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Indexed Universal Life Insurance: How Does It Work?

Learn how indexed universal life insurance policies can grow the cash value of your policy and find out whether it's the right choice for you and your family.

People generally build assets over time with the goal to one day retire.

In the beginning, people don’t often start with much. Instead, it takes decades to accumulate wealth.

If you passed away today, chances are you’d want your loved ones to be supported financially.

Some people want them to be able to get back on their feet and have time to grieve. Others may want their spouse to never have to work.

Life insurance can help provide you with the money necessary for these goals if you pass away early in life before you’ve built up assets.

Several types of life insurance policies exist, but one is often more confusing than others.

This is indexed universal life insurance.

Here’s what you need to know so you can understand this complex financial product.

What Is Indexed Universal Life Insurance (IUL)?

Indexed universal life insurance, which goes by IUL for short, is a type of permanent life insurance.

Permanent life insurance lasts your entire life as long as you keep paying premiums.

It doesn’t end at a set date as term life insurance does.

It also builds cash value, an amount of money you can access while you’re still alive.

What makes index universal life insurance unique is how the cash value grows.

How does it work?

As with all life insurance, you pay monthly or yearly premiums.

In exchange for those premiums, your beneficiaries will receive a death benefit when you die.

That death benefit payment is usually income tax-free to the beneficiaries, but certain circumstances may require paying some taxes.

As you make payments, some of those payments will go toward your cash value.

This is a pool of money you can access while you’re still alive for whatever you need it for.

As long as you stay current and your cash value remains positive, your policy should remain in effect.

How cash value grows

Indexed universal life insurance is unique in the way the cash value grows.

Rather than increase at a fixed rate, the cash value grows based on the performance of one of many market indexes.

Your policy will specify which index it uses, such as the S&P 500.

This kind of makes it like an investment account, but it’s essential to understand it’s very different.

Here’s how:

The policy generally sets a minimum, or floor rate, at which your policy will increase every year.

This could be 1%. If the index loses 5%, you’d still have your cash value increase by 1%.

This can limit your loss potential.

They also limit your potential gains. They do this through a gains cap, such as 6%.

If the index grows 12%, you’d only get to participate in the 6% gain.

Fees, dividends, interest

The indexed account for cash value can have some other weird factors to limit your account’s growth.

Usually, fees eat up a portion of your earnings.

The fees may change, too. Make sure you understand exactly how the fees work before signing up for the policy.

Insurers usually don’t include dividends in returns, either. This limits your gains.

Finally, the insurer may only add interest to your account in specific time increments.

The interest is based on the performance over that period. That said, this could limit your returns if an insurance company selects an increment that usually benefits them.

These policies also offer some other interesting benefits.

Change the death benefit amount

You may be able to change the amount of the death benefit as your needs change.

Most notably, you can decrease it based on what the policy states as your life insurance needs decrease.

This can happen as you build other assets and don’t need to rely on life insurance as much.

You may be able to increase the death benefit, too.

In most cases, you would have to submit to a medical exam again to prove you’re healthy enough to increase the death benefit.

Flexible premium payment options

Because you build cash value, that can give you some flexibility with your premium payments.

You may be able to use some of your cash value to cover premiums when you need it.

Of course, this would deplete that part of your cash value.

Pros

This product has some benefits to consider.

Forced savings

People who have trouble saving on their own may like the forced savings aspect of this type of policy.

Part of the premium payments help build cash value. You can access that cash value in the future.

Can earn higher returns

The cash value could grow faster than a standard whole life policy.

This is due to the index tracking features.

Of course, this assumes the index performs well.

Downside may be limited

These life insurance policies usually limit the minimum amount your cash value will grow this year.

If the index has a bad year, you know the downside risk is limited.

Policy doesn’t end

This policy won’t expire like a term life insurance policy.

As long as you keep everything as needed and make payments, it lasts until you die.

Cons

Indexed universal life insurance has some very significant downsides.

It’s complex

This type of life insurance is insanely complex. So many variables can be changed when writing up a policy.

Even if you read through the policy, you may not understand the implications of the rules.

Life insurance companies can use this to boost their profits and limit your returns.

It’s expensive

This type of life insurance is expensive.

You have to pay fees. Gains are limited. You generally don’t get dividends from the index.

When you consider all of these factors, this product often looks unattractive.

You could purchase a simple term life insurance policy and invest yourself if you’re willing to take the investment risk.

Why Someone Might Want This Product

In general, indexed universal life insurance doesn’t make sense for most people.

It could make sense for the wealthy to buy a policy to help cover an anticipated estate tax bill.

It could also work for risk-averse individuals who know they wouldn’t invest for their future on their own.

When Indexed Universal Life Insurance Doesn’t Make Sense

Most people won’t find the cost and complexity of indexed universal life insurance to benefit them.

It lasts your entire life, but most people only need insurance for a couple of decades while building an investment portfolio.

It’s also costly.

You may be better off purchasing a term life insurance policy and investing on your own.

After all, life insurance companies sell indexed universal life insurance and pay hefty commissions to salespeople because they make money on it.

Other Life Insurance Products to Consider

Plenty of other life insurance products may better fit your needs if indexed universal life insurance isn’t a good fit.

Term life insurance

Term life insurance is often a good fit for many families.

It is almost always the cheapest version of life insurance available, too.

Term life insurance won’t last your whole life, though. Instead, it lasts for a set period called the term.

The term may be 10, 20, 30 or some other number of years.

This makes sense because most people don’t need life insurance their entire life. They only need it until they can build sufficient assets or their dependents grow up.

This type of policy doesn’t build a cash value, either.

Because of these factors, it is much cheaper than permanent life insurance.

You could invest the difference between an indexed universal life insurance premium and a term life insurance premium.

Some people may use mutual funds to do this over the long term.

If you do, your investment funds may end up with a hefty amount of money at the end of the term.

Whole life insurance

Whole life insurance is the most vanilla type of permanent life insurance.

It may be a more simple alternative than indexed universal life insurance for people that don’t like complexity.

As a permanent life insurance policy, whole life insurance has a cash value component. The policy will last your entire life as long as you continue making premium payments and the cash value remains positive.

The cash value grows at a set rate as determined in the insurance policy.

This gives you more certainty. It doesn’t give you the opportunity for more significant gains, though.

Consult an Expert

Purchasing a life insurance policy is a serious decision.

You could ask for help from a life insurance agent. They work on commission, though. Life insurance agents deserve to get paid. The problem is the type of product they sell you influences their commission.

The higher the cost of insurance is, the more they get paid by the life insurance company.

This means permanent life insurance policies pay more than term life insurance policies.

If a salesperson needs money or wants more money, they push more expensive products. This can happen even if the products aren’t necessary or the best fit for you.

Instead of consulting a salesperson first, you could consult a fee-only fiduciary financial advisor.

These advisors don’t take commissions. You do have to pay them for their time, though.

As a fiduciary, they must give you advice that is in your best interests. This is not something life insurance salespeople have to do.

It’s up to you who you consult.

Paying a fee-only fiduciary financial advisor may give you peace of mind you’re getting the best advice, though.

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