What is Indexed Universal Life Insurance?: The complete guide
First offered in 1997 by Transamerica, Indexed Universal Life Insurance (IUL) has seen tremendous growth over the last 20 years. Today there are around 40 companies that offer indexed universal life insurance and more joining the mix each year.
So what is Indexed universal life?
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IUL offers permanent life insurance protection with the opportunity to earn market like returns inside the policy. Whether you’re considering life insurance for personal or business needs, an Indexed UL policy could be a great solution. IUL is permanent life insurance that offers death benefit protection when death occurs. Like other forms of permanent life insurance, your premium payments may earn interest and grow the cash value of your policy. This cash value can be used to supplement your retirement or even finance practically everything you would normally ask the bank for such as cars, homes, home improvements and even college expenses.
Typically, people have several different kinds of assets working for them simultaneously, from stock portfolios to employer-sponsored 401(k) programs. An indexed universal life insurance policy builds cash value on a tax-deferred basis. In addition, the cash value can normally be accessed tax-free through withdrawals and policy loans which we will discuss shortly.
According to the Life Insurance Marketing and Research Association (LIMRA), this category of life insurance has been continually growing in popularity for several years now. Indexed UL was the fastest-growing product of the individual life insurance market in 2014, where it made up 52% of universal life premiums paid and 20% of all individual life insurance premiums paid. Better known in the life insurance industry, LIMRA is a worldwide research, consulting and professional development organization that helps more than 850 insurance and financial services companies in 73 countries increase their marketing and distribution effectiveness.
Let’s understand that indexed universal life insurance, just like other forms of permanent insurance are commonly used for the following:
- Retirement planning
- College planning
- Mortgage protection
- Pension Maximization
- Annuity maximization
- Legacy building
- Estate planning
- 1035 exchanges
- Buy-sell agreements
- Executive bonus
While we will not discuss each of these areas, we have discussed them in their individual post. They are very important strategies and can be used to create wealth and protect wealth in addition to just being for death benefit protection.
We have found that consumers are not only using indexed universal life insurance for the death benefit but also as a way to grow their investment portfolio.
Since there are several types of IUL policies sold in the marketplace, it is important to look at the entire picture, not just the premium that you will pay into the policy. When structured properly as an accumulation vehicle, you would want to pay the maximum premium possible while keeping the death benefit to a minimum. The difference between IUL and other permanent life insurance policies is the way interest is credited to the policy. In addition to offering a traditionally declared interest rate, IUL also offers the ability to earn interest that is linked to the movement of a selected stock market index over a specific period of time, usually 1 year but some policies offer 2 and 5 year periods.
Even if the index goes down, your credited interest rate will never be negative and that is guaranteed. So your worst case return for a year could be 0%. With IUL, you don’t participate directly in the stock market and the credited interest rate is never less than zero percent, guaranteed.
For example, let’s assume that you choose the S&P 500 annual point to point index allocation with a 15% cap within your policy. The day your premium is paid the S&P index is trading at 2000, we will use January 1. The insurance company will track the S&P index from January 1 through December 31. Whatever the S&P index is trading at on December 31 is the ending value in which your index credit is calculated. If the S&P index is trading below 2000 then the policy will receive 0% interest for that policy year. However, let’s assume that on December 31, the S&P index is trading at 2200. That is a 10% increase in the S&P index and your policy would receive an interest credit of 10%. That sounds great but also keep in mind that there is a feature called annual reset. This makes a great design even better.
Indexed life policies contain annual reset design. Annual reset means that each year’s interest credits are locked in on the Index Crediting Date and a new starting point is determined. The interest credits can’t be taken away due to negative index performance and they will participate in future growth, giving your policy the advantage of compounding interest in future years. In the example above let’s assume that the S&P index is trading at 1800 on December 31. That is a 200 points lower that where we started on January 1. Instead of losing 10% from your account you lose 0% and your new starting value on January 1 is now 1800. This is the beauty of annual reset. You do not have to wait until the S&P value is above 2000 to share in any gains. Now in one year, on December 31 the value of the S&P is measured and interest credits are calculated again.
This protection from loss is a great way to keep peace of mind while also growing your assets. The protection that IUL offers from negative return years is a key benefit to purchasing an IUL policy.
A few items to be aware of are:
- Interest is credited to the policy’s index account value is based on the performance of the index chosen and will never be less than zero percent.
- Premiums are not directly invested in any stocks, bonds, or equity investments.
- Index performance does not include dividends on the stocks that make up each index.
- Premium allocation to an Index Selection does not represent an investment in any index or market.
