Today, there are many different types of life insurance policies on the market. One of the newest – and most flexible – is indexed universal life. This type of policy is thought by some to offer the “best of both worlds” in that it provides death benefit protection, along with some nice savings and investment features as well.
How Does Indexed Universal Life Insurance (IUL) Work?
Indexed universal life insurance works in a similar fashion to a regular universal life insurance policy in that it provides a death benefit component and a cash value component. Within the cash value component, the funds will grow, based on an underlying index, such as the S&P 500 or NASDAQ 100.
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There are some parameters that are set within the cash portion of an indexed universal life insurance plan, whereby the policy holder can only earn a maximum amount of interest per year. This, however, is offset by the fact that they are also guaranteed a minimum amount of return, or “floor,” as well.
For example, an indexed universal life insurance policy will set a cap rate. This means that the interest that is earned in the cash value will earn a maximum rate per year. Therefore, as an example, if the index that is being tracked by the policy returns 11% for a certain time period – and the annual cap on the policy is 10% – then the most that the policy holder will earn on the cash value component for that year will be 10%.
However, there is also a floor that is set with indexed universal life insurance policies. This feature will help in guarding against market losses in the cash value account. The floor is the minimum amount of annual interest that that policy will be guaranteed in a given time period.
Therefore, if the cash value is guaranteed not to go below 1% for a given year, even if the underlying index has a year when it returns a negative 14%, the policy holder will still return 1% on his or her cash for that period of time.
Advantages of Indexed Universal Life Insurance
Although indexed universal life insurance provides some of the same protections that other types of permanent life insurance does, this type of coverage also offers a great deal more in terms of its overall flexibility. Some of the benefits that are offered by this product include:
- Tax free death benefit – One of the biggest benefits of any life insurance policy is the fact that the death benefit is free from federal income taxation to beneficiaries. This allows loved ones the use of the full amount of proceeds for paying off debts, replacing income, or any other need that they see fit for its use.
- Tax deferred growth – Also like most other permanent life insurance products, the cash that is inside the cash value component of an indexed universal life insurance policy is allowed to grow on a tax deferred basis. This allows the funds to accumulate and compound even faster than if they were taxed each year.
- Additional growth opportunities – Unlike whole life and many other types of universal life, indexed universal life insurance policies allow the crediting of interest of funds in the cash value component based on the performance of an underlying index such as the S&P 500. Therefore, the cash in these types of policies can essentially accumulate even more.
- Funds can be taken out tax free as income – By taking out tax free loans or withdrawals, the policy holder of an indexed universal life insurance policy can essentially receive tax free income in retirement. This means that income from these policies do not need to be recorded as income to the IRS (Internal Revenue Service).
- Annual resetting of gains – Unlike a mutual fund or a stock, gains in the cash account of an indexed universal life insurance policy are essentially “locked in” each year and can never be taken away based on future market downturns. This will protect funds from the market’s ups and downs going forward.
- Protection from lawsuits and creditors – In some states, life insurance cash values are also protected from lawsuits and from creditors – including bankruptcy, to an unlimited dollar amount. (This varies by state).
- No probate issues – Because life insurance proceeds can pass directly to a named beneficiary, these funds will not be held up in the costly and time consuming process of probate.
- Protection from market losses – The cash value component in an indexed universal life insurance policy also offers protection from market losses. This means that principal is protected, regardless of what occurs in the market, or even in the economy overall.
Indexed universal life insurance can offer a great way to build up tax deferred savings, while at the same time protecting principal from market losses. In addition, the death benefit can offer loved ones peace of mind in knowing that expenses will be covered in the event of the unexpected.