Indexed universal life (IUL) is a permanent life insurance policy with pros and cons based on your unique financial situation and goals. This type of coverage provides both a death benefit and a cash value component, allowing for potential growth linked to a market index. While it offers downside protection to help ensure you don’t lose money when the stock market falls, it isn’t a set-it-and-forget-it plan.
Success with an IUL depends on balancing market growth with internal fees and actively managing the policy to avoid a lapse, which occurs when the policy's costs exceed the available cash value, effectively canceling coverage.
How Your Money Can Grow with An IUL Policy
If you’re considering an IUL policy, there are several ways this permanent life insurance coverage can support your long-term financial strategy. Because it’s designed to last your entire lifetime, it serves as a foundational piece of a comprehensive estate plan.
A Policy Floor Acts As a Safety Net
One of the most attractive features of an IUL is the "floor." Even if the market index your policy tracks (like the S&P 500) takes a significant dip, your account is protected. Most policies have a floor of 0%, meaning that while you might not gain anything in a down year, you won't lose your principal due to market volatility.
Caps, Participation, and Spreads
To provide that safety net, insurance companies have "rules of the game" for how interest is credited. It’s important to understand these three mechanics:
Caps: This is the maximum amount of interest you can earn in a period. If the market gains 15% but your cap is 10%, your growth is limited to 10%.
Participation: This is the percentage of the market's gain you actually receive. If the market goes up 10% and your participation rate is 80%, you’ll see an 8% gain.
Spreads: Think of this as an entry fee. The company may subtract a specific percentage (the spread) from the index's gain before adding the remaining interest to your account.
IUL and Your Social Security
The cash value you accumulate within an IUL doesn't count toward the earnings threshold for your Social Security benefits. This is a significant advantage for high-income earners; you can take a loan against your policy’s cash value to supplement your retirement lifestyle without compromising your monthly Social Security checks.
Hidden or Complex Challenges of IULs
While an IUL can be a powerful tool, it’s a sophisticated financial product that carries certain risks and costs that are important to be aware of.
The Rising Cost of Insurance (COI)
As we get older, the insurance portion of any universal life insurance policy naturally becomes more expensive. You need to ensure your account grows enough to cover these rising costs so the policy stays active. If the market sees several "0% years" in a row, the cost of insurance (COI) can start to eat into your accumulated savings.
The Risk of a Policy Lapse
If the cash value hits zero due to poor market performance or high internal costs, the policy could lapse. A lapse doesn't just mean you lose the death benefit—it can also trigger a tax surprise if you have outstanding loans against the policy.
Managing the Fees Bucket
In addition to the COI, there are monthly administrative fees and expense charges related to the indexing strategy. These are typically deducted before interest is added. It’s also important to understand surrender charges, which are fees applied if you cancel the policy or withdraw too much money within the first several years (often the first 10 to 15 years).
Using Your IUL Policy While You’re Alive
Beyond the death benefit, the primary appeal of an IUL for estate planning is its liquidity. This type of coverage allows for the strategic build-up of equity within the policy, similar to the equity found in real estate. As premiums are paid and the market index performs well, the policy builds a cash reserve that can serve as a versatile financial asset. Because these plans are designed for long-term growth, this cash can be leveraged during your lifetime—providing a private source of capital without the need to liquidate other market-sensitive investments.
Borrowing Money Without The Tax Bills
One of the primary reasons to choose an IUL is for these living benefits. You can take a loan from the insurance company using the cash value as collateral. Since the IRS views this as a loan rather than a withdrawal, it’s usually tax-free. This provides access to liquidity for estate needs, business opportunities, or even a child's education without selling off other assets or triggering a capital gains tax event.
The MEC Rule: A Speed Limit
While it is possible to put significant capital into an IUL, the IRS has a speed limit known as Section 7702. Funding the policy too quickly can cause it to be treated as a modified endowment contract (MEC). If a policy is classified as an MEC, it loses its tax-favored status on loans, and withdrawals could be subject to taxes and penalties. Our seasoned, licensed agents help monitor these limits to protect these tax advantages and ensure the policy remains a high-performance wealth tool.
Comparing IUL to Other Choices
When evaluating how best to protect a family's future and preserve a legacy, it is helpful to weigh the features of an IUL against those of more traditional options. While an IUL offers flexibility and the potential for significant accumulation, other policies may prioritize simplicity or an ironclad guarantee.
IUL vs. Return of Premium (ROP)
A Return of Premium (ROP) policy is essentially a money-back guarantee on a basic term policy. If you outlive the term, the insurance company refunds the premiums you paid. It is a straightforward way to ensure that insurance costs are recouped if the death benefit is never needed.
In contrast, an IUL is a more complex, permanent tool meant to build wealth over time. While an ROP policy provides a simple exit strategy, an IUL provides a growing pool of capital that can support estate planning and tax-advantaged income for decades.
Is an IUL Right for You?
Selecting the right policy involves careful consideration of long-term goals and the level of involvement preferred in managing the plan. An IUL may be a suitable fit for those seeking a plan that can adapt to life's changes while offering the potential for cash value accumulation. Consider these questions:
Do you need lifelong coverage rather than a temporary term?
Do you want to grow money for retirement or estate liquidity on a tax-deferred basis?
Can you handle a few years of 0% growth if the market index is flat?
Can you afford to pay higher premiums or manage the policy actively if market performance does not cover the rising cost of insurance?
Ultimately, the best choice depends on whether you value the predictability of a guaranteed return or the flexibility to grow your wealth alongside the market. By weighing these factors, you can select a policy that serves as a reliable anchor for your financial legacy.
Let SelectQuote Help You Protect Your Legacy
If you’re wondering whether indexed universal life insurance is the right fit for your estate plan, we’re here to help. In just minutes, we can search a variety of IUL policies from different trusted carriers and compare the results for you. With over 40 years of experience, we’re equipped to help you navigate these complexities and find the right fit for your family’s future.
This content is for informational and educational purposes only and does not constitute professional financial, investment, or legal advice. While we strive for accuracy (see our Editorial Standards), financial markets and laws change frequently. We recommend consulting with a qualified financial professional or attorney before making any major decisions.
