policy grows at a fixed rate, set by your insurer.
Indexed universal life | Whole life | |
Policy duration | Permanent | Permanent |
Death benefit | Flexible | Fixed |
Cash value accumulation | Based on a market index | Set by your insurer at a fixed rate |
Premiums | Flexible | Level |
Indexed universal life insurance vs. term life insurance
Term life insurance is one of the most affordable life insurance options on the market. It’s the best option for most people looking to protect their income and provide their family with a financial safety net to cover any debts. Indexed universal life insurance is more of a niche product, commonly used for more complex financial planning by those with a higher risk tolerance.
Indexed universal life | Term life | |
Policy duration | Permanent | 10 years to 40 years |
Death benefit | Flexible | Fixed |
Cash value accumulation | Based on a market index | N/A |
Premiums | Flexible | Level, more affordable |
→ Explore the differences between whole vs. universal vs. guaranteed universal life insurance
Is indexed universal life insurance worth it?
Whether IUL is worth it for you depends on your financial situation and need for life insurance. Most people don’t need their life insurance policy to last their entire lives; once you pay off debts, have few dependents, and become self-insured, it’s usually not worth paying for a policy.
If your primary goal is to replace your income and provide a financial safety net for your family, it’s hard to justify the extra costs associated with an indexed universal life insurance policy when a term life insurance policy paired with an outside investment plan is more affordable and can provide a better ROI.
Indexed universal life insurance has the added drawback of being complex. It’s common for IUL policies to lapse if they’re underfunded or if the market index underperforms — so it can be hard to know exactly how well the policy will work out for you long-term.
If you’re considering purchasing indexed universal life insurance, it’s important to speak with a trusted financial professional first.
Other types of permanent life insurance
Frequently asked questions
How does an indexed universal life policy work?
The policy premiums you pay fund a death benefit and a cash value component, which grows according to a cap rate set by the life insurer based on the performance of a specific stock index.
Is indexed universal life a good investment?
IUL is not the best investment for most people. There's potential for large investment gains, but performance can be unpredictable compared to traditional investing and it will cost more than a term policy. While IUL policies have a floor of 0%, your rate may also be capped so that your growth is less than you’d get from investing separately.
Can I cash out my indexed universal life policy?
Most index universal life policies have a surrender fee schedule for the first seven to 14 years, limiting the amount you can withdraw the first few years. You're also penalized if you withdraw from your cash value if it's in an active index segment. (Segments are like CDs, you're locking in your money for that segment period.)
But after the surrender period, you can withdraw from the cash value of your IUL policy up to the amount you’ve paid into it without incurring fees or taxes. You can also cash out your policy entirely by surrendering it and forfeiting your coverage (though this may come with high fees).
What happens to my cash value after I die?
Your cash value usually stays with the life insurance company if you die.
