Indexed Universal Life Insurance Pros and Cons
There are several indexed universal life pros and cons to consider before you make a life insurance purchase. Indexed universal life (IUL) policies have the benefit of a faster-growing cash account and tax advantages, but do carry some risk and become more costly over time. IUL insurance policies have an investment aspect that may be right for some people and can provide income while you are alive.
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UPDATED: Jun 1, 2022
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- Indexed Universal Life (IUL) Insurance policies include benefits like higher cash value growth potential, income tax-advantaged gains, and the same death benefits as traditional policies.
- IUL policies have floors to prevent significant losses but still come with financial risk.
- Indexed universal life insurance policies have drawbacks such as hidden fees and expenses, capped gains, and a complicated structure that does not benefit most policyholders.
When it comes to life insurance, there are a lot of options. Many people assume that a life policy only helps family members in the unfortunate event that the policyholder dies. But did you know that some life insurance policies can also grow your net worth while you’re still alive?
If you didn’t, it might be helpful to learn about indexed universal life insurance (IUL), a type of permanent life insurance that can generate wealth through compound interest.
While an IUL insurance policy may be right for some, others may want to stay away from this financial vehicle. Wondering if an IUL insurance policy is right for you? Read on to discover indexed universal life insurance pros and cons.
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What is indexed universal life insurance?
Before we dive into the financial nitty-gritty, it may be helpful to know what an IUL insurance policy is and how it differs from other life insurance policies.
Let’s first look at a few key terms:
- Cash value – In insurance and investment speak, cash value refers to the amount of money in a whole life insurance policy or another cash-generating annuity. In other words, your cash value is equivalent to the money in your account.
- Index – An index, simply, is a numerical measurement or indication of change. In the financial industry, it indicates the growth or depreciation of a particular asset, thereby tracking the performance of your investment. Some common indexes include S&P 500, the Dow Jones Industrial Average, and the Consumer Price Index.
- Cap rate – The cap rate refers to the maximum amount of cash value your IUL insurance policy can accrue. In many cases, the cap rate is 10%. This means that your accruable interest cannot exceed 10%, regardless of how well the market is doing.
- Floor – If the cap rate refers to the maximum interest your policy can accrue, the floor represents the minimum guaranteed interest that will be added to your cash value. In most cases, the floor is 0%. This means that even if the index suffers huge losses, your account won’t lose value.
In short, an indexed universal life insurance policy is a way for the policyholder to accrue capital in a high-reward, relatively low-risk manner.
How does an IUL insurance policy work?
When a policyholder pays their monthly life insurance company’s premium, a portion is transferred to the cash value account, which increases or decreases based on the index (or indexes) tied to the account.
Keep in mind that accrued interest is limited by the cap rate. And even though the cash value amount depends on index movement, the money isn’t actually invested in the index. It merely corresponds to the index’s fluctuations.
The indexed account’s ability to earn money in the form of fluctuating interest gains is what separates IUL insurance policies from other types of life insurance that rely on fixed interest rates.
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What are the pros of an IUL insurance policy?
IUL insurance policies carry a lot of advantages over traditional forms of life insurance. Let’s dive into some of these indexed universal life policy advantages.
#1 – Increased Cash Value
Although other types of life insurance can accrue money in the form of interest gains, these gains are limited by the indexed universal life policy’s fixed interest rate. IUL insurance policies, however, can see much larger gains because the cash value is tied to market index performance.
Suppose you take out a whole life insurance policy with an annual fixed interest rate of 1.5% and your account has a cash value of $1,000. At the end of the year, you can expect a $15 gain.
Now, suppose you take out an IUL insurance policy with the same cash value. If your policy’s market index experienced a 6% increase, you could expect a $60 gain.
In short, IUL insurance policies can result in higher returns than other policies.
#2 – Tax Advantages
An IUL insurance policy comes with a few tax advantages, including:
- No capital gains tax – A capital gains tax applies to earnings, paid by the policyholder upon withdrawing gains from their account. Many accounts, especially ones tied to assets like stocks and bonds, are subject to a capital gains tax. IUL insurance policies, on the other hand, are not (as long as the policyholder doesn’t withdraw from the account before it matures).
