Indexed Universal Life Insurance

What is Indexed Universal Life Insurance?

Indexed universal life is a permanent life insurance policy with a unique cash value accumulation structure.

The policy lasts for your entire lifetime, unlike term. Many people take advantage of it for the cash value growth benefits, in addition to the death benefit.

With the recent volatility in the stock market, clients are looking at alternative places to grow their money without risk. 

Why Do You Want Life Insurance as Part of Your Portfolio?

One of the benefits to this type of policy in addtion to its death benefit , is its potential to build cash value. You can take cash value from your policy to use for anything you choose through policy loans and withdrawals.

Interest is credited based on a fixed rate or how indexed accounts perform. While not directly invested in the stock market, the interest credited to an indexed account is based on the performance of the index.

Each indexed account includes a minimum crediting rate of 0% (the floor) that protects you from market based loss; it may also include a maximum crediting rate that would limit growth as well (the cap).

IUL's have a growth floor, usually between 0% and 2%. For example, if you have $100,000 in a regular stock account and it drops 15%, you will be down to $85,000. If you had the same amount in the cash value of an IUL and the index drops 15%, you still have $100,000 (minus fees) because of the floor.

In this example, let’s say that same index grows 15% the next year. In your stock account, you would have $97,750 – almost back to where you started. But in your IUL, which didn’t lose any money the previous year, you would be up to $115,000. The floor on the IUL prevents you from losing money, and more importantly, losing the time trying to regain your losses whenever the market drops.

No Taxes

Most qualified plans, such as a 401(k), will be subject to income taxes when you take income from your account. IRA’s have the same tax problem.

In an IUL, you have a tax-free death benefit that will pass on to your heirs. If your estate is large enough to trigger estate taxes, your life insurance policy can be put into a trust to avoid these taxes.

Loans are not income, according to the IRS. Since you are borrowing the money from your IUL, and not taking income from it, you won’t pay income taxes on this money. Because they are not taxable income, your yearly IUL loan in retirement won’t bump you up to a higher tax bracket. The distributions from your IUL are not reported on your tax return. As a result, this money also will not affect your social security taxes nor your medicare.

Death Benefit

IUL is a permanent life insurance policy. This means that you will not outlive the death benefit, whereas you probably will with a term policy. If something unexpected happens, your IUL will pay out a life insurance death benefit to your heirs. If your agent designed the IUL correctly, the death benefit grows as you fund the policy. Also, the death benefit pays out tax-free. This provides unbeatable peace of mind for you and your loved ones.

IUL Fees are Less Than Other Options

For the first 5-10 years, depending on someone’s age and health, the IUL will have higher fees than other financial vehicles. However, you may have this policy to age 80, 90, or beyond. If you’re 40 years old now, this policy may be with you for the next 50-60 years. Fees are front-loaded in an IUL. They start higher and then decrease. After the first 10 years or so, the IUL fees begin to become less than the prices in other options. When you look at the costs over 30-40 years or more, the total IUL fees are much less than other options over time. 

The IUL Loan Structure

The tax-free loans are one of the most compelling reasons to use an IUL for retirement income planning. Yet few advisors educate consumers on how these loans work. IULs offer different types of loans that you can take advantage of. The one I want to focus on is called an Indexed or Participating loan. When you need money from your policy, you call the insurance company and tell them how much to send you.

Indexed universal life loans don’t require applications. If you have the cash value in your account, you can borrow money. Remember, this is your money in your policy. You can access it wherever you want. You don’t have to apply for a loan or worry if you’re working or not. If you don’t want to pay back the loan, then the balance is subtracted from your death benefit when you pass. When accumulating funds in the policy, you’d typically want to pay back the loan. That way, you can use the money in the policy again and again. The IUL is a great option for a car purchase, home remodel, or any other large purchase.

The other great thing about IUL loans is that you can pay it back (if you want to) on your terms. If you want to take 3, 5, or 15 years to pay back the loan, it’s entirely up to you.

Is Indexed Universal Life Insurance Too Good To Be True?

Families have used permanent life insurance to build wealth for over 100 years. It’s not just the wealth within the cash value. You can use the loans at any time for any reason. You can use it to pay for vacations or cover a financial emergency, instead of depleting your savings. If an investment opportunity presents itself, you have the liquid capital to take advantage of it. Some people even use it to fund their businesses.

During the Great Depression in the 1920s, JCPenny was facing bankruptcy – closing its doors and putting even more people out of work. James Peny took out a loan from his life insurance contract instead of shutting down his store like so many others. It kept the lights on until the store could become profitable again.

Because this particular style of life insurance offers growth that’s sheltered from taxes, it becomes an excellent vehicle to build up liquid assets.

Tax Code 7702, TEFRA, DEFRA, TAMRA

These are IRS Codes that explain what qualifies as life insurance and how life insurance is taxed. As life insurance policies have evolved over the years, the IRS has added these new laws. Life insurance is an incredible tax shelter. Naturally, the IRS wants to have their say in the plan. These IRS codes set limits on the amount of cash value in the policy compared to the death benefit. 

They also established rules on the abuse of life insurance and how it can become taxable. These laws also created the MEC rule and 7-pay test.

MEC Rule

In the 80s, using life insurance as a wealth-building vehicle was so popular that the legislature had to impose new restrictions to prevent a massive tax loophole. Now, life insurance policies must pass a 7-pay test. If they fail, the IRS considers them a Modified Endowment Contract (MEC) and are subject to taxes. A MEC is very similar to how a 401(k) or IRA is taxed.  Before the MEC rule, you could fund an entire policy with a single payment. Now you have to pay premiums over at least 5 years to maintain all of the tax benefits listed above. 

This tricky rule is one of the primary reasons it’s wise to work with an insurance agent who has experience in designing indexed universal life policies. They need to know how to avoid the MEC classification. They also need to understand how to maximize the growth of the cash value rather than follow whole life or term policy design.