Indexed universal life (IUL) gets a lot of attention online, often from people promising more than any insurance policy can deliver. It can be a useful tool for the right person. It can also disappoint people who buy it for the wrong reasons. This guide explains how IUL works and walks through the pros and cons in plain English.
What IUL is, in one paragraph
IUL is a type of permanent life insurance. Like other universal life, it has flexible premiums and a cash value account. What makes it "indexed" is how the cash value is credited: interest is based partly on changes in a market index, such as the S&P 500, subject to limits set by the policy. Your money is not invested in the stock market or the index itself. FINRA notes that IUL is generally not considered a security (FINRA: Insurance). It is life insurance first. Our IUL guide covers the basics in more detail.
How index crediting works
Each crediting period, often a year, the insurer looks at how the chosen index moved and applies the policy's formula. A few terms control the result:
- Cap rate: the most interest the policy will credit for the period, even if the index rose more.
- Participation rate: the share of the index's gain used to figure your credit.
- Spread: a percentage some policies subtract from the index gain before crediting.
- Floor: the minimum credit for the period, often zero, so a falling index does not create a negative index credit.
Caps, participation rates, and spreads vary by carrier and product, and insurers can usually change them over time within limits stated in the policy. Index gains usually do not include dividends paid by the companies in the index.
The pros
- Lifelong coverage. IUL is designed to last for life if it is funded well enough, which suits needs that never go away, such as leaving money to family or covering estate costs.
- Flexible premiums. Within limits, you can pay more in good years and less in tight ones. The NAIC notes universal life lets you choose a flexible payment pattern as long as you pay enough to keep the policy in force (NAIC Life Insurance Buyer's Guide).
- Index-linked crediting with a floor. The cash value can receive credits linked to index gains, and the floor prevents negative index credits in down years.
- Tax treatment. Cash value generally grows tax-deferred, and the death benefit paid to a beneficiary is generally not taxable income (IRS). Policy loans can provide access to cash value, but loans have costs and risks.
- Optional riders. Many IUL policies offer riders, such as accelerated benefits for a qualifying illness. Availability and cost vary.
The cons and risks
- Charges come out every month. The cost of insurance, administrative fees, and rider charges are deducted from the cash value. The floor protects against negative index credits, not against these charges, so cash value can go down in a year with a zero credit.
- Caps limit the upside. In a strong year for the index, the cap or participation rate limits what is credited. If the insurer lowers caps later, future credits may be smaller than you expected.
- It can lapse if underfunded. Flexible premiums cut both ways. If you pay too little, or credits come in lower than assumed, the policy may need more money later to stay in force. If it lapses with a loan outstanding, there can be a tax bill.
- Illustrations are not promises. An illustration shows guaranteed values and non-guaranteed values based on assumed crediting rates. The NAIC regulates how these are shown because the non-guaranteed columns can look rosier than reality (NAIC: Life insurance illustrations). Actual results will differ.
- Surrender charges. Most policies charge a fee if you cancel in the early years, so IUL suits money you can leave alone for a long time.
- Complexity. There are more moving parts than with term or whole life. If you don't understand how your policy works, it is hard to manage it well.
IUL compared with term and whole life
- Term is usually the least expensive way to get a large death benefit for a set number of years, with no cash value. See how much term life insurance you need.
- Whole life typically has a fixed premium and a schedule of guaranteed cash values, backed by the claims-paying ability of the issuing insurer. See how whole life cash value works.
- IUL sits in between: permanent coverage and cash value like whole life, with more flexibility and fewer guarantees.
Who IUL may fit, and who it may not
IUL is often considered by people who want permanent coverage, can fund a policy consistently for many years, are comfortable with some uncertainty in how the cash value grows, and plan to review the policy regularly. It is usually a poor fit if you need the most coverage for the least money right now, can't commit to steady premiums, or are buying it mainly because someone promised big returns. If an ad or a salesperson calls IUL a way to "get market returns with no risk," be cautious. That is not how it works.
Questions to ask before you buy
- What happens to the policy if credits are at the floor for several years in a row?
- Can the insurer change the cap, participation rate, or charges, and what are the guaranteed limits?
- How much do I need to pay each year to keep the policy in force on guaranteed assumptions?
- What are the surrender charges, and for how many years?
- How do policy loans work, and what is the loan interest rate?
The bottom line
IUL can provide lifelong coverage with flexible premiums and index-linked cash value, but it comes with charges, caps that can change, and a real risk of lapse if it is underfunded. It is not an investment in the market. If you are curious whether it fits, an independent agent can compare IUL with whole life and term from several carriers and walk you through the guaranteed columns, not just the projections. Request a free quote, or read our IUL guide. If you are mainly thinking about retirement income, also see fixed vs. fixed indexed annuities.
Frequently asked questions
What is a cap rate in an IUL?
The cap rate is the most interest an IUL will credit for a crediting period, even if the index rose more. Caps vary by carrier and product, and insurers can usually change them over time within limits in the policy.
What is a participation rate in an IUL?
The participation rate is the share of the index's gain used to calculate your credit. Some policies use a participation rate with a cap, some use a spread instead, and the rates vary by carrier and can change over time.
What does the floor in an IUL do?
The floor sets the minimum index credit for a period, often zero, so a falling index does not create a negative index credit. It does not stop monthly policy charges, so cash value can still decline in a year with no credit.
Can an IUL policy lapse?
Yes. If premiums are too low, credits come in lower than assumed, or loans grow too large, the cash value may not cover the policy's charges, and the policy can lapse unless more money is paid in. A lapse with a loan outstanding can also create a tax bill.
Who might consider an IUL?
IUL is often considered by people who want lifelong coverage, can fund a policy steadily for many years, are comfortable with some uncertainty in cash value growth, and will review the policy regularly. It is usually not a fit for someone who needs the most coverage for the least money.
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This article is general and educational, not an offer to sell insurance or financial, tax, or legal advice. Coverage, benefits, and availability vary by carrier, product, and state, and all coverage is subject to underwriting.