- No distribution requirements – IUL insurance policies are similar to IRA and 401(k) accounts in that all three are tax-deferred. However, unlike IRA and 401(k) accounts, IUL insurance policies don’t have a minimum age for withdrawals or require withdrawals once you reach a certain age. You can grow your money until you need it, but you can also access it at any time.
These tax advantages can translate into a stronger cash value account.
#3 – Relatively Low Risk
When your index is performing well, you can expect your cash value to grow. However, as many investors know, indexes can be quite fickle. All indexes experience periods of growth and stagnation.
The good news is that IUL insurance policies typically have floors of 0%. This means that even if your index completely tanks, your original cash value is protected from a massive loss.
The 0% floor is thus a major boon to IUL insurance policies.
#4 – No Impact on Social Security Benefits
Unlike other types of income, which can reduce your total available Social Security benefits, IUL loans and gains don’t affect them at all. This is because your IUL loan doesn’t count towards the year’s earnings threshold, and therefore, can’t cut into your retirement benefits.
#5 – Protection for Your Loved Ones
The fact that your family is financially protected is the central benefit of life insurance policies, and IUL insurance policies are no exception. The tax-free money your family receives following your death can be used to cover funeral expenses, debt payments, mortgages, and more.
The primary difference is that IUL insurance policies, through their cash value advantage, can also provide ongoing income while you’re still alive.
What are the cons of an IUL insurance policy?
Just because IUL insurance policies come with several benefits doesn’t mean these types of policies are advantageous for everyone. In some cases, you may be better off taking out a traditional life insurance policy.
Let’s look at a few disadvantages of IUL insurance policies.
#1 – Capped Gains
Because IUL insurance policies have a cap rate dictated by the insurance company, the money the account can generate is ultimately limited. This can be disheartening when the index is performing higher than the cap rate allows.
For instance, if the index grew by 16%, but your cap rate is 10%, you won’t make as much money as you would if you simply invested in the index itself.
What’s more, insurance companies typically set participation rates, which cut into your earnings. This means that your account won’t be credited with the full amount generated from the index’s performance. Instead, you might have a participation rate of 50%, meaning the insurance company will pocket half of your 10% growth.
#2 – Increasing Premiums with Age
Unlike some life insurance policies, such as whole life, IUL insurance premiums increase as you age. After the age of 50, you can expect to pay as much as 10% more for your policy each year. This increase in premiums can pose problems for older policyholders who haven’t saved enough to cover these expenses.
If you want a life insurance policy with fixed premiums based on age and other factors, an IUL insurance policy isn’t for you.
#3 – Complications and Risk
Between cap rates, fluctuating indexes, and growing premiums, IUL insurance accounts can be difficult to understand and manage. In many cases, the insurance companies fail to properly advise new policyholders about the intricacies and inherent risks.
While it’s true that floors are in place to prevent massive financial losses, the insurance company can recoup your death benefit if you don’t have enough cash value to pay your increasing premiums. This decreased cash value is typically related to poor index performance.
And while no gains are better than huge losses, investing in a fluctuating account with no guaranteed returns is inherently risky.
#4 – Fees and Expenses
Due to the complications and risks associated with an IUL insurance policy, insurance companies may charge the policyholder extra fees and expenses.
These fees and expenses include:
- Administration fees, taken by the insurance company
- Annuity riders, which guarantee minimum living and death benefits but increase the recurring cost and complexity of your policy
- Premium increases, as time goes on
- A surrender charge, paid out if you cancel your IUL policy altogether
This surrender charge applies if you willingly cancel and cash out your account and if you experience extenuating circumstances like losing your job and the ability to pay your growing premium. This puts many policyholders in the tough position of either paying premiums they can’t afford or losing the account altogether. It’s one of the most significant drawbacks of IUL insurance policies.
To Index or Not to Index, That is the Question
Taking out an IUL insurance policy comes with many benefits. In addition to potentially growing your cash value, Indexed ul insurance policies offer distinct tax advantages. That said, IUL insurance policies come with their own collection of drawbacks, many of which aren’t disclosed until it’s too late. If you’re wary of financial risk, premium increases, and potentially forfeiting funds, an IUL insurance policy isn’t for you.
Ultimately, the best thing to do is weigh the pros and cons before making any insurance decision. Fortunately, we have you covered.
Start by comparing life insurance policies now, and you can set yourself up for financial security in the future. Enter your ZIP code right now for free life insurance quotes from top companies.