What Is Indexed Universal Life Insurance? How Does It Work?

A young couple looks over life insurance paperwork at the kitchen table.

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Editor’s note: This is part one of a two-part series about indexed universal life insurance and how it can be used in retirement planning. Part one explains indexed universal life (IUL) policies and how they work. Part two, Retirement Planning With Life Insurance, explores three ways an IUL could be used to generate retirement income.

Life insurance is often put into two groups. You’ve got term life insurance, which has no cash value unless you pass. Or you’ve got whole life insurance, which has a cash value, but you’ve got to keep paying those premiums for life. There’s another type of life insurance that you can consider that offers funding flexibility and a cash-value component — universal life insurance.

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There are three types of polices within the universal life category: variable universal life, fixed universal life and indexed universal life (IUL). In this article, we'll explore how IUL works so that you can determine if it is right for you.

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Please note that these are extremely complex products that should be set up and guided by a trusted financial professional. Your current health may have a major impact on the policy and its associated fees, which will influence whether it makes sense for you to fund it. Please proceed with caution when considering an IUL, or any investment product, for that matter. There is no such thing as a perfect investment.

First, an explainer about indexed universal life insurance (IUL)

IUL is a type of permanent life insurance that provides a death benefit to your beneficiaries. It offers a cash-value component that can grow over time. You typically want to fund an IUL policy over a series of years, typically five to 10, rather than all at once, to maintain its tax-free status. Unlike many insurance policies that require you to keep paying premiums so the policies do not lapse, an IUL allows you to have the flexibility to adjust or even stop paying premiums if your policy’s cash value is sufficient to support the policy costs.

An IUL can grow the cash value by crediting interest to the policy based on the performance of an external market index like the S&P 500. The cash-value growth that is based on the underlying index is subject to caps, floors and participation rates. Please note that the policy is never actually invested in the market or index itself and that it doesn’t lose money due to negative market performance.

However, the policy will deduct fees and any interest from policy loans each year. Especially during years in which no interest is credited, this will reduce your policy’s cash value. You may be able to minimize some costs in the policy by adjusting different parts of the policy.

For example, after you have funded the policy over several years, you may decide to lower the death benefit, assuming you do not need as much coverage, which should help lower some of the internal insurance costs and hopefully help the cash value of the policy increase over time.

Understanding IUL loans

What’s interesting about an IUL is that the policy’s cash value may grow based on the gross amount even if you take out a loan. Let’s say your policy has a cash value of $100,000, and you pull out $15,000 as a loan. The policy still has a gross amount of $100,0000 because the $15,000 is a loan against the policy, allowing the $15,000 to be tax-free. Now, let’s say that after a year, the policy earns a 10% interest credit. The policy's cash value would grow by $10,000, not $8,500, because the interest is based on the gross amount of $100,000 despite the loan.

As I’ve said before, though, there’s no such thing as a perfect investment. The $15,000 that was borrowed against the policy will be assessed loan interest. For the sake of example, let’s say that the loan interest is around 3%. If the policy earns an interest credit that’s more than 3%, that’s called positive arbitrage, because you are making more money than you are paying in loan interest.

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Think of the landlord who charges their renters more than the cost of the monthly mortgage. This is positive arbitrage for a real estate investor. As long as the landlord can keep renters in the house, there may be less reason to pay the mortgage off quickly. Over time, the renters will help do this with their rent payments. When it comes to an IUL, as long as the underlying index allows for more interest credits that are higher than the interest rate on a loan, you could still come out ahead.

However, it is crucial to understand that the loan payment will need to be made regardless of the underlying index performance. Let’s say markets are down and the policy receives 0% interest. That means you’d still have to pay whatever the loan is. In the example above, that would be 3% of the $15,000 (3% x $15,000 = $450). This is one of the risks you take when utilizing an IUL in a retirement plan for income. If the underlying index doesn’t perform consistently, the poor performance in the underlying index could slowly eat away at the policy’s cash values with fees and possible loan payments.

Please note that IULs are typically complicated and nuanced financial products that must be set up correctly. Once set up, they must be managed, or at least monitored, annually.

Now that we’ve covered the basics of how IULs work, you're ready for part two of this series, Retirement Planning With Life Insurance, which discusses three potential ways people might use them within their retirement plans. The first strategy demonstrates how you might use an IUL as a tax-free source of income with the intention of keeping your overall tax liabilities low. The second strategy is a way to convert pre-tax dollars into tax-free dollars. The third strategy can help alleviate tax liabilities from pensions and other pre-tax income streams.

Closing thoughts

Life insurance is often thought of as an estate planning tool or a just-in-case part of a financial plan. When structured and funded correctly, indexed universal life insurance policies can offer many more benefits.

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Before you decide to purchase a policy, make sure you spend time learning about the risks and detriments of IULs. Remember, there’s no such thing as a perfect investment. If you want to explore using an IUL, consider finding a financial adviser who works with a CPA or enrolled agent who can help you discover how an IUL could be utilized to help support your unique financial goals.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Mike Decker, NSSA®, is the founder of Kedrec Wealth, a flat-fee financial planning firm that offers one-time services or ongoing management for a fixed monthly fee. He is also the creator of Cash Flow and Capital, an app designed to help people develop a healthier relationship with money by improving awareness around spending and decision-making. Mike is the author of How to Retire on Time, How to Prepare to Retire on Time (coming soon) and The Bear Market Protocol (also coming soon). He shares practical retirement and wealth-building strategies through his podcast, weekly newsletter and two YouTube channels.