05 May Indexed Universal Life
What Is Indexed Universal Life Insurance?
There is no better way to provide for your loved ones after you’re gone than acquiring a robust life insurance policy. This ensures that your beneficiaries won’t have to lower their standard of living after you’re gone. However, there are several different kinds of life insurance, and some of them can get quite complicated.
The most common types of life insurance are term and whole. Term life insurance is a policy that provides coverage for a predetermined amount of time, typically a matter of decades. These policies will pay a death benefit if you pass away during the coverage period. But if you outlive your policy, the account simply closes without a payout.
Whole life insurance is also quite popular. This form of insurance provides coverage until you die, no matter how long that takes. You could pass away a few months into the policy or several decades later — either way, your beneficiaries would receive your full guaranteed death benefit. In addition, whole life insurance includes a cash value component.
But what is universal life insurance? And how does an indexed universal life insurance policy work? The world of life insurance can get complicated in a hurry when you start digging into indexed universal policies. Therefore, it’s important to consider all of their benefits and drawbacks to make sure you’ve chosen a life insurance policy that fits your needs today and will grow with your changing circumstances into the future.
The Basics of Universal Life Insurance
Universal life insurance is similar to whole life insurance in that the policy provides coverage for as long as you live, whether you pass away in your 60s or live to see your 100s. With universal life insurance, your account also has a cash value component, which operates much like a savings account, just like you’ll find in a whole life policy.
When you pay your monthly premiums, your insurance provider will split up that payment into two portions. One of those portions pays your life insurance policy costs, while the other goes to the cash value component. These policies always have a monthly minimum that’s required to keep your life insurance active, and anything beyond that amount goes into your cash value.
There are also maximum contribution limits provided by the Internal Revenue Service (IRS). You will often see people paying the maximum allowable amount in the first few years of the policy, as policyholders try to build their cash value up enough to cover their premiums when they reach retirement age.
Universal Life Insurance: Guaranteed vs. Variable vs. Indexed
If you’re interested in universal life insurance, you should know that there are three main types of this coverage. Guaranteed universal life insurance grows at a fixed rate according to the interest rates you agree to when you initially purchase the policy. This type of policy also includes a guarantee (hence the name) that it will never lapse if you pay your minimum premium each month.
Guaranteed universal life coverage is the most conservative form of investment when it comes to universal life insurance. It’s also the easiest to understand, as there isn’t much underlying complexity with guaranteed universal policies. There isn’t much risk involved, as market conditions don’t have any effect on the growth of your account. However, these accounts typically have low interest rates, and the cash value component usually does not gain much value.
Another form of this insurance is variable universal life. With this option, you can invest your cash value component in mutual funds. Of course, there is more risk involved with a variable policy than a guaranteed life insurance plan, but also considerably more upside. The growth of this account depends on how your chosen mutual fund performs. In a worst-case scenario, your cash value could actually lose value if the fund performs poorly.
That brings us to indexed universal life insurance. This form of coverage ties your cash value account to a stock market index, such as the S&P 500 or the Nasdaq. As that index grows, your cash value component does so as well. However, unlike the variable form of universal life insurance, an indexed account usually cannot lose value, thanks to its downside interest rate. The upside is also obviously much higher than you’ll find with a guaranteed universal life policy, even though your insurer will take a cut of your earnings with an indexed policy.
In some ways, an indexed universal life insurance policy has more in common with a fixed indexed annuity than it has with a standard term or whole life insurance plan. These two different types of investment product both include the upside for robust capital growth due to their ties to a market index. In addition, a fixed indexed annuity and an indexed universal life insurance policy will both offer a baseline interest floor that protects you from market downturns.
The Advantages and Disadvantages of Indexed Universal Life Insurance
Indexed universal life insurance might sound simple enough, but there are actually many complicating factors to these policies. That’s why it’s important to fully understand all of the nuances of this form of insurance. Let’s take a look at some of the biggest pros and cons of indexed universal life coverage. Depending on your unique needs, you might find that either the advantages or disadvantages outweigh the other.
First and foremost, the reason most people choose an indexed universal life insurance plan is because of the growth potential. This type of policy has more growth potential than any other permanent life insurance policy. In addition, an indexed universal policy typically has a downside minimum interest rate, which safeguards your cash value against potential market downturns.
Another reason that people like indexed universal life insurance policies is the tax advantages. Especially if you have a high net worth, and you have lots of other assets beyond your life insurance policy, the tax-free nature of the indexed universal life insurance policy can be a big advantage. If you’re wealthy enough that your loved ones will need to pay estate taxes on their inheritance, your indexed universal life insurance plan’s payout will remain untaxed.
