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.

Key Takeaways

  • Permanent life insurance offers two things; death benefit and cash value which you can withdraw and borrow against.
  • With indexed universal life insurance policy, you can take advantage of the high returns that come with investing in index funds.
  • Indexed universal life policy gives you the freedom you make adjustments to your death benefit.
  • It can be a good option for those who want lifelong coverage and are looking to build cash value over time.

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. 

How to buy indexed universal life insurance

Indexed universal life is a type of policy that has many benefits. But the first thing to know about IUL policies before talking with an agent, though, is how they are sold: when you sit down for your discussion with the agent, it's important to understand what illustrations show- these projections on cash value growth rates based on predicted interest rates and fees can be misleading as there really isn't any way of knowing if predictions will come true.

It is important to consider the implications of illustrations which predict future potential outcomes that may not come true. Insurance companies are hyper-focused on their bottom line and will do anything in their power for a quick buck, so they might sell policies with caps or fees without mentioning them upfront--all hidden behind an illustration intended just as a marketing ploy.

Be aware when you consider indexed universal life insurance policy, that lower interest rates could affect your results. Also watch out for higher fees and smaller premium payments as they can have a negative effect on the death benefit of your plan.

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

What are the benefits for indexed universal life insurance?

With Indexed universal life insurance, you get flexibility and higher interest rates as compared to other types of life insurance policies. If you want to take control and invest in something with potential growth opportunities but are also comfortable managing risks, indexed universal life insurance is a right choice for you.

Some of the benefits of indexed universal life insurance are

  • Death Benefit Adjustments: When you invest in an indexed universal life policy, the death benefit is flexible and can be lowered at any time. However, increasing the death benefit may require a medical examination before your insurer approve it.
  • Accessible Cash value: If you need extra cash to cover an emergency situation it may be worth taking out your indexed universal life insurance policy. You can borrow money from the account or get some money by withdrawing funds from the cash value account that's built up over time.
  • Guaranteed Interest rate: As per National Association of Insurance Commissioners (NAIC), policies come with interest rate guarantee, which means that if returns on the market are too low, they still receive a minimum amount.
  • Flexible premium payments:  Your policy offers flexible premium payments and it will likely be predetermined, but if you have money saved in your cash value account, then paying for the premiums won't be an issue at all.

Who might choose indexed universal life insurance?

Life insurance is a great way to protect your family from the financial burden of losing you. Permanent life insurance, specifically, may be an option for those who want lifelong coverage and are looking to build their cash account over time.

Indexed universal life insurance can provide both protection from falling markets and the potential for growth, making it a good choice for people who want to protect their investments while still being able to take advantage of higher rates. An agent will help you decide if this is right for your individual needs- make sure that indexes are included in any comparison shopping you do.

Frequently asked questions about indexed universal life insurance

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."

Can I cash out my indexed universal life policy?

Yes, you may be able to withdraw your cash value from an indexed universal life policy. There are no fees or taxes applied and you can also decide to forfeit coverage altogether in order to take out a loan against that money.

What happens to my cash value after I die?

If you die, your cash value is usually forfeited to the life insurer. However, some permanent life insurance policies allow to pass on the accrued cash-value benefits along with death benefit to the beneficiaries after you die.

Why are premium flexible with indexed universal life insurance?

Individuals with an indexed universal life insurance (IUL) plan control how much they risk in their accounts along with what the death benefit amount will be. There is also protection from markets going down since most policies offer death benefit guarantee and guarantee against lapses - so you won't lose any of those hard-earned dollars if something goes wrong.

What is equity indexed universal life insurance?

Equity-indexed life insurance is a type of permanent life insurance and an investment product for people who enjoy risk and are looking to hedge against inflation. The insured can borrow from the cash value, invest it in a variety of assets or use this as collateral on loans. It has the potential for higher returns on premiums paid than traditional policies because it also includes stock market investments.

This option may be best suited for those already self-investing because managing these investments requires additional time and effort beyond what other types of permanent life insurance policies require which could make them difficult to manage by themselves without outside assistance.