Life insurance can be difficult to understand. But it is important to have if your family members will still depend on you after your death.
The two primary types of insurance are term life insurance and permanent life insurance. Universal and indexed universal life insurance are two particular types of permanent life insurance.
A thorough understanding of how indexed universal life (IUL) insurance works is necessary to determine if it might be right for you and your family. Here is our IUL policy guide.
Types of Life Insurance
All life insurance policies fall under one of two definitions:
Term Life Insurance
This type of insurance is only in effect for a period of one to thirty years, during which fixed payments and a predetermined death benefit have been agreed upon. The beneficiary only receives a payout from this policy if the policyholder dies during the specified term. If the policyholder outlives the term, they must apply for a new policy if they would still like coverage. Term life insurance premiums tend to be less expensive than other types of insurance. However, there is no investment component as the policy has no cash value.
Permanent Life Insurance
All life insurance policies that don’t expire are permanent life insurance. These policies remain in effect regardless of how long the policyholder lives. Whole life insurance, universal life insurance, and indexed universal life insurance fall under the umbrella of permanent life insurance. Whole life policies combine coverage with an investment fund. So, buying this kind of policy guarantees a fixed payout amount upon the policyholder’s death and allows the insurance company to invest some of the money from the premiums to increase the cash value of the policy.
You should learn more about the differences between term and whole life insurance before taking out a policy.
What Is Indexed Universal Life Insurance?
Like other forms of permanent life insurance, indexed universal life insurance covers you for your entire lifespan and guarantees your beneficiaries a payout upon your death.
IUL is a popular type of permanent life insurance. This is because it offers low premiums and ways to build cash value through investment savings.
What is indexation in life insurance? Indexation means that the premiums and value of the insurance policy can be adjusted based on the performance of the stock market. Part of the money that you pay towards your indexed universal life insurance will be invested in a stock market index, meaning that it can gain value if the stock does well.
How Does Indexed Universal Life Differ from Other Forms of Life Insurance?
Indexed universal life insurance offers more flexibility than traditional permanent life insurance policies like whole life insurance because premium payments and death benefits can be adjusted at any time during the length of the policy.
Indexed universal life insurance is not based on a fixed interest rate. Instead, its performance is linked to a stock market index like the Dow Jones, Nasdaq, or the S&P 500. When the market does well, the policy’s cash value grows. However, no money is lost if the market falls.
How Does Indexed Universal Life Insurance Work?
When the monthly premium is paid, the money is used for different purposes. Some of it pays for the insurance itself, and some of it pays for fees or other costs. The rest of the premium payment goes toward the cash value of the policy. The insurance company invests this money in a stock market index. In general, indexed universal insurance policies offer a guaranteed minimum fixed interest rate and a choice of indexes for the policyholder.
Investing in an index is not the same thing as investing in the stock market. Rather than measuring the performance of an individual stock, the overall performance of the index is measured. For example, the value of the chosen index is recorded at the beginning of each month so that it can be compared to the value at the end of the month. If an increase is seen, the interest from the investment is added to the cash value of the policy either monthly or annually as set forth by the insurance company.
When the value of an individual stock goes down, the stockholder loses money. Conversely, if the value of the index goes down, the policyholder gains nothing and loses nothing.
Comparing a 401K to Indexed Universal Life Insurance
The purpose of each program is to ensure future income, but there are drastic differences. A 401k is an investment and savings plan that offers tax breaks on money contributed by the employee. On the other hand, indexed universal insurance is paid for using after-tax dollars. The resulting income stream is then tax-free.
What are the Pros and Cons of indexed Universal Life Insurance?
Indexed universal life insurance policies are attractive for many reasons, including:
- Lower premiums – since the policyholder carries the risk of the investments, the premium costs are lower.
- Flexible options – the policyholder can decide how much money to invest in an equity index, adjust the death benefit amounts, and add riders like no-lapse guarantees and death benefit guarantees.
- Permanent death benefits – the benefits don’t go through probate and are not subject to death or income taxes.
- No stock market involvement – since the money is invested in the equity index rather than actual stocks, the risk of loss is not nearly as great.
- No contribution limits – annual contributions are not limited in any way.
- Tax deferment – the growing cash value is tax-deferred. So, if it is large enough, the policyholder can use it to pay the premiums and eliminate out-of-pocket costs.
- No distribution limits – the cash value can be accessed at any time with no penalties and with no specifications as to the policyholders’ age.
There are also some drawbacks to these policies, including:
- Limits on index returns – caps can restrict the percentage of index gains returned to the policy to the detriment of the policy owner.
- Polices with lower face amounts don’t see any appreciable gains – there is no real advantage of investing in an indexed universal insurance policy over a regular universal policy.
- Failure to outperform the equity index – adding value to the policy is based on the premise that interest will be earned from increases in the monthly equity index. If that doesn’t happen, the cash value of the policy doesn’t increase.
Is an Indexed Universal Life Insurance Policy Right for You?
Indexed universal policies will be the best option for some people, but not everyone. People who want to earn interest while knowing that their benefits are fixed and guaranteed will find indexed universal policies most attractive. A qualified insurance agent or financial planner should be able to evaluate your needs and recommend the right policy for you.
Buying an Indexed Universal Life Policy
Choosing a policy can be just as confusing as understanding how a policy works. Depending on who you seek advice from, you may be presented with skewed views about the appropriateness or the pitfalls of indexed universal life insurance policies.
For example, a life insurance agent who wants to push you toward an indexed universal policy may only tell you about the pros of your decision and brush over the possible cons. On the other hand, agents who want to sell other whole life policies may exaggerate the possible downsides of indexed universal insurance policies.
Your best course of action is to find an insurance agent who has a reputation for being honest and who will present all your options without bias. Ideally, he or she will be able to provide an indexed universal insurance policy guide and fully inform you about IUL insurance pros and cons.
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