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Indexed universal life insurance (IUL): Risks, costs, and how it works

Depending on who you ask, indexed universal life (IUL) insurance is either a powerful wealth-building strategy or an overly complicated insurance product that promises more than it delivers. The truth may lie somewhere in the middle.

An IUL is first and foremost a life insurance policy. Like other permanent life insurance products, it can provide lifelong coverage and build cash value over time. What makes it different is how that cash value grows. Instead of earning a fixed interest rate, it is tied to the performance of a stock market index, such as the S&P 500.

Here is how indexed universal life insurance works, who it may fit, and what to know before buying a policy.

What is indexed universal life insurance?

Indexed universal life insurance is a type of permanent life insurance that combines a death benefit with a cash value account. As long as the policy stays in force, your beneficiaries receive a death benefit when you die, and part of the premiums you pay has the potential to grow inside the policy over time.

Unlike whole life insurance, which credits your cash value at a fixed interest rate, an IUL ties cash value growth to the performance of a market index such as the S&P 500, the Dow Jones Industrial Average, or the Nasdaq Composite. That is why it is called “indexed.”

Every premium payment for an IUL policy is generally split three ways:

• Cost of insurance: funds your life insurance coverage and death benefit
• Policy fees and expenses: covers administrative costs and other charges
• Cash value: accumulates over time and earns interest based on your policy’s crediting method

As with all cash value life insurance, you may be able to borrow against your balance, withdraw funds, or use it to help cover future premiums. However, loans and withdrawals can reduce your death benefit and, if not managed carefully, may cause your policy to lapse.

How indexed universal life insurance builds cash value

The biggest difference between an indexed universal life policy and other permanent life insurance policies is how the cash value earns interest.

With whole life insurance, you earn a fixed interest rate on the cash value portion of your balance. With an IUL policy, the interest you receive is tied to the performance of a stock market index.

Your money is not actually invested in the stock market. Instead, the insurance company uses the index as a benchmark to determine how much interest to credit to the cash value portion of your policy. If the index performs well, your cash value may earn more interest. If the index has a bad year, your credited interest may be lower, sometimes even 0%, depending on your policy’s terms.

For example, if you have $50,000 in cash value and the index your policy tracks gains 10% over the year, your cash value could earn about $5,000 in interest before fees and policy charges, if your policy credits the full 10%.

How caps, floors and participation rates affect returns

When people hear that an IUL’s cash value is linked to the stock market, they may assume they will earn whatever the market earns. That is rarely how it works.

Most IUL policies include features such as caps, floors and participation rates that can limit how much interest gets credited to the policy.

What is a cap rate?

A cap is the maximum interest your policy can earn during a crediting period. You can usually find your cap in your policy illustration or documents.

For example, if your policy has a 10% cap and the market index gains 15% that year, your policy would still be credited only 10% before fees and other policy charges.

What is a floor?

A floor is the minimum interest rate your policy can receive. Many IUL policies have a 0% floor, meaning you will not lose cash value simply because the underlying market index has a negative year.

For example, if the index falls 18%, your credited interest may be 0% instead of -18%.

However, a 0% floor protects you from market losses, not from policy costs. Insurance charges and administrative fees can still reduce your cash value, even in a year when your credited interest is 0%.

What is a participation rate?

A participation rate determines how much of the index’s gain is credited to your policy.

For example, if your policy has an 80% participation rate and the index increases 10%, you would receive 8% interest, assuming no cap limits the return. If the participation rate is 100%, you would earn the full 10% as long as it does not exceed the cap.

Why reviewing IUL features matters

Caps, floors and participation rates are one of the biggest reasons IUL policies can be difficult to compare. Two policies tracking the same market index can produce very different results depending on how these features are structured, so policy illustrations and contract details matter as much as the index name itself.

How the death benefit works in an IUL policy

Most indexed universal life policies let you choose between two types of death benefits:

Option A: Level death benefit

Your beneficiaries receive a fixed death benefit throughout the life of the policy. As your cash value grows, it generally becomes part of that total death benefit rather than being paid in addition to it. This option is usually less expensive because the insurance company’s risk decreases over time.

Option B: Increasing death benefit

Your beneficiaries receive the policy’s face amount plus the accumulated cash value, or, depending on the policy, a death benefit that increases as the cash value grows. This option is generally more expensive because the insurance company agrees to pay a larger benefit over time.

