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Young couple discusses insurance with a broker

Life insurance can provide a measure of financial protection against the worst-case scenario. Whole life insurance and indexed universal life insurance (IUL) are two types of permanent policies you might consider if you’re interested in lifetime coverage. While both policies can offer the opportunity to accumulate cash value while leaving behind a death benefit for your loved ones, they aren’t exactly the same. Understanding the differences between IUL vs. whole life insurance can help you decide which one may be right for you.

A financial advisor can help you sort through all the decisions that go into successful financial planning, not just deciding which type of insurance is appropriate.

Whole Life Insurance, Explained

Whole life insurance is a type of permanent life insurance. When you buy a whole life policy, you’re covered for life as long as your premiums are paid. This is different from term life insurance, which only covers you for a set term, say 20 or 30 years.

With a whole life insurance policy, you have a guaranteed death benefit that’s paid out to your beneficiaries when you pass away. Premiums usually remain level even as you age and the policy accumulates cash value over time.

You can borrow against that cash value if needed or use it to cover the premiums for your policy. Any outstanding loans remaining when you pass away are deducted from the death benefit that’s paid to the policy beneficiaries.

Indexed Universal Life Insurance, Explained

Indexed universal life insurance is also permanent life insurance coverage. Similar to whole life insurance, IUL insurance policies can accumulate cash value over time. You can take out loans against the cash value or leave it in the policy to grow.

The biggest difference between whole life and IUL is how cash value accumulates. With a whole life insurance policy, the cash value is guaranteed by the insurance company. If you’re using life insurance as an investment, that means the rate of return on your policy is fairly predictable.

Indexed universal life, on the other hand, works differently. The rate of return and the rate at which cash value accumulates in the policy is based on the performance of an underlying stock market index. Stock market indexes track a particular sector or segment of the market. So, for example, your IUL policy may track the movements of the S&P 500 Composite Price Index or the Nasdaq.

While the return potential for an indexed universal life policy can be higher than whole life insurance, returns aren’t unlimited. Insurance companies can impose a cap rate or ceiling on your returns each year. For instance, your policy might have a cap rate of 3% or 4% annually. The insurance company may also offer a minimum guaranteed rate of return.

IUL vs. Whole Life: Which One Is Better?

An insurance agent prepares a proposal for her clientsIndexed universal life insurance and whole life insurance can both help you accumulate cash value while retaining a death benefit. But one may suit you better than another, depending on your financial needs and goals. This is where it helps to understand what each one is designed to do. For instance, you might choose a whole life insurance policy if:

  • You’re interested in guaranteed, stable returns year over year
  • You want reassurance that premium costs won’t increase over time
  • You want a guaranteed death benefit with the option to borrow cash from the policy if needed

Whole life insurance is more expensive than term life insurance, but it can be less expensive than indexed universal life insurance. Guaranteed returns also make it the less risky option of the two, which may appeal to you if you’re looking for a more conservative addition to your financial plan.

On the other hand, there are some benefits to choosing an IUL policy over whole life. For example, you may consider an indexed universal life policy if:

  • You’re interested in earning higher returns
  • You need or want flexible premiums
  • You’re looking for a way to supplement retirement income

Indexed universal life insurance carries more risk since your returns hinge on how well the policy’s underlying index performs. It’s possible that you could even lose money but those losses may be limited if your insurance company offers a guaranteed minimum rate of return.

You also have more leeway with IUL insurance premiums compared to whole life insurance premiums. For example, you may be able to adjust your premium amount or temporarily suspend making premium payments and allow them to be covered by the policy’s cash value.

With both types of policies, the cash value can grow on a tax-deferred basis. You wouldn’t owe capital gains tax on earnings unless you were to surrender the policy. And any death benefits passed on to your policy beneficiaries would be tax-free.

How to Choose a Life Insurance Policy

Life insurance is something most people need to have and there are several questions to consider when choosing a policy. Specifically, ask yourself:

  • How long you need coverage to remain in place
  • What amount of coverage is appropriate for your financial situation
  • How much you’re comfortable paying toward premium costs
  • Whether you’re interested in accruing cash value
  • What degree of risk you’re comfortable taking

These questions can help you determine whether term life or a permanent life insurance policy is the better fit. And if you opt for permanent life insurance, they can also help you decide between IUL vs. whole life insurance.

Don’t forget that there’s also a third permanent life insurance option available: variable universal life insurance. With variable universal life insurance, you’re investing the cash value portion of the policy directly into mutual funds or other securities, rather than tracking a stock market index. This type of policy can offer the highest return potential but it can also carry the most risk.

Talking to an insurance agent or broker can help you decide whether IUL vs. whole life insurance or another type of life insurance, makes the most sense. You may also want to talk to your financial advisor about how to use life insurance effectively when crafting your estate plan.

The Bottom Line

Life insurance documentsIndexed universal life insurance essentially combines an investment tool with a life insurance policy. You might find that attractive if you’ve exhausted your 401(k) contributions or IRA contributions for the year but still have money to invest. On the other hand, you might lean toward whole life insurance if you want a guaranteed death benefit with lifetime coverage.

Tips for Estate Planning

  • Using an online life insurance calculator can help you determine how much life insurance you need. Generally, financial experts often recommend having anywhere from 10 to 15 times your annual income in coverage but the specifics of your situation may dictate having a larger or smaller death benefit.
  • Talk with your financial advisor about the best type of life insurance for your needs and how much coverage to get. If you don’t have a financial advisor yet, finding doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area in minutes. If you’re ready, get started now.

Photo credit: ©iStock.com/AleksandarGeorgiev, ©iStock.com/PeopleImages, ©iStock.com/designer491

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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