Edited by 
Edited by 
Reviewed by 
Indexed universal life (IUL) insurance offers a unique blend of life insurance protection and the potential for cash value growth linked to market indexes. One of the primary tax advantages of IUL policies is that the cash value growth is typically tax-deferred. As a result, you won’t pay taxes on the gains as they accumulate within the policy. Additionally, the death benefit paid to beneficiaries is generally tax-free, providing a significant financial advantage.
A financial advisor can help you determine what role life insurance could play in your finances and retirement.
Benefits of Indexed Universal Life (IUL) Policies
IUL insurance offers a blend of life insurance protection and earnings potential. Because of this, it can be an attractive option for individuals seeking financial security and growth. Here are eight of the main benefits of IUL.
Tax-Deferred Growth
The cash value within an IUL grows tax-deferred, allowing for a more efficient accumulation of funds. You won’t pay taxes on the gains as they grow with compound interest over time.
Tax-Free Death Benefit
Beneficiaries receive the policy’s death benefit without having to pay income taxes on it. This means your loved ones can get the full financial protection that you intended.
Flexibility in Premium Payments
IULs offer flexible premium payment options, which allow policyholders to adjust their contributions based on their financial situation. This flexibility makes it easier to maintain the policy during different life stages and financial circumstances.
Potential for Cash Value Growth
The rate of return on an IUL policy is typically linked to the performance of a stock market index, like the S&P 500. It’s credited as interest, though, so returns are not directly invested in the stock market. Instead, the interest credited to the policy’s cash value is based on the movement of the selected index. The insurance company usually sets caps and floors.
Access to Cash Value
Policyholders can access the cash value of an IUL through withdrawals or policy loans. It’s possible to receive withdrawals without federal income tax up to the policyholder’s investment in the contract under applicable rules. Additionally, policy loans generally are not treated as taxable income when they are taken. However, the tax result can change if the policy is a modified endowment contract (MEC) or if a policy with outstanding loans later lapses or is surrendered.
Downside Protection
While IULs offer the potential for market-linked growth, they also include downside protection. So, even if the linked index performs poorly, the policy will usually still credit a minimum guaranteed interest rate. This helps protect your cash value from market losses.
Customizable Coverage
It’s possible to customize IUL policies to meet individual needs and preferences. Policy holders can add riders, such as long-term care, chronic illness and disability, to enhance the policy’s benefits and gain additional protection.
1035 Exchange Option
A 1035 exchange allows policyholders to transfer the cash value from one life insurance policy to another without incurring immediate tax liability. This provision can be beneficial if the policyholder wants to switch to a different type of life insurance policy or another IUL with better terms. To qualify for tax deferral, the 1035 exchange must meet specific IRS requirements.
How Indexed Universal Life (IUL) Policies Are Taxed
IUL policies can offer many tax advantages. But they also carry tax consequences. It’s important to understand how to report them correctly on your taxes to avoid issues with the IRS.
Paying Taxes on Tax-Deferred Gains
IULs accumulate cash value on a tax-deferred basis, meaning you don’t pay taxes on the growth each year. However, you must report any taxable events related to the policy. This includes withdrawals or policy surrenders that result in taxable gains.
Reporting Withdrawals and Loans
Policyholders can access the cash value of their IUL through withdrawals or loans. For a life insurance policy that is not a MEC, withdrawals generally can recover the policyholder’s investment in the contract before a gain is recognized. Once distributions exceed the remaining investment in the contract, additional amounts can become taxable income.
Policy loans generally are not treated as income when the loan is made. However, borrowing against a policy reduces the value available to support the contract and can reduce the death benefit. If a policy with an outstanding loan later lapses or is surrendered, the resulting transaction can produce taxable income. This occurs when the amount exceeds the policyholder’s investment in the contract.
Different distribution rules apply to a MEC. A MEC generally treats distributions as coming from taxable income in the contract before the policyholder’s investment, and loans can be treated as distributions. A taxable MEC distribution taken before age 59½ may also be subject to a 10% additional federal tax unless an exception applies.
Policy Surrenders and Lapses
If a policyholder decides to surrender their IUL policy, the amount the policyholder receives about their investment in the contract is generally taxable as ordinary income. This is calculated based on the policyholder’s tax basis rather than simply the total premiums originally paid, as previous distributions and other adjustments can affect that amount.
An outstanding loan can also affect the tax consequences when a policy is surrendered or lapses. As a result, a policyholder who has borrowed heavily against an IUL should review the policy’s remaining basis, cash value and loan balance before ending coverage.
Tax-Free Death Benefits
The death benefit that an IUL policy provides is generally tax-free to the beneficiaries. However, exceptions can apply. For example, special rules may limit the income-tax exclusion when a policy is transferred for valuable consideration or is subject to certain employer-owned life insurance rules. Interest paid to a beneficiary on retained death-benefit proceeds is generally taxable.
1099-R Form
Insurance companies issue Form 1099-R for distributions from an IUL policy that are taxable. This form provides details on the total distribution amount and the taxable portion, which you must report on your tax return.
When an IUL Can Create a Tax Bill
Describing an IUL as “tax-free” can overlook the difference between tax deferral and a permanent exclusion from income. Cash value growth generally is not taxed each year while it remains inside a qualifying life insurance policy. However, certain transactions can cause part of that accumulated value to become taxable.
Consider a simplified policy with $100,000 of investment in the contract and $150,000 of cash value. The policy has $50,000 of gain. If the owner fully surrenders the policy for $150,000 and there are no other adjustments to basis, the calculation would be:
- $150,000 surrender proceeds – $100,000 investment in the contract = $50,000 taxable gain
Policy loans require a different analysis. Receiving a loan generally does not create taxable income at that time, but the loan is still a debt that the policy secures. If borrowing and policy charges later cause the contract to lapse, the owner can face taxable income even without receiving additional cash at the time of the lapse. That makes monitoring an IUL with a substantial loan balance particularly important.
MEC status can also change the result. A policy generally becomes a MEC when it fails the federal seven-pay test. Distributions from a MEC receive less favorable tax treatment than distributions from a non-MEC life insurance contract, and loans can count as distributions for federal tax purposes. Policyholders considering large premium payments or substantial access to cash value can ask the insurer or a tax professional how the policy’s MEC status would affect the transaction before moving money.
Bottom Line
The tax-deferred growth of an IUL can help you build wealth and offer tax-free death benefits to your beneficiaries. However, an IUL is not universally tax-free. Withdrawals above the applicable investment in the contract, a surrender or lapse with gain and distributions or loans involving a MEC can create taxable income. Understanding the tax implications of withdrawals, loans and policy surrenders can help you maximize your policy coverage and potential for growth.
Financial Planning Tips
- A financial advisor can help you create a personalized financial plan that includes life insurance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s quick and easy savings calculator to project how your nest egg will grow over time.
Photo credit: ©iStock.com/zamrznutitonovi, ©iStock.com/Jacob Wackerhausen, ©iStock.com/fizkes