More on Life Insurance
More on Life Insurance
Indexed universal life insurance has a cash value tied to indexes and allows you to control coverage and premiums, but it may be too complicated for most people.
Updated September 16, 2020|6 min read
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But in practice, term life insurance is the only type of life insurance that keeps it simple. Other types of life insurance can include additional investment components, enact age restrictions, or allow for the customization of premium payments and death benefits. These additions can help you tailor a plan to fit your needs, but they also add a lot of layers to the one thing you really need a life insurance policy to do: provide a financial safety net for your loved ones.
Indexed universal life (IUL) insurance comes with a cash value that earns interest and provides you with options to adjust your death benefit or pay your premium out of your cash value amount but it can quickly get complicated. There’s potential for big gains with an indexed universal life insurance policy, but you’ll also need to track your cash value’s performance and the restrictions around accessing those funds. Combined with the fact that IUL is often much more expensive than term life insurance, you may prefer to buy a traditional policy and put the difference in a traditional investment account.
Indexed universal life (IUL) insurance includes a death benefit and a cash value, which grows at an interest rate controlled by your insurer
There is a minimum guaranteed interest rate, but your actual rate varies based on the performance of a chosen investment fund and could outperform other cash value policies
Policies also allow you to adjust the death benefit and pay your premiums with your cash value
IUL is more expensive and complex to manage than standard term or whole life insurance
Indexed universal life insurance is a type of permanent life insurance — a life insurance policy that 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). Other types of permanent life insurance include whole life insurance, variable life insurance, and universal life insurance.
All permanent life insurance policies are split into two parts: the death benefit (which pays a lump sum to a beneficiary when you die) 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 "indexed" part. These policies have a minimum guaranteed interest rate (so you won’t lose money), but the interest rates aren’t fixed; instead, they’re based on an index chosen by the insurer.
An index is essentially a group of investments like stocks or bonds. The S&P 500 and the Nasdaq 100 are examples of 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.
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. But there are some cases in which the cash value of a permanent life insurance policy can be useful (to pay off large estate costs, for instance, or as a means to pass a tax-free inheritance if other assets are large enough to trigger estate taxes) and an IUL insurance policy can come in handy.
You can see larger cash value growth with IUL than with other permanent policies, depending on the index against which your interest rate is set, and the minimum interest rate means that the financial risk is minimal if the market falls. 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.
There are downsides to any permanent life insurance policy in that they are generally more expensive and more complex than term life insurance policies. But the primary downside of IUL insurance is that it’s a confusing product. Why is it so confusing? Because there are a lot of complications and nuances associated with the index and the growth of the cash value.
For instance, 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. Indexed universal policies don’t take into account dividend yields, which creates another situation in which your interest rate wouldn’t match the index growth. There may also be participation rates or "point to point" timeframes that limit when interest is calculated and applied to your cash value.
Your growing cash value may also come with fees, which may be subject to increases throughout your policy’s life and are often higher than the fees on a traditional investment account. And if you want to withdraw from your cash value, you’ll encounter restrictions and taxes if you withdraw more money than you’ve paid into the policy.
Term life insurance is very straightforward in comparison: you pay the premiums, and the death benefit is paid out if you die. Even whole life insurance is easier to manage once you understand how the cash value component works. 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.
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If IUL sounds like a lot to handle and you aren’t sold on the higher growth potential of an index-based interest rate, there are simpler alternatives. A standard term life insurance policy or whole life policy are more straightforward, and there are even other universal life insurance policies that you may find easier to manage.
A basic term life insurance policy is more affordable and more easily understood. Term life insurance should serve anyone who simply wants financial peace of mind — no indexes, cash values, or interest rates to worry about.
Whole life insurance is like a stripped-down version of indexed universal life insurance. The policy has a cash value component that acts as a forced savings vehicle but at a fixed rate of return set by the insurer, not based upon the performance of an index.
There are other types of universal life insurance policy that are less complex. The main difference between indexed universal life insurance and, say, variable universal life insurance is how the cash value gains are realized — variable life grows the cash value by investing it in funds offered by the insurer. The potential for cash value growth may not be equal across policies, but both offer the same benefits in terms of the flexibility of the premiums and death benefit.
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Like other permanent life insurance policies, 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 convoluted; there are so many details specific to every policy that it can be hard to know exactly how well it will work out for you long term. Ultimately, indexed universal life insurance isn’t the best option for most people, and a more straightforward term life insurance policy will provide the protection needed at a lower price.
The policy premiums you pay fund a death benefit and a cash value component, which grows according to an interest rate set by the life insurer based on the performance of a specific stock index.
IUL is not the best investment for most people. There is 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 guaranteed minimum interest rate, your rate may also be capped so that your growth is less than you’d get from investing separately.
You can withdraw from the cash value of your indexed universal life 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. You may also be able to take a loan against your policy.
Your cash value is meant to be used while you’re alive, so it usually stays with the life insurer if you die. Some more expensive permanent policies allow you to pass the cash value on to your beneficiaries along with your policy’s death benefit.