I mentioned above that the cash value in the policy could be accessed for items such as emergencies, auto loans, mortgages, college expenses and retirement income. You may access your cash value through withdrawals or loans. Withdrawals from your policy are income tax-free as long as you don’t withdraw more than the premiums you paid into the policy. Only the gains would be taxable. This is why we typically use policy loans to access the cash in your iul policy. Loans from your policy are income tax-free.
Withdrawals – when you take a withdrawal from your policy, you will permanently reduce the face amount of your policy. The withdrawal will generally be income-tax free up to the amount of premiums that you have paid into the policy. You may also face surrender charges on the amount that you withdraw.
Loans – On the other hand, taking loans can be a huge advantage to accessing your cash value and they don’t even need to be repaid. Loans are also not taxable. Just like taking a home equity loan against your home – those loans are not taxable. Now there are generally 2 types of loans. Standard and variable loans. The most commonly used loan in an IUL is the variable loan. The variable loan allows you to borrow from the policy at a rate of interest tied to a published monthly average such as Moody’s Corporate Bond Yield Average. Some policies place a rate cap on the interest that can be charged. Your funds continue to earn interest based on the allocations that you have selected or in the fixed account. That means that you win when your loan rate is less than the interest that your policy earns. For example, your loan rate is 4% but the interest that your policy earns is 8%. This keeps your cash working for your even when you have taken a loan against it. The variable loan is not as predictable as a standard loan but based on past performance has a huge advantage when accumulating more cash in your policy.
In contrast, standard loans charge a fixed interest rate set by the company. When a standard loan is used your cash is moved to the fixed interest allocation. Standard loans will typically result in a net zero cost loan because the interest that the fixed account is guaranteeing is also the interest rate that the company is charging for the loan. This is very appealing because it is very predictable. When choosing a company, you should look for one that allows you to switch between variable and fixed loans. We can help you identify the company that is best suited for your situation.
One very important feature in an IUL is the Overloan Protection benefit. Not all companies offer this benefit. Your policy will remain in force when extensive loans have been taken if the overloan protection benefit has been elected. This means that your policy will continue to provide death benefit coverage. If elected, the guarantee provided by this benefit may help you avoid tax consequences of a policy lapse due to excessive loans or withdrawals. This benefit is very useful if you plan to use your policy as an income supplement vehicle.
As an example of the above, let’s assume that you are 40 years old and decide to purchase an indexed universal life insurance policy for supplemental income purposes. You might have a need for one million dollars of life insurance coverage, but purchasing one million of IUL and funding it to the maximum limit may be out of your budget. You may decide to purchase just $250,000 of Indexed UL and for the remaining $750,000 of life insurance you purchase a term life policy. You are getting the entire one million of life insurance you need and also able to purchase the indexed universal life policy.
Let’s take a look at how an indexed UL policy can provide tax-free income.
The Indexed Universal life insurance policy premium is flexible. This means that the insured can increase or decrease the premium to the policy as finances change. They may even stop paying premiums for a while if needed. The more premium that is paid into the policy the better it will perform. The minimum premium for this 40-year-old in a $250,000 policy with one of the top Indexed universal life insurance companies would be around $125 per month and the maximum would be around $850 per month. If this 40-year-old will fund the policy for 25 years to age 65 he would have over $600,000 in cash value that could generate over $65,000 of tax-free yearly income till he reached age 100. This is based on just earning on average 7% per year. The death benefit at age 65 would also have grown to around $850,000. Assume he starts to take the income at age 66 and lived to age 90, he would have received over $1.7 million and the death benefit at that time to his beneficiaries would be a little over $300,000. So for around $250,000 of premiums paid into the policy, the income he received, plus the death benefit that the beneficiaries will receive, is about $2 million dollars. If instead, he chooses to contribute these funds into his 401k the income would run out at age 80. This is a 230% increase in benefits over what the 401k will provide. See the chart below.
This is an example of using indexed universal life insurance for supplemental retirement planning. Many will compare this strategy to using a 401k. In most cases the life insurance benefits will far outweigh the benefits that the 401k provides. Remember that our example is a male age 40 in a 30% tax bracket. This would mean that while we put $13,600 ($1134 per month) into the 401k the net amount that we are showing going into the indexed universal life is $10,200 per year ($850 per month). We are actually putting less money into the indexed universal life insurance policy.
Since all payments into the 401k have never been taxed, every dollar that comes out of the plan is taxed at their current tax rate. Look at the difference below. The dollars spent on the Indexed universal life insurance policy are actually less than what we put into the 401k due to already paying the taxes on the indexed universal life premiums but the benefits are less. This is accomplished by using loans to access the cash value in the policy and allowing your money to continue to grow inside the policy.