Flexibility is another intriguing advantage. Indexed universal life insurance policies usually allow policyholders to adjust their plan’s death benefit. While the policy will have limits set on how much you can raise or lower your death benefit, you can adjust it to meet your needs as you age.
As an example, has your financial situation taken a turn for the worse since you bought the policy? If so, you could decrease your death benefit payout amount and redirect your cash value component to pay your monthly premiums. This allows you to save money in the short term in exchange for a decreased payout for your beneficiaries when you pass away.
While there are plenty of upsides to indexed universal life insurance, those advantages come with one big disadvantage as well. Simply put, these policies are expensive, typically considerably more costly than other forms of life insurance. To begin with, your insurance provider will certainly take a cut from your index earnings. In addition, these accounts often have earnings caps on your cash value.
For instance, let’s assume that you index your universal life insurance plan on the Nasdaq 100, and that index gains 10% over the course of several years. If your policy has an earnings cap of 5%, it doesn’t matter how much the index gains above that limit. You won’t see a dime beyond that 5% level.
Your policy might also have a participation rate, which is another method of limiting your earnings. Let’s use that 10% earnings example again here. If your indexed universal life insurance policy has a 70% participation rate, you will only enjoy 70% of the index’s total earnings. Therefore, that 10% index growth will only reflect a 7% gain within your policy’s cash value component.
We haven’t even mentioned the fees yet, which can add up more than you’ll find with other forms of life insurance. These fees are also usually higher than those you would pay with a standard investing account, like a mutual and index fund account with Fidelity or Vanguard. Additionally, whenever you make a withdrawal from your policy’s cash value, you’ll need to be careful to withdraw less than you’ve already paid in. Otherwise, the IRS will come knocking at the door asking for its cut.
We haven’t even mentioned yet that the fees on indexed universal life insurance policies often aren’t guaranteed. This means that the fees you pay throughout the life cycle of your policy can increase, often without much advance notice.
Is an Indexed Universal Life Insurance Policy Worth It?
As you can see, there are plenty of pros and cons with indexed universal life insurance policies. With this in mind, let’s discuss some situations where you may or may not want to purchase one of these insurance plans.
An indexed universal life policy can be a good idea if you want to use your cash value component while you’re still alive. Most of these insurance plans return the remaining cash value to the insurer when you pass away. The exceptions are usually more expensive policies that permit policyholders to pass on their cash value component to their beneficiaries. That said, if you plan on spending your policy’s cash value, an indexed universal life insurance policy can be a solid fit for your needs, thanks to its relatively high growth potential.
As we mentioned earlier, indexed universal policies are also popular for wealthy individuals, as these policies allow them to package tax-free death benefits for their beneficiaries. Wealthy people are also less likely to be deterred by the potentially high expenses and fees that often come with these policies.
However, for many people, the high expenses and complex nature of the indexed universal life insurance policy are enough to make them seek out other options. After all, compared to most forms of traditional retirement investments — like 401(k) plans, individual retirement accounts (IRA), annuities, etc. — the limits placed on indexed universal life insurance earnings significantly limit their upside.
And if the cash value component of the policy doesn’t interest you, there’s no reason to choose this form of life insurance instead of a simpler type of policy. For example, there’s a reason term life is so popular. All you need to do is pay your premiums each month, and your insurer pays out your death benefit if you pass away during the term. It doesn’t get much simpler than that.
Life insurance is a vital means of providing for your loved ones after you pass away, and some forms of life insurance provide significant benefits in addition to this core concept. However, you need to make sure you’re selecting the best type of insurance for your unique situation.
In many ways, choosing between the different forms of life insurance plans depends on how much risk tolerance you have. In other ways, it’s based on how much complexity you want to deal with. Many people enjoy the cash value component and moderate growth potential of an indexed universal life insurance policy. On the other hand, many people also prefer to keep their investment and insurance portfolios strictly separated.
In the end, whether an indexed universal life insurance policy is right for you depends on your preferences. If you like the idea of using your life insurance policy as an additional investment vehicle, it can be a nice fit for your portfolio. Otherwise, there are simpler forms of life insurance that cut out all of the “side dishes” and solely serve up the main course of providing a death benefit for your loved ones.
No matter which form of life insurance you choose, it’s important to stay current on all of your premium payments. Regardless of whether you purchase an indexed universal policy or a basic term life insurance plan, if you don’t keep up with your premiums, you’re just throwing money away.