Indexed universal life, explained clearly

Indexed universal life (IUL) is permanent life insurance. It pays a death benefit to your beneficiaries and includes a cash value account that can earn interest.

What makes it “indexed” is how that interest is calculated: it is based partly on the performance of an external market index, such as the S&P 500®. Your money is not invested in the index and you don’t own any stocks or funds. The insurance company credits interest using a formula with limits, which we explain below.

IUL is also “universal” life — meaning premiums and the death benefit can be adjusted within the policy’s rules.

Each premium you pay goes into the policy. Every month, the insurance company deducts policy charges and the cost of insurance. What remains is your cash value, which earns interest based on the crediting strategies you choose.

The death benefit is the amount paid to your beneficiaries. Most IULs offer two main options:

• Level death benefit — the benefit stays the same; as cash value grows, the insurance company’s “net amount at risk” shrinks, which lowers cost of insurance over time.
• Increasing death benefit — the benefit equals the face amount plus cash value, which costs more.

Death benefits are generally paid income-tax-free to beneficiaries under current federal law. Outstanding loans are subtracted from what’s paid.

Cash value is the policy’s internal account. It is funded by premiums, reduced by charges and increased by credited interest. You can typically allocate cash value among:

• A fixed account that earns a declared rate, and
• Index accounts that earn interest based on an index formula.

Cash value usually grows slowly in the early years, when charges are highest relative to the account. Surrender charges may apply if you cancel in the first years.

At the end of each crediting period (often one year), the insurance company measures the index’s change, applies the participation rate, then limits the result with the cap and floor. Index returns generally exclude dividends.

The participation rate is the percentage of the index’s change used in the calculation. With a 100% participation rate, a 6% index gain counts as 6%. With 80%, it counts as 4.8%. Some strategies offer participation above 100%, often paired with lower caps or additional charges.

Participation rates are set by the insurance company and can change within the limits stated in the contract.

A cap is the maximum interest rate that can be credited in a period. If the cap is 10% and the index formula produces 14%, you receive 10%. Caps can be changed by the insurance company, subject to any guaranteed minimum cap in the contract. Some strategies are uncapped but use a spread or lower participation instead.

A floor is the minimum interest rate credited to an index account, commonly 0%. If the index falls, the floor prevents negative interest from being credited.

Important: a floor does not mean your cash value can’t go down. Policy charges and the cost of insurance are deducted every month, so in a 0% year your cash value will typically decrease.

IUL policies have several types of charges, which vary by carrier and design. Common ones include:

• Premium loads (a percentage of each premium)
• Per-policy administrative fees
• Per-thousand charges based on the face amount, often for the first years
• Rider charges
• Surrender charges if you cancel during the surrender period
• Cost of insurance (next section)

Your illustration shows how these charges affect values over time. We walk through it with you.

The cost of insurance (COI) is the monthly charge for the pure life insurance protection. It is based on your age, health rating and the “net amount at risk” (the death benefit minus cash value). COI generally increases as you age.

This is why strong early funding matters: a larger cash value can reduce the net amount at risk and help offset rising COI later in life.

You may be able to access cash value in two main ways:

• Withdrawals (partial surrenders) permanently reduce cash value and the death benefit. Withdrawals above your cost basis may be taxable.
• Policy loans use the cash value as collateral. Loans accrue interest (fixed, variable or indexed, depending on the policy) and reduce the death benefit and cash value available.

Risk to understand: if loans and interest grow faster than cash value, the policy can lapse. A lapse with an outstanding loan can create a taxable event. Regular reviews help manage this risk.

Many IULs offer accelerated death benefit riders that may pay part of the death benefit early after a qualifying terminal, critical or chronic illness. Availability, definitions and benefit amounts vary by carrier, policy and state, and accelerated amounts reduce the death benefit. Learn about living benefits →

Many people start with term for pure protection. IUL may make sense when you want permanent coverage and can fund it for the long term. Some use both.

Some people fund an IUL for many years and later take policy loans or withdrawals to supplement other retirement income. This can offer flexibility because there are no required minimum distributions and, if structured and maintained properly, loans are generally not taxed as income.

It also carries risks: results depend on credited rates, charges, loan interest and funding discipline, and none of these are guaranteed. An IUL is best viewed as one tool alongside retirement accounts — not a replacement for them. We never describe it as “guaranteed tax-free retirement.”

Parents sometimes start an IUL on a child because cost of insurance is low at young ages and the policy has decades to accumulate. It also provides permanent coverage that doesn’t depend on the child’s future health, subject to policy terms. Weigh it against other savings options and expect slow early growth. Children’s life insurance →

Design decisions have a big effect on long-term results:

• Death benefit amount and option — a lower death benefit relative to premium can leave more room for cash value (within tax limits).
• Funding level and schedule — how much you pay and for how long.
• Crediting strategy allocation — fixed vs. index accounts and their caps and participation rates.
• Riders — useful protections often have a cost.
• Loan type — fixed, variable or indexed loans behave differently.

A policy built for maximum death benefit and a policy built for accumulation can look very different even with the same premium.

If premiums are too low for the policy’s design, charges and cost of insurance can consume most of each payment. Cash value grows slowly or shrinks, and as COI rises with age the policy may require much higher premiums later — or lapse.

If you’re unsure whether your policy is on track, an in-force illustration and review can show where it’s headed.

“Maximum funded” generally means paying as much premium as federal tax rules allow for a given death benefit, without the policy becoming a modified endowment contract (MEC).

The IRS uses tests (including the 7-pay test and guideline premium or cash value accumulation limits) to cap how much can go into a life insurance policy relative to its death benefit. A MEC loses some tax advantages: loans and withdrawals are taxed on an earnings-first basis and may carry a 10% penalty before age 59½.

Maximum funding isn’t right for everyone. It requires the budget and commitment to fund at that level.

IULs are flexible, which means they need attention. Caps and rates can change, loan balances grow, and your goals evolve. A periodic review — ideally annually — compares actual performance to the original plan and runs an updated in-force illustration.

Request an IUL policy review