Indexed Universal Life Insurance (IUL), Explained
12 Min Read | Dec 5, 2024
Table of Contents
What Is Indexed Universal Life (IUL) Insurance?
Why Someone Would Pick Indexed Universal Life Insurance
Drawbacks of IUL Insurance
IULInsurance vs. Other Life Insurance Policies
Is an IUL Better Than a 401(k)?
The Truth About IULs
Frequently Asked Questions
Life insurance is on the same list with water or oxygen or champagne—essentials everyone needs. (Or sparkling apple cider if you prefer the mocktail version.) But there’s one kind of coverage being served up over the past few years that nobody should cheers. It’s called indexed universal life (IUL) insurance.
IUL is a rip-off that tries to use a slick package to bundle life insurance with a lousy investment product. It’s like slapping a Dom Perignon label onto a bottle of Miller High Life. Sound too bad to be true? It’s very real, and it’s worse than a hangover.
Let’s find out why!
What Is Indexed Universal Life (IUL) Insurance?
IUL insurance uses your premiums to pay for two features:
- A life insurance payout for your family or estate
- A cash value account that follows the performance of an index fund (that’s why it’s called indexed)
So, that’s the basic explanation. But here’s the deal: Insurance is not an investment. Whenever you see an insurance product that also tries to be a savings or investment account, that’s a huge red flag.
Max-Funded IUL vs. Level-Option IUL
If you’re into gross flavors, you’re in luck! Because with IULs, you can choose from two different kinds of this bottom-shelf swill: a max-funded IUL or a level-option IUL. The main difference is in what your premium is allocated toward—the cash value (investment) part or the death benefit (insurance) part.
In a max-funded IUL, you pay more money through your premiums into your IUL account, which is the investment part. Salespeople say this will help you grow your cash value faster. And while these have a floor on returns (meaning you won’t lose money if the index fund that your IUL account mirrors goes down), they also have a cap on returns. This type of IUL also has more fees. Yum.
A level-option IUL focuses on the insurance side of the contraption and is your typical kind of IUL. This means more of your premium goes toward the death benefit.
How IUL Insurance Works
IUL insurance is sold as a flexible plan that lets you set your own premiums and put money into a savings account that follows a little something known as an index fund. Basically, IUL puts a new spin on a bad idea.
Don’t get me wrong. I love life insurance—specifically level term life insurance. But not all life insurances are created equal, and I’d never recommend any form of whole life or universal life insurance. It’s a bad deal for you every time.
The Index Part of an IUL
So, what are index funds?
Even if you’re an investing rookie (we all start somewhere), you’ve probably heard of the stock market. You’ve probably also heard of some of the popular indexes, like the Dow Jones industrial average and the S&P 500. You’ve also heard of the Indy 500. No relation there, sadly.
Now, an index like the S&P 500 isn’t an actual fund that you can invest in. It’s a measurement of how the stock market is doing. But they don’t measure every stock out there because that would be insane and take forever—they pick a bunch of them as a set to represent the whole market. In the case of the S&P 500, it’s the largest 500 companies in the U.S.
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Index funds invest in the companies that are being measured by a specific index. So, you can invest in an S&P 500 index fund, for example, which is made up of stock in the largest 500 companies in the U.S.
The question is, how do index funds tie in with an IUL? Let’s break it down. I’ve already mentioned that an indexed universal life insurance plan has both a life insurance portion with a death benefit and a cash value portion. Well, with an IUL, returns on the cash value account mirror the returns of index funds. When people say an IUL is tied to an index fund, this is what they mean.
Now, you may be saying, This sounds very complicated! And to that I say, yeah! Insurance companies take the pretty simple process of investing in the stock market and add as much nonsense to it as possible—all to pinch money off you here, there and everywhere. How? Fees and earning caps. And they can do this because your money’s not actually in an index fund—it’s tied to one, but in an account they control.
Premiums
With an IUL, your premium isn’t fixed—and it’ll rise as you age. (Sorry to be the bearer of bad news, but older people have a higher chance of death.)
In theory, your IUL account could grow enough to allow you to pay lower premiums as you age because you’re allowed to cover some (or all) of your premiums through the cash value of your IUL policy! Doesn’t it sound great?
Keep reading.
