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Understanding the differences between universal life and indexed universal life can help you choose the option that better fits your goals. Both are types of permanent life insurance, but they work differently. Comparing their features may clarify which aligns with your needs and comfort with risk.
How Does Indexed Universal Life Insurance Work?
Indexed universal life (IUL) insurance offers similar core benefits to traditional universal life, but it uses a different method for growing the policy’s cash value.
With IUL, your cash value isn’t tied to a fixed interest rate. Instead, it’s credited interest based on the performance of a stock market index, such as the S&P 500. However, your money is not directly invested in the market. Instead, the insurer uses a formula that includes:
- Participation rate: The portion of the index’s return credited to your policy
- Cap: A ceiling on how much interest you can earn
- Floor: A minimum interest rate, often 0%, that protects against losses
For example
Say your IUL policy tracks the S&P 500, and your contract includes a participation rate of 80%, a cap of 10%, and a floor of 0%. You have $10,000 in cash value.
- If the S&P 500 goes up 12%, you’d earn 9.6% (80% of 12%), or $960, bringing your cash value to $10,960.
- If the index jumps 20%, your gain would be capped at 10%, so you’d get $1,000.
- If the market drops 8%, you’d earn 0%—no loss, but no gain either. Your cash value stays at $10,000 (not counting fees or other changes).
This example is for illustration only. Actual results may vary, and growth isn’t guaranteed. Participation rates, caps, and floors can vary by policy and may change over time. Be sure to review your contract to understand how your policy works.
Key Features
- Market Index-Linked Growth: Cash value growth is tied to index performance, not a fixed rate
- Downside Protection: A 0% floor typically helps shield your cash value from negative index returns
- Upside Limits: Caps or participation rates may limit how much interest is credited
- Tax-Deferred Growth: Gains typically grow tax-deferred
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How Does Universal Life Insurance Work?
Universal life insurance is a type of permanent life insurance that combines a death benefit with a cash value component.1 It’s designed to offer flexibility, both in how you pay premiums and how you adjust your coverage over time.
When you make a premium payment, it’s split into two parts: one pays for the cost of insurance, and the other goes into your policy’s cash value. That cash value earns interest, usually at a minimum guaranteed rate. Some insurers may credit more based on market interest rates or their own investment performance.
Unlike whole life insurance, which typically locks in both the premium and interest rate, universal life lets you change how much you pay, as long as there’s enough value in the policy to cover the insurance cost.
Key Features
- Life-long Coverage: Provides lifelong coverage as long as the policy is funded properly.
- Premium Flexibility: You may be able to increase or decrease payments within certain limits.
- Adjustable Death Benefit: Some policies allow you to increase or decrease the death benefit with approval.
- Cash Value Accumulation: Earns interest at a rate set by the insurance company.
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Deciding Between IUL & Universal Life
Both indexed universal life and traditional universal life offer flexible, long-term coverage with a cash value component. The right choice for you may depend on how you prioritize growth potential, risk tolerance, and the level of involvement you’re comfortable with in managing your policy.
Costs & Fees
Both UL and IUL policies come with costs like insurance charges, admin fees, and potential surrender charges. Costs vary widely by insurer and product. Some IULs may include multipliers or riders that increase costs. UL often has lower premiums but offers more modest growth in cash value.
Suitability for Long-Term Goals
When comparing UL and IUL, think about whether your long-term goals. UL may suit estate planning, while IUL could help build more value for wealth transfer or retirement income. Both offer access to cash value, but IUL may have more upside.
Risk & Preference
Both indexed universal life (IUL) and universal life (UL) include a cash value component, but they grow differently. UL generally offers more predictable, stable returns based on insurer-declared interest rates tied to conservative investments.
IUL, on the other hand, links growth to a stock market index, offering more upside potential but with added complexity, caps, and variability. Your comfort with market-based movement may guide which option feels like the better fit.
Remember, indexed universal life policies do not invest directly in the market or participate directly in any index. The index-linked interest is calculated using a formula.
Tax Considerations
Cash value growth is generally tax-deferred with both UL and IUL. Withdrawals are generally tax-free up to the cost basis, but loans and withdrawals that cause the policy to lapse could result in taxable income. Overfunding an IUL may cause it to become a Modified Endowment Contract (MEC), which could eliminate certain tax advantages.
Medical Exams, Providers & Claims Experience
Permanent policies typically require a medical exam, and the insurer’s reputation matters. It’s worth researching the provider’s financial strength, how it handles claims, and whether it offers added options like estate planning tools or dividend payments.
Loans & Withdrawals
You can typically take loans or withdrawals from a UL or IUL policy, but doing so may reduce your death benefit and trigger fees or tax consequences, especially if the policy lapses.
Loans generally accrue interest, and withdrawals above what you’ve paid in could be taxable. Some policies also apply surrender charges or early withdrawal fees.
Which is Right For You?
You may want to consider Universal Life if you:
- Prefer steady, predictable growth
- Aren’t comfortable with market-based risk, even indirect
- Value flexibility in premium payments & coverage amounts
You may want to consider Indexed Universal Life if you:
- Want some exposure to stock market index performance without investing directly
- Are comfortable with more complexity in exchange for growth potential
- Want to potentially supplement income later through policy loans or withdrawals
Final Thoughts
Both UL and IUL are designed to offer long-term coverage with flexibility, but the right choice often depends on your priorities. Either way, it’s important to understand how each policy works and how it fits into your broader financial picture.
A financial professional can help you weigh the trade-offs and explore what may align best with your goals and risk tolerance.
Get personalized help with choosing between IUL and UL policies. Get a Free Life Insurance Quote
Sources
- National Association of Insurance Commissioners. "Life Insurance." https://www.westernsouthern.com/life-insurance/what-is-whole-life-insurance
