Permanent life insurance offers more than a death benefit for your beneficiaries -- you'll also build cash value you can withdraw and borrow against. 

Your life insurance policy's cash value will increase each time you make a premium payment, hopefully growing into a nice lump sum over time. An indexed universal life insurance policy allows you to earn more than nominal interest on your balance. 

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But is indexed universal life insurance the right coverage for you? Take an in-depth look at how index universal life insurance works.

How does indexed universal life insurance work?

When you buy indexed universal life insurance, your premium mainly goes to two things: funding the death benefit and the policy's cash value. (A small amount of your premium also pays policy fees.)

The growing cash value amount sits there, similar to the balance in a savings account. If you know a little about investing, you know that earning less than 1% interest on your savings isn't ideal. You probably won't even beat inflation at that rate. 

An indexed universal life insurance policy invests the cash value into an index fund with the goal of earning higher returns than current interest rates.

An index fund invests in the top performers of the index. The best-known indexes are the S&P 500 or Nasdaq. They're home to the biggest, most successful companies, including Apple, Coca-Cola, Facebook, Google and Amazon.

Your risk is spread out because your money is invested across hundreds of companies instead of one. And historically, investing in an index fund brings you the steadiest returns over time. Take a look at the S&P 500 index total return in the last few years:

  • 2020 -- 16.88%
  • 2019 -- 31.49%
  • 2018 -- -4.38%
  • 2017 -- 21.83%
  • 2016 -- 11.96%

Based on these returns, investing in an index fund beats any CD or money market rate. Your life insurance's cash value account will grow at a better rate nearly every year when compared to earning simple interest.

There's a caveat -- insurance companies cap your earnings. If the index had a good year, say 20% returns, you may only earn a maximum of 15% and the insurance company keeps the rest. 

On the other hand, you'll have a floor on the policy. Even if the stock market is having a bad year, you won't lose your cash value. Indexed universal life insurance may be a better way to grow your cash value than other permanent life insurance types. 

Whole life vs. indexed universal life insurance

When comparing whole life vs. indexed universal life insurance, you have more flexibility with indexed universal life insurance. 

Whole life insurance is predictable, making it ideal if you have low risk tolerance. You know exactly how much your insurance premiums are for life. You also earn a set interest rate. 

Ed Frye of Cover America said a whole life insurance policy's annual rate of return is between 1.5% and 3.5%

In comparison, an indexed universal life insurance policy’s rate of return can vary, based on the stock market. Most insurers will limit your returns and losses, using a minimum floor (typically 0%) and maximum cap amount (typically 15%) to reduce volatility. And unlike whole life insurance, your premiums are more flexible -- you can change your payment amount and frequency. Once you build enough cash value, you could even use part of the balance to pay your premiums.

Indexed universal life insurance pros and cons

When evaluating what type of life insurance is the best option for your needs, consider the following indexed universal life insurance pros and cons:

Pros

  • Guaranteed coverage for life
  • You can adjust the premium frequency and amount.
  • Change the death benefit as you need without losing coverage
  • You can withdraw or borrow against your cash value
  • You have the potential to earn higher returns on your cash balance
  • A floor of at least 0% protects your investment against loss
  • Tax-deferred growth

Cons

  • Increasing the death benefit may trigger a new medical exam
  • Cash balance returns may fluctuate depending on the stock market
  • Your growth potential is capped
  • Overdrawing the cash balance can decrease the death benefit amount
  • The insurance company keeps the cash value after you die

Is indexed universal life insurance a good investment?

Indexed universal life insurance is a good investment if you've maxed out your retirement accounts and exhausted all your other investment options. You won't earn the full amount if an index is performing well. In addition, indexed universal life insurance comes with relatively high fees, eating up a portion of the money you contribute.

Above everything, it's important to be strategic about how much money you intend to keep in the cash value account. Once you die, the balance will not go to your beneficiaries -- the insurance company will keep it. And if you borrowed funds and didn't pay them back before you passed, the outstanding amount is deducted from the death benefit. 

Therefore, holding a large amount of money in your cash value account isn't the best investment.

Is indexed universal life insurance good for retirement?

The most common ways of structuring indexed universal life insurance is for retirement and executive bonus plans, according to Frye. 

"Unlike a 401(k) or other qualified plan that is funded with pre-tax money, IULs are funded with post-tax money allowing the insured to take tax-free withdrawals from the policy," he says.

You won't have to follow a traditional retirement path, either. Unlike retirement accounts, which prevent you from withdrawing until you're at least 59 1/2, you can access the funds at any age, which could be useful for individuals on the FIRE (Financial Independence, Retire Early) track. 

Plus, Frye says you don't have any minimum required distributions (RMD) "since the IRS doesn't consider life insurance as an investment."