The Indexed universal life policies that we have discussed thus far are geared towards cash accumulation and not guarantees. Since we recommend over funding these policies to the maximum limits, the guarantee is not that important. We are creating a huge bucket of cash using very little life insurance death benefit. On the other hand, we do have clients that want that lifetime guarantee regardless of the cost. We have many companies that do offer lifetime guaranteed indexed universal life policies. As a matter of fact, I will discuss the basic features of one of these indexed universal life policies in particular. Most of these policies can be overfunded just like the ones that I have already discussed, but a guaranteed indexed universal life policy also has a minimum premium that if paid will create a policy that will be guaranteed never to lapse until age 120. Now that sounds funny but every day we see people living over the age of 100. These policies still offer the indexing options that can help to grow your cash value for the same needs. These policies also have the same accelerated benefits as the ones discussed. Withdrawals and loans are also available on these policies and may be used any way that you would see fit. So very little about the policies are different, but the cost to provide the lifetime guarantee can cause your policy to underperform compared to the non-guaranteed policies.
We would normally recommend the guaranteed indexed universal life for someone that has death benefit protection as the number one goal. They may be able to secure a cheaper universal life policy that offers the same guarantee but there is usually no cash value growth. Just by paying a little more premium, usually around 10%, they could buy the indexed universal life with the same guarantee. This may give them enough cash surrender value to later be able to surrender the policy for the amount of premium they have in it. Situations change in life and you never know, you may at some point in your life find that you no longer need the policy or do not wish to continue paying premiums. You could refer to this as a return of premium or escape route.
If you’re concerned about the financial security death benefit protection can provide for your family today should something happen to you, and you’re also uneasy about the future and falling short of retirement income, indexed life insurance could be the way to go. With life insurance you gain death benefit protection that will help your family pay the mortgage, utility bills, and other expenses should you die. Now, imagine your retirement. What retirement lifestyle do you imagine? It’s easy to underestimate the cost of your ideal retirement. Indexed universal life insurance can help bridge any gap between what you have already saved and what you will need in the future. If you’re looking to control your financial future, you should consider an indexed universal life insurance policy with the potential to build cash value that can be used to help supplement your retirement income.
The most important feature of indexed universal life insurance is to pay a death benefit when needed the most, at the death of the insured. Many in the life insurance business refer to indexed universal life insurance as living insurance. As shown in the example above, not only does IUL offer the ability to provide a tax-advantaged method of cash flow, many IUL policies offer riders and endorsements for critical illness, chronic illness, and terminal illness. These accelerated benefits allow the policy owner to accelerate the death benefit without having to die. We all have a family member or friend that has suffered from heart attack, cancers, strokes, or even losing the ability to care for themselves due to an accident or illness. Having these benefits attached to your life insurance policy can allow you to receive funds at the time these events occur. That can be a game changer to your family’s financial future.
Let’s examine these benefits. These features allow a policy owner to advance a portion of the death benefit if the insured meets the requirements described in the rider or endorsement forms. Accelerated Death Benefit Endorsements may cover critical, chronic, and terminal illness. Each company has different levels of benefits, so it is important to question what the policy you are purchasing covers. Features from one of our more popular companies include the following.
Critical Illness Benefits – Specific medical conditions that may qualify for the critical illness benefit include heart attack, certain types of cancer, stroke, major organ transplant, and kidney failure. For this company, the minimum accelerated death benefit amount is $2,500 of the death benefit. The maximum per election is 25% of the death benefit at the time of election or $50,000, whichever is less. The accelerated death benefit payment will be made in a lump sum. The policy owner can file a claim for each qualifying critical illness event that the insured incurs.
Critical Illness Payment: Any accelerated death benefit payment a policy owner receives will be less than the amount of the death benefit that is accelerated – because the benefit is paid prior to the insured’s death. All approved claims will receive a payment guaranteed to be 40% of the death benefit amount accelerated (for example, 40% of $50,000 = $20,000), less any amounts needed for debt repayments – regardless of the type of specified medical condition event, policy age, gender or severity of illness.
Chronic illness Coverage- Coverage for a chronic illness allows the policy owner to accelerate a portion of the death benefit when the insured is diagnosed with a chronic illness as defined below:
A physician must provide written certification that within the last 12 months the insured is chronically ill. This medical certification is valid for 12 months. The insured is considered to be chronically ill if he or she:
- Is permanently unable to perform at least two Activities of Daily Living (bathing, continence, dressing, eating, toileting, and transferring) without substantial assistance from another person for at least 90 consecutive days; OR
- Requires substantial supervision by another person to protect oneself from threats to health and safety due to Severe Cognitive Impairment, defined as deterioration or loss of intellectual capacity that is measured by clinical evidence and standardized tests, which reliably measure impairment in:
– Short-term or long-term memory;
– Orientation to people, places or time;
– Deductive or abstract reasoning; and
– Judgment as it relates to safety awareness.