How premium flexibility works in an IUL

One major appeal of universal life insurance policies is the ability to adjust premiums within certain limits. For example, you may be able to increase, decrease or temporarily skip premium payments if your policy has built up enough cash value to cover its ongoing costs.

That flexibility can be especially useful if your income changes from year to year or if you go through a major life event such as divorce or temporary work leave and still want to keep your policy in force. But it also means you need to pay closer attention to the policy over time, because paying less than expected may leave less room to absorb fees and insurance charges.

Indexed universal life vs. other types of life insurance

If you are considering an IUL policy, you may also be comparing other types of life insurance. The main differences are below:

IUL vs. whole life insurance

Both whole life insurance and indexed universal life provide permanent coverage that builds cash value, but how that cash value grows is very different.

Whole life insurance generally has guaranteed growth at a fixed rate, while IUL has the potential for higher returns because its cash value is tied to a market index. Those returns are not guaranteed and may be limited by caps, participation rates and other policy features.

IUL vs. term life insurance

Term life insurance is generally the most affordable and easiest type of life insurance to get. It does not build cash value, but it provides a guaranteed death benefit for a set period of time, often at a fraction of the cost of an IUL policy.

IUL vs. variable universal life insurance

A variable universal life insurance policy is generally one step above an IUL policy in terms of risk and reward. Unlike IUL, a variable universal life policy invests cash value directly into investment subaccounts. That gives it greater growth potential, but also the possibility of investment losses.

Pros and cons of indexed universal life insurance

Like any financial product, indexed universal life insurance has advantages and trade-offs.

Who should consider indexed universal life insurance?

If your main goal is simply replacing your income for your family, a term life insurance policy is usually simpler and far less expensive.

An indexed universal life policy may make more sense if you:

• Need permanent life insurance but also want the opportunity to build cash value tied to a market index instead of a fixed interest rate
• Have already maxed out tax-advantaged retirement accounts and are looking for another tax-advantaged vehicle that can also provide a death benefit
• Need a policy that could support estate planning, business planning or wealth transfer goals rather than just income replacement
• Like the downside protection of a floor, even if it means dealing with caps and participation rates
• Are comfortable actively managing your policy

How much does indexed universal life insurance cost?

Indexed universal life insurance can cost anywhere from $150 to $500 per month for most healthy adults, according to Life Stein, an online IUL provider.

Common costs may include:

• Cost of insurance, which generally increases as you age
• Administrative fees for managing the policy
• Premium expense charges deducted from your payments
• Optional rider fees if you add features such as long-term care or chronic illness benefits
• Surrender charges if you cancel the policy during its early years

Before you buy: How to read an IUL illustration

Before you buy an indexed universal life policy, the insurance company will typically provide an illustration showing how your policy could perform over time.

When reviewing an illustration, pay close attention to:

• The assumed interest rate: The illustration may include an assumed interest rate based on average returns. This rate is not guaranteed and could make projected returns appear more attractive than they actually are.
• Caps, participation rates and floors: These determine how much interest may be credited to your cash value.
• Policy charges and fees: Look at how much is deducted each year and how those costs change over time.
• Guaranteed vs. current rates: Most illustrations include both. The guaranteed illustration shows the minimum contractual values, while the current rate illustration assumes policy performance that may never occur.

Indexed universal life insurance FAQs

Is an IUL better than a 401(k) or Roth IRA?

If you are eligible for an employer match or still have room to contribute to tax-advantaged retirement accounts, many financial professionals recommend prioritizing those first. An IUL may make sense as an additional planning tool for some high-income earners, but it generally should not replace a 401(k) or Roth IRA.

What is the difference between IUL and whole life insurance?

Whole life insurance has a fixed premium and earns a fixed rate for as long as it remains in force. An IUL credits interest based on the performance of a market index, subject to caps, floors and participation rates.

What is the downside of an IUL?

The biggest drawbacks are that it can cost more than other types of life insurance and has more moving parts to keep track of.

Is an IUL worth it?

Whether an IUL is worth it depends on what you are trying to accomplish. If you simply want to make sure your mortgage can be paid and your spouse and children would be taken care of if you are the breadwinner, term life insurance may be the more affordable solution. If you want to build cash value tied to the performance of the stock market, an IUL could be worth exploring with a trusted financial planner.

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