I should remind you that insuring your life becomes more expensive as you age. So, if your cash value is only holding steady over time, or even dipping when the market dips, but your premiums keep rising . . . do you see a problem developing? Yeah. Keeping your policy in force is going to become very expensive—and it could even wipe out anything you’ve saved in the cash value.
That’s how IULs work, and that’s why they’re a terrible way to take care of retirement planning or life insurance. Stay far, far away.
Why Someone Would Pick Indexed Universal Life Insurance
So, if IUL insurance is such a scam, why would someone pick it?
Well, if you’re planning to retire and you love your family—and that’s practically everybody—combining savings and a death benefit in an IUL might sound like a win-win. I get the thought process! But think about this—while a few of the features in an IUL seem appealing, there are really more catches here than in a game of Pokémon Go.
Let’s look at why people fall for IUL insurance so you can avoid the slick talk.
Here are the benefits that attract people:
- It includes a cash value account (some people might refer to it as an IUL account) that can grow through modest returns based on how well a certain index fund does.
- Any investment growth in your IUL is tax-free. (But the same goes for many kinds of retirement accounts.)
- The death benefit is in force (aka active) permanently—as long as you keep up with the premiums. (But if you’re staying out of debt and building wealth with the Baby Steps, you’ll eventually become self-insured.)
Sometimes an IUL includes a minimum guaranteed rate of return. (But even if it does, it’s unlikely to get you as much cash as you’d get from investing in growth stock mutual funds.)
Drawbacks of IUL Insurance
Now let’s take a deeper look at all the problems:
- The investments in an IUL never perform like they should because the cash value portion gets eaten up with fees the insurance company takes for managing the investment.
- Those aren’t the only fees you’ll face with an IUL: They also come with commissions for the sale, administrative expenses, premium expense charges and the surrender charge. Yeah, there’s a charge for ending the policy.
- When you cancel an IUL policy, you give up two huge things—your death benefit and, even worse, most or all of the cash value you’ve managed to build. Whoops! Makes you wonder what exactly you were getting for all those high premiums.
- Because the pesky fees keep returns pretty low, your IUL investment will never beat inflation, which is one of the main goals of investing. Let’s not go there. Check out investing in mutual funds through a Roth IRA or 401(k) if you want to get ahead of inflation and actually make something.
- If you have a max-funded IUL, your growth will also be under the cap set by the insurance company. So no matter how well the index fund does, your returns will always be less than the cap. For example, if the cap is set at 10%, but the index fund gives really great returns one year at, say, 18%, you’ll still only get 10% returns. Plus, they can move the cap whenever they want (including downward). If the fund does poorly one year, they can set the cap even lower—and you’re getting even less than the crappy returns you would’ve made.
- Market performance affects your premiums, which might rise or fall depending on how well the index fund does. But premiums can definitely rise in a down period. And remember what we discussed about unaffordable premiums? You’ll risk losing the life insurance coverage that was supposed to be the whole point of buying the policy! It’s like signing a prenup that lets your spouse ditch you if your portfolio dips—a bad deal all around.
Again, an IUL tries to solve two unrelated financial issues and is no good at solving either. Having the two services wrapped together winds up making the insurance portion very expensive, especially compared to what you’d pay for another option.
IUL Insurance vs. Other Life Insurance Policies
I think it’s pretty clear already that an IUL isn’t your best bet for life insurance. But let’s compare it with a few other kinds.
IUL vs. Term Life
The real purpose of life insurance is to guarantee that when you’re young and healthy, the people who depend on your income will be okay even if something bad happens to you.
Term life insurance is designed to keep coverage simple. Based on your age, term life companies look ahead 15 or 20 years and figure out the average price to insure you throughout the term. Then you buy insurance for a term that lasts roughly as long as you will have people depending on your income. That’s it!
It’s way cheaper than what you’d get with any form of permanent coverage. And the price is locked in throughout the life of the policy—no fluctuating premiums and no worries about a bad stock performance wiping out your policy. Once you no longer need life insurance, you can drop the premiums and put the savings toward your tax-advantaged retirement accounts. Doesn’t that sound like a much smarter way to be sure your family is covered? (That’s rhetorical. It is!)
IUL is designed to last your whole life, which means you’re paying for life insurance way longer than you need to (because, as I mentioned earlier, if you follow the Baby Steps, you should be self-insured by the time your kids fly the nest).