For a chronic illness claim, the minimum accelerated death benefit amount per election, except the final election, is 5% of the death benefit on the initial election date or $50,000, whichever is less. The maximum per election is 24% of the death benefit or $240,000, whichever is less. One election is available every 12 months.
The payment will be paid in a lump sum. A new Application for Election of Accelerated Benefits must be completed for each election.
A final election occurs if all of the available death benefit in the policy is accelerated, excluding the residual death benefit. The residual death benefit is equal to 5% of the death benefit on the initial election date, or $10,000 if greater. This will allow for the insured to keep a portion of death benefit even when chronic illness benefits have been exhausted.
Terminal Illness – In the event that the insured is found ineligible for critical or chronic illness coverage at the time of policy issue, terminal illness coverage may still apply. Terminal illness coverage has the same criteria as the life insurance policy issued, with the maximum issue age of 85.
In order to qualify for terminal illness, the physician must provide written certification that the insured has a life expectancy of 24 months or less. This timeframe may vary by state jurisdiction.
The minimum terminal illness accelerated death benefit amount is 10% of the death benefit or $100,000, whichever is less on the election date. The maximum the policy owner may accelerate is 75% of the death benefit or $750,000, whichever is less. This company will allow only one election per policy for terminal illness and the payment will be paid in a lump sum.
These accelerated benefits or as some call them “Living Benefits” go a long way in protecting your financial well-being should a need for critical illness, chronic illness, or terminal illness arise. These benefits are usually part of the policy that you purchase at no additional cost.
According to a national study published in The American Journal of Medicine in 2009, more than 60 percent of all U.S. bankruptcies in 2007 were caused by medical bills and 78 percent of those individuals had health insurance. As we see more and more of these benefits included in life insurance policies we should see a reduction in these financial catastrophes.
Why indexed universal life insurance?
Permanent life insurance provides death benefit protection that can help you protect your loved ones in the future. Since we all know that life is uncertain, Indexed Universal life can also be designed with the flexibility to address these changing needs throughout your lifetime. Indexed universal Life insurance can be a twofold strategy as part of your financial plan:
- Death benefit protection during working years. A solid financial plan often begins with life insurance. In the event of death, the proceeds are distributed to your beneficiaries generally income tax-free.
- Potential source of funds to help support a longer retirement. Your premium payments on a permanent life insurance policy may accumulate cash value on a tax-deferred basis. Through policy loans and withdrawals, the cash value may then be used to help pay for a wide variety of needs in retirement. These could be planned distributions for planned expenses or potential cash value may be used as additional funds to help protect you from outliving other retirement income sources or unplanned expenses. You may also access a portion of this death benefit during your lifetime in case of an unexpected illness. Cash value from your policy may be used for anything, emergencies, home improvements, vacations or supplement retirement
Who can benefit from Indexed Universal Life Insurance? Retiring and getting older has become a key concern for many people. Here are a few reasons why:
- Loss of Mom or Dad during working years could disrupt family finances, including retirement plans, house payments, or a child’s tuition.
- Employers may no longer offer defined benefit plans or retirement health care, so we have to plan for ourselves.
- Life expectancy. A male that retires at the age of 65 can expect to live to age 86 and a female can expect to live to age 89. Therefore, the length of time people live in retirement continues to grow and will require more money.
- Some form of chronic care is a 70% probability for those over age 65. The average cost of a private room can be over $80,000 a year.
A big misconception is that we only need life insurance while we are young and working and have kids that still depend on us financially. How would your family handle these uncertainties? Are your needs adequately protected? Indexed Universal Life insurance could be a viable solution.
No matter what your age, chances are an indexed universal life insurance policy may be one of the best assets you can own.
- 4 Reasons to buy IUL in your 20’s
- IUL at 35, Why it makes sense
- Should I buy Indexed universal life at age 45
- 3 Great Reasons to buy Indexed universal life when you are 50
While IUL is intended to provide cash to beneficiaries when the insured dies, it can also provide cash for the insured while still alive in the form of withdrawals or loans or even accelerated benefits in the event of a critical or chronic illness. The best way to see if this policy will work for you is to allow us to design an illustration based on your personal situation. After a thorough needs-based discussion with us, we can help you select a life insurance policy that matches those needs.
Don’t take the advice of any one with a big name such as life insurance advice by Dave Ramsey or Suze Orman life insurance advice. We are truly here to help you and know your specific needs and get the best coverage possible for you and your family.
We will help structure the policy to match the desired death benefit coverage, and provide you with the ability to access any potential cash values to help supplement your retirement income. Ready to get started? We can help you financially protect what’s important now while helping to supplement your retirement income later. Are you still asking what is indexed universal life insurance?
You can call us at 1-800-712-8519 or use the quote request form to the left for a personalized quote.