Life insurance policies are an affordable way to provide financial assistance to your loved ones after you pass away. In addition, they’re relatively easy to understand: You pay a monthly or annual premium, and in exchange, the insurance company pays a benefit to your family after your death.
There are quite a few types of life insurance policies in Texas, and each can be customized to fit your individual needs. The type of policy we’re going to examine today is Indexed Universal Life or IUL for short.
What Is Indexed Universal Life Insurance?
Indexed universal life insurance policies are a type of permanent life insurance. “Permanent life” means they extend their coverage for as long as you live, or until age 100. These are quite different than term life insurance policies, which only last for a specified period of time.
An indexed universal life policy uses a portion of the premium to purchase annually renewable term life insurance, and the rest is added to the policy’s cash value. Then, on either a monthly or yearly basis, the cash value is credited with interest based on increases in an equity index. These can be very valuable policies for most people, but we’ll need to understand more about how they work before determining if they will work for you.
How Does Indexed Universal Life Insurance Work?
There are two kinds of permanent life insurance: whole life and universal life. We’re going to talk mostly about universal life insurance today, but we mention whole life so that you understand their differences. Basically, whole life policies have consistent premiums and guaranteed cash value accumulation, while universal life policies have flexible premiums and death benefits.
Let’s take a moment to define what a universal life policy is before we dive deeper into the indexed version.
Universal life (UL) insurance has an investment savings component (the cash value) and lower premiums like those of a term life policy. Many UL policies offer flexible premiums, but some require a single lump-sum premium or multiple fixed premiums. Most of the time, the death benefit can be adjusted.
Universal life insurance policies also have another component called the cost of insurance or COI. The COI is the minimum premium required to keep a policy in effect. Administration fees, charges for mortality, and other associated expenses are all included in the cost of insurance. Your COI will vary based on your age, insurability, and insured risk. It will also increase as you age.
Any premium you pay that is over the COI will accumulate within the cash value component of the policy. In a universal life insurance policy, the cash value will earn interest based on the current market or the minimum interest rate, whichever amount is greater. As their cash value accumulates, the policyowner can access a portion of it without impacting the guaranteed death benefit. Withdrawals from the cash value are taxed as normal income.
Policyowners can also borrow against the accumulated cash value without having any tax implications. However, interest will be calculated on the loan, and you’ll incur a cash surrender fee. Any unpaid loans will reduce the death benefit by whatever amount is outstanding. Unpaid interest will also be deducted from the cash value.
Now, let’s talk more specifically about indexed universal life insurance.
You’ll often hear an indexed universal life policy pitched as a cash value insurance policy that benefits from the stock market’s gains tax-free, with no risk of loss during a drop in the market.
The cash value component of your IUL will earn interest based on the performance of one of the stock market indexes. For example, many IULs are linked to the S&P 500. This index tracks the market value of the largest 500 companies in the U.S. As that index increases or decreases, so does your policy’s cash value.
The insurance company holding the IUL can offer a minimum guaranteed rate of return, but they may also include a rate cap on return.
IULs are riskier than fixed universal policies, which always have a guaranteed return rate, but they are less risky than variable universal life policies, which invest your money in mutual funds and other securities.
Common Riders for Indexed Universal Life Insurance Products
A rider is a provision that can be added to an insurance policy that either provides extra benefits or amends the policy’s terms. They offer policyowners additional coverage options and allow them to customize the policy to fit their needs. Most riders include an additional cost that will be added to the premium. You might hear them referred to as insurance endorsements.
There are many different riders, but we’re going to discuss the ones most often found in an indexed universal life insurance policy.
Long-Term Care Rider
Long-term care expenses are worrisome for all older adults. For those with an IUL, a long-term care rider is a great way to assuage this worry. If the policyowner gets admitted to an LTC facility, they can access the policy’s death benefit. Once the owner passes away, their beneficiaries will receive whatever amount is left in the death benefit.
Waiver of Premium Riders
The waiver of premium rider is not available in every state, and it is usually only available when the policy begins. Under this rider, if the insured becomes critically ill or disabled, they are relieved of paying premiums. Most of the time, there are age limitations and certain health requirements that must be met in order for this waiver to be granted.
Pros and Cons of Indexed Universal Life Insurance
As with any type of life insurance, there are some pros and cons to IULs. You should do thorough research on both the type of policy you want and the insurance company with whom you’re investing. Make sure the policy is in line with your financial goals.
Let’s review some of the pros and cons of indexed universal life insurance plans.
Pros of IULs
Higher Growth Potential
An IUL has the benefit of leveraging call options, the option to buy stocks, bonds, commodities, or other assets. The underlying asset, an index, in this case, will add to the policy’s cash value when the market is up. This is different than a whole life policy, which has a lower, fixed rate. Of course, higher rates are not guaranteed, but there is certainly more potential for growth. Typically, the insurance carrier still offers a guaranteed minimum interest rate, which will protect policyholders in a market downturn.
Indexed universal life policies offer flexibility when building the plan. Owners can choose how much risk to take, adjust their premiums and death benefits, and add riders to further customize their policy.
Tax-Free Capital Gains
You will not pay capital gains taxes on any increase in the cash value unless you terminate the policy before it matures. Other types of accounts usually incur capital gains taxes upon withdrawal. This benefit also extends to any policy loans. Having a cash source is beneficial to those who want to avoid taxes and penalties that are triggered when taking an early withdrawal from an IRA or 401(k).
No Impact on Social Security
Social Security benefits are often an important source of income during retirement. You can start receiving Social Security at age 62 or wait until age 70. If you decide to take the benefits prior to age 70, your benefit amount will be smaller. In addition, if you continue working while getting benefits, the amount can also be reduced.
One way to increase your cash flow is by using the cash value of your IUL. This is not counted towards your earning threshold, so it will not reduce your Social Security benefits.
The main goal of all life insurance policies is to provide financial support for your heirs. The death benefit will be given to your beneficiaries tax-free and can be used however they want – funeral expenses, outstanding debts, mortgages, college loans, or simply for everyday living.
Cons of IULs
Bad Market Timing (Maybe)
This isn’t always the case with every IUL, but it is possible that the indexed feature of an IUL could put you at a disadvantage. If the policy is established when the market is performing poorly for a period of time, you could wind up paying higher premiums that don’t go towards the cash value.
A common feature of IUL policies is a return cap. The insurance company will set a maximum participation rate. Some are nearly 100%, but they can be as low as 25%. You’ll also be capped on how much you can earn in a given period of time.
You might be able to earn more by investing directly in the market or choosing a variable life insurance policy. However, keep in mind that unlike an indexed universal policy, there are no guaranteed minimums on those options.
Since returns are based on an index, your cash value can vary over time, and your premiums may fluctuate. You’ll need to get comfortable with market fluctuations and budget for the possibility of increased monthly premiums.
Fees / Cost of Insurance
All insurance policies have fees, so this is not unique to IULs. The cost of insurance is included in your premium and helps pay for things like administrative fees, premium expense charges, commissions, surrender charges, and any riders you added to the policy.
If you’re considering a life insurance policy, you’ve got a lot of options and it can feel overwhelming. The good news is, it doesn’t have to be. Our licensed insurance agents know the ins and outs of all life insurance policies and can help you choose one that would work well for you and your family. Call CoverMile today to schedule an appointment with one of our advisors.