IUL Insurance: What is Index Universal Life Insurance?

What Does ‘IUL’ Mean?

Indexed universal life insurance (IUL) is a type of permanent life insurance that is often praised for its flexibility for policyholders. An index universal life insurance policy can last your entire life while also building cash value within its accounts. However, these insurance policies can be a little complicated to understand. Indexed universal life policies typically place a portion of the premium payments from the policyholder into an account that has the potential to earn interest that is based, in part, on the performance of a market index - but money isn’t directly invested in the market. So index universal life insurance policies aren't like traditional investing. Some IUL policies also offer a fixed account option that can earn interest at a set rate.

How Index Universal Policies Work

Indexed universal life insurance policies usually function similarly to fixed universal life insurance policies, with the primary difference being in how they accrue their cash value. 

The cash value in an indexed universal life insurance policy is  tied to a market index, whereas in a typical fixed universal life insurance policy, the cash value may accrue using fixed interest rates that are set by the insurer. 

An index universal life insurance policy will usually grow cash value by setting aside a portion of the policyholder’s premium payments and providing the opportunity to earn interest on that amount based in part on the performance of a specified market index. The insurance policyholder’s cash value can grow when the index performance is positive, though, it’s important to note that index interest may be subject to limitations such as a cap or participation rate. However, because this type of insurance policy is not an investment, the cash value is not reduced due to negative index performance.  It is important to note that cash value can be reduced due to the insurance policy’s fees and expenses.

Many index universal life insurance policies’ cash values will earn a minimum interest rate no matter how the market performs, but some insurance policies will have an interest rate cap. These financial interest rates will usually cap between 8% and 12%, but can vary from insurance policy to insurance policy. It is important to note that it is still possible to experience negative performance in these types of policies due to the effects of insurance policy fees and expenses.

Fixed Universal Life Insurance Versus Indexed Universal Life Insurance

Essentially, index universal life insurance is not very different from a fixed universal life insurance policy. Both fixed universal life insurance and IUL policies can offer insurance policyholders a great deal of flexibility. Both have a cash value component and a protection  component to the plan, and you may be able to adjust your monthly insurance premiums based on the funds in your cash value. However, IUL policies may offer more growth potential than a universal life policy.

An Indexed Universal Life Insurance Policy Versus Whole Life Insurance

When searching for permanent life insurance policies, ‘whole life insurance’ and ‘indexed universal life insurance’ are two terms you’ll commonly see. Both of these insurance policies aim to provide you with lifelong coverage, but the key distinction between the two is how the cash value grows and the cost of IUL coverage.

In index universal life, your cash value is tied (in part) to a market index’s financial performance. With whole life insurance policies, it’s more straightforward–it’s life insurance where the cash value earns a set interest rate. You pay your insurance premiums, your policy premiums remain at a fixed rate, and your beneficiaries receive a death benefit after your passing. With whole life insurance, the primary focus is permanent coverage with limited potential to grow cash value, so premiums are typically lower than IUL policy premiums.

Some insurance policyholders may prefer an index universal life policy over a whole life insurance policy because IUL policies can offer them increased flexibility with greater potential cash value accumulation. Index UL policies may allow insurance policyholders to adjust their premium rates and/or access their cash value while living.

Who May Benefit From an Indexed Universal Life Insurance Policy?

Families with dual incomes and individuals with higher net worth who are interested in tax-advantaged savings may find index universal life policies appealing, especially if they are seeking flexibility with their life insurance policies.  For these potential buyers, indexed universal life insurance may be a good fit for their objectives. It may be helpful to have strong financial literacy, or to work closely with a professional insurance agent to ensure this type of insurance policy best suits your needs and objectives. It’s important to understand the potential downside of an IUL policy should the underlying financial index not perform well.

Advantages of IUL Insurance

Death Benefit

Just like with other permanent life insurance policies, index universal life insurance comes with a death benefit. This death benefit is typically not subject to income tax or estate tax, and may not be required to undergo the probate process. The insurance death benefit will be paid out to the named beneficiary(ies) upon the passing of the insured person. This death benefit from the universal policy that helps provide for your family after your death is the primary reason people purchase life insurance.

Flexibility

From flexible insurance premiums to accessing your cash value when you need it, indexed universal insurance can allow you to take the reins when it comes to your IUL policy. Index universal life insurance  policyholders can increase or lower their insurance premiums (provided their policy values are adequate to sustain the policy) and control the amount they contribute toward their cash value. 

There are insurance policies that can offer a range of optional riders, allowing someone who is shopping for life insurance the ability to find a policy that is best for them and their family. An insurance rider is an addition to an existing insurance policy, which allows you to add features that can help meet your specific life insurance needs. It’s always best to speak with a financial professional or licensed insurance agent for education on these policies and how they may be beneficial to you and your family.

Cash Value

With an indexed universal life insurance policy, the amounts credited to the policy’s cash value can grow tax-deferred. Index universal life insurance  policyholders may be able to pay their insurance premiums by using their cash value,  allowing them to stop paying premiums, or to pay smaller premium payments. Some index universal life insurance policies may offer a rider that will allow the cash value to be added to the death benefit upon the passing of the insured.

Disadvantages of IUL Policies

Limitations on Accumulation

Certain insurance companies will limit the amount of cash value that can be accumulated within the policy either through a cap, or other mechanism such as a participation rate.

Tied to a Stock Market Index

Because the interest earned on the cash value is tied to a market index, this can have both positive and negative effects on your accounts depending on how that index performs. For example, if the financial index goes down, the insurance policy may not credit any interest to the cash value of the accounts. Check that your insurance policy offers a ‘floor’ on financial losses. A ‘floor’ means there is a minimum interest rate on the indexed account, so in times of negative financial returns, the growth rate credited to the policy will not go below a certain interest rate threshold. While having a floor can help protect against market losses, it is still possible to experience a loss when insurance policy fees and expenses are factored in. Conversely, many IUL policies have a cap – meaning that even if the market performs very well, the cash value you receive may be limited based on your insurance company’s maximum financial cap.

Additional Costs

Some insurance policies may charge additional financial fees, which can potentially drain your account’s cash value. Talking to your insurance provider can help you understand the rates and costs of different policies.

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