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Permanent life insurance provides more than just a death benefit to your beneficiaries. With some policies, you also build cash value that can be withdrawn or borrowed against. 

Indexed universal life insurance is one type of permanent life insurance that provides this extra value. It’s a policy that ties earning potential to the market via an equity index.

If you’re unsure if indexed universal life insurance is the right choice, here’s some information to help. However, remember that due to the complex nature of indexed universal life insurance, you should consult with a certified financial planner when purchasing a policy.

Key Takeaways

  • With an indexed universal life insurance policy, you can take advantage of the high returns of investing in index funds.
  • Indexed universal life insurance allows you to adjust your death benefit.
  • While indexed universal life insurance can be a good option for those who want lifelong coverage and are looking to build cash value over time, it also comes with some risks.

How does indexed universal life insurance work?

When you buy indexed universal life insurance, your premium goes toward funding the death benefit and the policy’s cash value. A small portion of your premium also goes toward policy fees. 

An indexed universal life insurance policy invests the cash value into an index fund intending to earn higher returns than current interest rates. Instead of being invested in the market outright, the cash value is usually invested via options contracts that cut down on risk. 

An index fund invests in the top performers of the index. The best-known indexes include the S&P 500 or Nasdaq, which invest in some of the most successful companies, including Apple, Coca-Cola, Facebook, Google and Amazon.

With index funds, 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.

Between 2017 and 2021, the S&P 500 had an average annual return of over 19%, which easily beats any CD, money market rate or savings account. 

However, there is a caveat — insurance companies usually 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, there is also a floor on the policy. You won’t lose your cash value if the stock market is in turmoil. Because it’s linked to index funds, indexed universal life insurance policies see higher rates of return than other types of permanent life insurance, like whole life insurance. 

How to buy indexed universal life insurance

Before you buy indexed universal life insurance, you should consult a certified financial planner or your estate planning attorney. Indexed universal life insurance is very complex and how it fits into your financial plan requires extra planning.

When you’re ready to purchase a policy, shop around and speak to several agents. When talking about the market, remember that growth rates cannot be guaranteed, and there is no way to know if an agent’s market predictions will come true. 

Additionally, ask about the caps and fees imposed by the insurer. This information may not be presented upfront, but these factors can greatly impact your policy’s earning potential. 

When considering indexed universal life insurance, be aware that lower interest rates could affect your results. High fees and smaller premium payments can also negatively affect the death benefit of your plan. As with everything insurance, read the fine print.

Whole life vs. indexed universal life insurance

Whole life insurance and indexed universal life insurance both fall under the permanent life insurance umbrella but are very different. 

Whole life insurance is predictable, making it ideal if you have a low risk tolerance. You know exactly how much you will pay in insurance premiums throughout your life, and the interest rate is set from the beginning of the policy. 

“A whole life insurance policy’s annual rate of return is between 1.5% and 3.5%,” explained Ed Frye, CEO of Final Expense of America.  

On the other hand, an indexed universal life insurance policy’s rate of return varies 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. Unlike whole life insurance, your premiums are more flexible — you can change your payment amount and frequency. Once you build enough cash value, you can use part of the balance to pay your premiums.

What are the benefits of indexed universal life insurance?

If you want to take control and invest in something with potential growth opportunities but you’re also comfortable managing risks, indexed universal life insurance is the 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 approves it.
  • Accessible cash value: If you need cash, you can take it out of the cash value of your indexed universal life insurance policy. You can borrow money against the account or withdraw from the cash value account that you’ve built up.
  • Guaranteed interest rate: Reputable policies come with an interest rate guarantee, which means that if returns on the market are too low, your policy will still receive a minimum amount of interest.
  • Flexible premium payments: If you have money saved in your cash value account, you can use it to pay for all or some of your premiums.

People trying to grow their retirement or executive bonus plans will benefit from indexed universal life insurance the most. 

“Unlike a 401(k) or other qualified plans that are funded with pre-tax money, IULs are funded with post-tax money allowing the insured to take tax-free withdrawals from the policy,” Frye says.

What are the drawbacks of an indexed universal life insurance policy?

While indexed universal life insurance may potentially carry a higher rate of return than other types of policies, there are some inherent risks and other drawbacks to know. 

Some of these drawbacks include:

  • Fluctuating cash balance: As with anything involving the stock market, your policy’s cash balance will fluctuate depending on how the index is doing at any point in time. 
  • Growth caps: Insurance policies often have caps on how much your cash value can earn when the market increases, typically around 15%. This might not be as much as you could earn if you directly invested in the index. 
  • New medical exam: If you increase your policy’s death benefit, you may have to take a new medical exam.
  • The insurance company keeps cash value when you die: You can only use the cash value while you’re alive, and when you die, the insurance company keeps the cash value. Your beneficiaries don’t see any of the cash value proceeds.

Who should get indexed universal life insurance?

Indexed universal life insurance is a good choice for people who want to protect their investments while still taking advantage of higher rates. However, it is not for everyone. People who have maxed out other investments will benefit from indexed universal life insurance the most. 

An insurance agent will help you decide if an indexed universal life insurance policy is right for your individual needs – make sure that indexes are included in any comparison shopping you do.

Is indexed universal life insurance a good investment?

Generally, it is better to focus on your retirement accounts and other investment options than using indexed universal life insurance policy as your main investment strategy. 

However, indexed universal life insurance can be a good investment if you’ve maxed out everything else. Keeping in mind that you won’t earn the full amount if an index is performing well because of policy caps and you’ll have to pay comparatively high fees, only certain people will benefit from the policy.

It’s also worth noting that holding a large amount of money in your cash value account is not a good investment. Be strategic about how much money you intend to keep in the cash value account because 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. 

Frequently asked questions

What happens to my cash value after I die?

If you die, your cash value is usually forfeited to the life insurer, not your beneficiaries. Check your policy, though, because some companies allow you to pass on accrued cash value benefits along with the death benefit to the beneficiaries after you die.

Can I cash out my indexed universal life insurance policy?

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

Why are premiums flexible with indexed universal life insurance?

Individuals with an indexed universal life insurance plan can control risk in their accounts and the death benefit amount. There is also protection from markets going down since most policies offer a death benefit guarantee and guarantees against lapses. This is so you won’t lose any hard-earned dollars if something goes wrong on Wall Street.

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Barry Eitel
Contributing Researcher

 
  

Barry Eitel is a content writer and journalist focused on insurance, small business and finance. He has researched and written about personal finance since 2012, with a special focus on entrepreneurship, freelancing and other small business operations. His writing on insurance and small business has been featured in 7x7, Brit + Co, Intuit Quickbooks, Bankrate, Policygenius and Lendio.