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SmartAsset: Indexed Universal Life (IUL)

In exchange for paying premiums, life insurance provides beneficiaries with a large payment upon the insured’s death. It’s a way to protect your family after you pass, especially if that happens when they still depend on you financially. But there are many varieties of life insurance, including indexed universal life (IUL) insurance. This allows the cash value of your policy to grow when certain stock market indexes are doing well, while protecting you from losses.

Choosing the right insurance policy takes some planning. Find a local financial advisor today.

Explaining Indexed Universal Life (IUL) Insurance

Indexed universal life insurance, or IUL, is a type of universal life insurance. Rather than the cash value portion growing on a fixed interest rate, it’s tied to the performance of a market index, like the S&P 500.

Unlike investing directly in an index fund, however, you won’t lose money when the market has a downturn. This is because a guarantee applies to your principal, insuring it against losses. On the other hand, there’s usually a cap on the maximum return you can earn. Many times, you’ll also be able to divide your assets between fixed and indexed portions of your policy.

To better understand IUL, it helps to have a grip on the main types of life insurance. Broadly speaking, the two main versions are term life insurance and permanent insurance. Within the latter category, there are many varieties, the most common of which are whole life and universal life insurance.

  • Whole life insurance: This is a permanent policy, which means that there’s no time limit on when your family can receive a benefit. Furthermore, some of the premiums you pay go toward funding a cash account. Once enough money inhabits that account, it will fund your eventual payout. However, you can also borrow against or withdraw from the cash while you’re still alive.
  • Universal life insurance: Also a permanent policy, it comes complete with a cash-value account. They’re mainly differentiated by their flexibility, allowing you to adjust your premiums and death benefits. You may also be able to realize higher interest rates on the growth of the cash value, and use that cash value to pay for premiums.
  • Term life insurance: This type of insurance covers a specific time frame which typically ranges from 10 to 30 years. It’s a temporary type of coverage since it covers you for a certain amount of years. If you die within the covered period, your family gets a death benefit, which it can use to cover funeral expenses and replace your lost income. It’s usually less expensive than other insurance options.

The table below displays how one IUL policy works given four different changes in the selected market index. Various IUL policies have a variety of index caps and index floors.

How Indexed Universal Life Insurance Works
Change in index Index cap Index floor Change in cash value
9% 8% 0% 8%
2.5% 8% 0% 2.5%
-11% 8% 0% 0%
-3 8% 0% 0%

What Are the Benefits of IUL Insurance?

SmartAsset: Indexed Universal Life (IUL)

One of the most attractive features of an IUL is the ability to take advantage of stock market returns without the risk of loss. And it does so while building up a death benefit that your beneficiaries will receive tax-free.

Other benefits of indexed universal life insurance include:

  • Unlimited contributions: Traditional retirement avenues have contribution limits, but IULs don’t.
  • Tax-free growth and distributions: “IUL distributions are tax-free versus tax-deferred in the other vehicles,” says Chris Abrams, an IUL expert at Abrams Insurance Solutions. That means you don’t have to pay taxes on the money you eventually draw from the cash value of the IUL. It’s similar to a Roth IRA in this respect.
  • Use at any time: With regular retirement programs, you have to wait until you hit the 59.5 minimum age for distribution before you can start taking money out. With an IUL, there is no age requirement.
  • Death benefit: A tax-free death benefit is distributed to your beneficiaries, which means it won’t face income or death taxes.
  • Loan availability: Depending on your policy and available cash, you can borrow money from your IUL without facing penalties, taxes or a credit check. You also do not have to pay back the money you take out.

Downsides of IUL Insurance

There are many reasons to buy an IUL insurance policy. Like any financial product or policy, though, there are some drawbacks that might hold you back from investing in an IUL. Critics point to high fees associated with permanent life policies, including sales and administrative fees. By contrast, a retirement account, especially one comprised of low-cost ETFs or mutual funds, will lose significantly less to fees.

Someone seeking both life insurance protection and tax-free retirement distributions might be better off getting a term life policy (which tend to be much cheaper) and opening a Roth IRA, rather than trying to combine the benefits into one product.

Other cons of IUL insurance include:

  • Earnings caps: Most policies have a limit on how much you can earn within the plan. When the market is having a particularly good year, your money will earn less than you would just investing directly. Along with this, there are index caps and maximum participation rates that the insurance company can change.
  • Taxable income: If the policy lapses or is surrendered, the money you’ve taken out may be taxable.

Should You Get Indexed Universal Life Insurance?

SmartAsset: Indexed Universal Life (IUL)

While an IUL policy has some generous upsides, they might not work for everyone. Experts say that if you are an investor in your 20s, buying index funds or saving for retirement in a 401(k) or IRA might be a better fit.

“If someone has no need for life insurance, then another vehicle may be more appropriate for them,” Abrams says. That might mean just saving in a 401(k) or IRA. Of course, those accounts are subject to contribution limits and don’t offer the same principal guarantees. But less of your investment will go towards fees, and you won’t have a cap on returns when the market has a great year.

Abrams adds, too, that IULs aren’t for short-term investors.

“An IUL is a long term vehicle,” he says. “When saving money in an IUL, you shouldn’t plan on taking any income from [it] for at least 10 years or longer.”

Bottom Line:

Life insurance beneficiaries get a large payment on the insured’s death. But some varieties of life insurance like indexed universal life (IUL) insurance will allow the cash value of your policy to grow when certain stock market indexes are doing well and protect you from losses. IULs, however, are not a good fit for everyone. And if you are a young investor, you should consider other options like buying index funds or saving for retirement in a 401(k) or IRA.

Tips to Help You Save for Retirement

  • A financial advisor can help you create a financial plan to set and reach all of your retirement goals. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Life insurance is just one part of a retirement plan. The most important consideration, though, is how much income you’ll need to support yourself in retirement. SmartAsset’s retirement calculator can help project what you’ll need.
  • For some people, the value of their Social Security benefit is enough to cover their costs of living. While others may have to supplement it with other retirement savings. You can estimate your benefit amount with this Social Security calculator.

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Dori Zinn Dori Zinn has been covering personal finance for nearly a decade. Her writing has appeared in Wirecutter, Quartz, Bankrate, Credit Karma, Huffington Post and other publications. She previously worked as a staff writer at Student Loan Hero. Zinn is a past president of the Florida chapter of the Society of Professional Journalists and won the national organization's "Chapter of the Year" award two years in a row while she was head of the chapter. She graduated with a bachelor's degree from Florida Atlantic University and currently lives in South Florida.
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