Indexed Universal Life Explained Without the Sales Pitch

What it is

Indexed universal life, often shortened to IUL, is permanent life insurance. Its first job is to pay a death benefit. It is a type of universal life, which means premiums are flexible within limits and the policy has a cash value account that charges are deducted from each month.

What makes it "indexed" is the way interest is credited to that cash value. The rest of this article explains that mechanism and the risks that come with it. IUL is a complex product. It can serve some people well and it can disappoint people who were shown only the optimistic version. Our indexed universal life page has a shorter overview.

How interest is credited

You pay a premium. The insurer deducts a premium charge, and the remainder goes into the cash value. You choose how to allocate it between a fixed account, which earns a declared rate, and one or more indexed accounts.

In an indexed account, the interest credited may be linked to the performance of an external index, such as a broad stock index, under the policy's formula. The insurer measures the index change over a period, often one year, and applies the formula to decide what to credit.

Two things are essential to understand:

• The policy is not invested in the index. Your cash value does not own shares or index funds. The index is only a measuring stick.
• Dividends are usually excluded. Most crediting methods use the price change of the index, not its total return.

Caps, participation rates and spreads

The formula contains limits on what can be credited.

These figures are illustrations only and do not represent any product. In most policies the insurer can change caps, participation rates and spreads for future periods, within guaranteed minimums or maximums stated in the contract. Those contractual limits are backed by the claims-paying ability of the issuing insurer. The current rates you see at purchase are not promised for the life of the policy.

What the floor does and does not do

The floor is the most frequently misunderstood feature. A 0 percent floor means that index-linked interest for the period will not be negative. It does not mean the policy cannot lose cash value.

Charges continue every month regardless of what the index does. These include the cost of insurance, administrative and policy fees, charges for riders and, in the early years, surrender charges if you cancel. In a year when 0 percent is credited, those deductions reduce the cash value. Several such years in a row, especially in an underfunded policy, can do real damage.

Cost of insurance rates also generally rise with age, so the drag from charges can grow later in life.

Premiums are flexible, and can change

Flexibility works in both directions. You can often pay more or less than the planned premium. But the premium that keeps the policy in force is not fixed. If credited interest is lower than projected, or charges increase, or you skip payments, the premium required to sustain the policy can go up, sometimes substantially.

Some policies include a no-lapse provision for a stated period if specified premiums are paid on time. Read its conditions carefully, because late or missed payments and loans can end it.

Loans and withdrawals

Cash value can typically be accessed through withdrawals or policy loans. Both have consequences:

• Loans and withdrawals reduce the cash value and the death benefit.
• Loans accrue interest. With some loan types the rate charged can vary, and the loaned amount may still receive index credits that could be lower than the loan rate.
• Withdrawals above your basis, and loans from a policy classified as a MEC, may be taxable.
• If a policy with an outstanding loan lapses or is surrendered, the loan can be treated as a distribution, which may produce a tax bill with no cash to pay it.

Poor loan management or underfunding can cause a lapse. This is the scenario that harms people most: borrowing steadily for years, a stretch of low credited interest, rising charges, and a policy that fails late in life when replacing it is not realistic.

Illustrations are not guarantees

Before you buy, you will receive an illustration. It shows year-by-year values under guaranteed assumptions and under non-guaranteed assumptions. The non-guaranteed columns assume a constant credited rate and current charges for decades. Real crediting varies from year to year, and insurers can change non-guaranteed elements.

Illustrated non-guaranteed values are not guarantees. Treat them as one possible scenario. Ask to see the same policy illustrated at a lower assumed rate, and look hard at the guaranteed column.

MEC rules

Federal tax law limits how much premium can be paid into a life insurance policy relative to its death benefit during its early years. A policy that exceeds the limit becomes a modified endowment contract, or MEC. The status is generally permanent.

A MEC still pays a death benefit. The difference is how money taken out during life is taxed: loans and withdrawals are treated as coming from gain first, are taxable to that extent, and may be subject to an additional tax before age 59 and a half. Insurers test for MEC status and should warn you before a premium would trigger it.

Taxes in general

Death benefits are generally excluded from a beneficiary's federal gross income, subject to exceptions, and cash value generally grows tax deferred under current federal law. Withdrawals and loans can have tax consequences, particularly on lapse, surrender or modified endowment contract status. The IRS summarizes the treatment of life insurance proceeds. Tax treatment depends on your circumstances and on the law, which can change. Consult qualified tax and legal professionals before buying, and again before taking loans or withdrawals.

Who it may fit, and who it may not

IUL may be worth a look for someone who needs a permanent death benefit, has stable income, is already using other savings vehicles, can fund the policy well, and will review it every year. It should be compared with other forms of permanent life insurance.

It may not fit someone whose need is temporary, whose budget is tight, or who wants something simple. If flexibility is what you are after, Life Insurance That Adapts compares several routes. Life insurance is not a substitute for a workplace retirement plan, and it should not be evaluated as if it were one.

What to ask before you sign

1. What are the current and guaranteed cap, participation rate and spread for each indexed account?
2. What are all the charges, and how do they change as I age?
3. What does the illustration look like at a lower credited rate and at guaranteed values?
4. What premium keeps the policy in force to age 100 or beyond under conservative assumptions?
5. How do the loan options work, and what happens to the policy if I borrow?
6. How long do surrender charges last?
7. Which riders are included? Living Benefits Explained covers the illness riders.

If you already own an IUL, a policy review with an in-force illustration will show where it stands today.

Eligibility, premiums and availability depend on age, health, underwriting, state and carrier. This article is educational and is not legal, tax or investment advice.