IUL vs. Whole Life
Let’s start with the obvious: IUL and whole life are both forms of permanent life insurance. I’m not a fan of either kind, but some IULs will have a guaranteed minimum interest rate. That means it’s possible you’ll see slightly better returns on your cash value with an IUL than with whole life. Overall, it’s like comparing Peloton versus NordicTrack: There are differences, but you’re getting a similar product either way.
IUL vs. Variable Life
Next, let’s compare IUL and variable life. Once again, we’re talking about two different forms of permanent life insurance—otherwise known as two flavors of something gross (like those congealed salads your Aunt Donna brings to Thanksgiving every year).
Unlike an IUL, a variable life policy lets you pick from a variety of investment options to put your cash value into. Big whoop. It still messes with your life insurance, and it doesn’t compare as an investment to good old mutual funds. Hard pass.
Is an IUL Better Than a 401(k)?
Credit card versus debit card—is one superior? To ask is to answer. But just in case it’s not obvious yet, credit cards are dumb, and an IUL is totally inferior to a 401(k)—or any kind of tax-advantaged retirement account that invests in growth stock mutual funds. Stick to your 401(k).
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Building Wealth With IULs
An IUL is a terrible wealth-building tool. To repeat, letting an insurance company invest your money for you is an extremely overrated strategy to grow money. And the only ones who will tell you otherwise are the slimy life insurance salespeople selling it.
If the problems with IUL investing still aren’t clear, think about how the insurance company will pay out interest. Index funds are paid out by taking the average of the returns from a large group of funds. We emphasize average because in the investment game, you want better than average. So, while index funds generally trend up over the long term, they’re also less flexible than investments that let you choose from among many good growth stock mutual funds—our top choice for long-term wealth building.
Plus, since this is an investment, it’s subject to the same risk all investments share—you could lose money. With an IUL, your cash value could shrink or disappear completely if the IUL doesn’t have a guaranteed minimum rate of return. That sucks. This is why I’m telling you an IUL does a terrible job at being both a death benefit and an investment opportunity.
To recap on IULs, you’re looking at a sucky form of investment that doesn’t give you much buying flexibility or above-average rates of return. Not to mention, all the insurance fees end up devouring the already unimpressive cash value growth. Even that Miller High Life is starting to look good.
The Truth About IULs
Above all, life insurance has one job: to replace your income when you die. That’s it. IUL might do that, but it might also rob you blind before you ever see the benefits pay out. Life insurance is there to provide for your loved ones, not make them rich. Maybe you’re thinking, Yeah, IUL does sound like a big mess—but I’m still not completely sure what to do next.
Let me give you some next steps toward getting the best coverage possible for you and your family.
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Next Steps to Get the Right Life Insurance Coverage
- If you already have IUL insurance and this article convinced you to switch to term life, be sure to get the term life coverage in place and active before canceling your existing policy. That current policy is better than nothing, and you never want even a brief gap in coverage for life insurance.
- If you have a lot of general questions about coverage, check out the Ramsey term life resource page.
- Or if you’re wondering how much coverage you should get, check out this handy term life calculator to get a realistic idea of how much coverage you need for your specific situation.
- Maybe you’re curious about cost: Try this term life estimator to get a solid sense of how much you can expect to pay for term life insurance.
- Once you’re in the market for new life insurance or want to talk to an expert, I recommend working with RamseyTrusted provider Zander Insurance to get your free term life insurance quotes today.
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What does indexed mean in life insurance?
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The word indexed in the term IUL applies to the cash value. Your money is tied to—but not invested directly in—an index (that’s just a list of companies investment experts use to figure out how well the stock market is performing). By tracking the index, the company figures out what interest rate to pay on your account. (FYI, IUL returns rarely beat inflation because of all the fees.)
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Is an IUL tax-free?
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Any investment growth in your IUL cash value account is tax-free.
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Can you lose money with an IUL?
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As an investment, an IUL does include risk—so yes, you could lose money. The only exceptions would be if your IUL has a guaranteed floor for value or a minimum rate of return (guaranteed floor just means the life insurance company promises your account won’t go below a certain amount).
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Is IUL insurance a good option for retirement?
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An IUL is a very bad option for retirement planning. As with any investment tied to an index fund, your returns will be mediocre at best. About the most you can expect the cash value to do is beat inflation over time—and even that’s iffy. Plus, you’ll never get as good a return from an IUL as you’d see from investing in mutual funds in a Roth 401(k) or IRA.
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About the author
George Kamel