Indexed universal life insurance (IUL) is a complex insurance product that offers both a death benefit and a cash value component. It isn’t right for every investor, but it has a number of features that make it appealing to investors who are relatively experienced, have maxed out other tax-deferred investments, and want to limit their market risk.
How Does Universal Life Insurance Work?
Before we can get into the pros and cons of indexed universal life insurance, we need to outline what an IUL policy includes. First, IUL is a type of permanent insurance, which means it provides insurance coverage for your entire life, as long as you continue to pay the premiums. It also has a tax-deferred cash value component (i.e. you can grow money in your account without it being considered part of your taxable income.) Because IUL is an investment vehicle and doesn’t expire like term life insurance, it is also more expensive.
The “universal” part of indexed universal life insurance means that features such as the death benefit, cash value component, and premiums are flexible and can be changed throughout the contract. IUL policies have greater flexibility than whole life insurance, another type of permanent life insurance that has fixed premiums and a guaranteed cash value growth rate.
The “indexed” part of IUL means that the policy’s cash value is tied to a broad market index, such as the S&P 500, that the policyholder and their financial advisor select. Essentially, you’re using your life insurance policy to invest in the stock market. This is where things start to get tricky, because while the stock market affects the policy’s cash value return, investors will not lose money during a market downturn.
In other words, when the market is doing well, the cash value of your IUL policy will grow to reflect the market growth, but if there’s a stock market crash, you won’t lose your investment—your cash value just won’t grow. The trade-off is that there will be a participation rate or cap on your earnings.
- A participation rate is set as a percentage of a total index gain. For example, if the participation rate for your policy was set at 50%, your cash value component will grow at half the rate of the market. If the S&P was earning 6%, you would earn 3%.
- A cap puts an upper limit on the percentage gain you can get. For example, if the cap for your policy was set at 5%, your growth percentage would never go above that, even if the market was earning 8%.
Who Is a Good Candidate for Investing in an IUL Policy?
Because indexed universal life insurance is complex, tied to the stock market, and has high premiums, it’s probably not the right choice for novice investors. However, it can be a good investment opportunity for people who meet the criteria below:
- Have a stable income-- IUL policies require a significant investment because of their monthly premiums, and policyholders need to ensure their income can support these premium payments.
- Are conservative with their investments—An IUL policy isn’t entirely risk-free, but it will protect you from market downturns. IUL policies can be a good choice for risk-adverse investors who are willing to take a potentially lower return in exchange for a lower risk.
- Have maxed out other tax-deferred investment vehicles—If you’ve already maxed out your contributions to other tax-deferred vehicles, such as a Roth IRA, an IUL policy can give you another account in which to grow your wealth tax-free. You won’t pay taxes on your investment gains if the money stays in your policy or if you use money from the policy for a loan. There’s also no limit on contributions to an IUL policy.
- Understand the pros and cons of IUL policies—Investors should always read their IUL contract carefully and discuss it with an experienced financial advisor before deciding to invest.
If you need help deciding whether to invest in an IUL, the Southington, Connecticut-based Americans for Life Financial Services can help. Our retirement planning firm specializes in life insurance consulting and helping clients identify the best long-term investment vehicles. Contact us today to learn more about our life insurance advisory services.