Indexed universal life insurance: How does it work & is it worth it?

Indexed universal life insurance provides lifelong coverage with the ability to invest in an index fund. But should you really use life insurance as an investment vehicle?

You may know you need to get life insurance, but life insurance policies can make you feel like you're looking into a maze of choices.

But, first and foremost, give yourself a pat on the back for considering life insurance at all — many people don't, to the detriment of their loved ones in the face of an untimely death.

Now, let's hone in on one specific type of insurance — indexed universal life insurance.

What is indexed universal life insurance?

Indexed universal life insurance is a type of permanent life insurance. This simply means that in addition to a death benefit for your loved ones when you die, it also incorporates a cash account benefit that can earn interest.

How does the money in your account earn interest? Just like you'd invest in index funds through a broker, your insurer invests your money in a stock market index like the S&P 500 or the Dow Jones Industrial Average.

How does indexed universal life insurance work?

Indexed universal life insurance works similarly to other types of permanent life insurance but the keyword, "index," makes it just a little bit different than other types of permanent life insurance.

One of the most important things to know before you choose this type of life insurance is to understand how index funds work. Index funds, one of the most successful ways to invest in the stock market passively, offer a great way to own all of the stocks in a certain market index. Over the past 10 and 40 years, the S&P 500 index has returned 14% and 11% respectively.

Naturally, as the value of the index fund goes up, the account earns interest. If the index drops, the account earns less or nothing.

Your premium payments (the payments you make per month) fund the index fund, like this:

  1. Your insurer will take your money for insurance costs, rider charges, and other fees.
  2. The rest of the money goes toward your cash account.
  3. Your insurer may take money from your account if you forget to make a payment or don't pay your insurer enough money for your premiums.
  4. You'll be subjected to "floors" — the lowest your account can go and "caps" — the most you can earn.

Pros and cons of indexed universal life insurance

Let's take a look at both the upsides and downsides of indexed universal life insurance so you can make sure it makes sense for your needs.

Pros of indexed universal life insurance

Universal life insurance can offer the following perks:

  • Great investment vehicle: Index funds offer one of the most popular investment vehicles on the market. As with anything, your success depends on how the index performs. However, your insurance company will share with you a minimum guaranteed return on your investment before you choose this option. The longer your money stays invested in the market, the more it can grow.
  • Guaranteed minimum fixed interest rate: Your insurer will usually promise a guaranteed minimum fixed interest rate, which simply means that you'll benefit even if the index doesn't perform well — you can't lose money because your account won't dip below 0%. Not all insurers offer a guarantee above 0%, but some do offer a guarantee near 1%.
  • Tax-free capital gains: Unlike most investors, who have to pay capital gains taxes on earnings, you don't pay capital gains on earnings with an indexed universal life insurance policy. However, if you decide to stop making payments on your policy before it matures, you may be subject to capital gains if you decide to withdraw.
  • Permanence: The highlight of permanent life insurance policies: You don't have to worry about them expiring. (Just make sure you make your payments.)

Cons of indexed universal life insurance

As with anything, you may face some drawbacks to choosing indexed universal life insurance:

  • Caps on returns: You may not benefit completely from an index fund rise — most companies set a "cap" or upper limit on what you can earn. This type of restriction can limit how much your account benefits each year, even when the underlying index performs well.
  • Costs increase over time: Many whole life policies average the cost out over a number of years. However, indexed universal life insurance policies increase over time. You'll pay less for your premiums at the beginning and they get more expensive as you age.
  • Fees, fees, fees: You may pay numerous fees, which can affect how much you earn through your policy. For example, you may pay extra for administrative fees, riders, commissions, and more. Check with your insurance company about fees before you choose the right type of life insurance for you.
  • You won't earn dividends: You won't earn dividends on the money in your account. (Dividends, or payments, involve a distribution of a company's earnings to its shareholders, as determined by the company's board of directors.) If you invested in an index fund through the stock market on your own, you'd potentially receive dividends, unlike with an indexed universal life insurance policy.

Is indexed universal life insurance worth it?

All of this information begs the question: What kind of policyholder should have an indexed universal life insurance policy?

This type of insurance policy works for just about anyone. If you want to protect your family and build cash value, you may want to choose this type of insurance. If you've always been interested in growing your money in the stock market but tend to be pretty risk-averse or don't like losing money at all, an indexed universal life insurance policy can offer a great option. You get instant protection so you don't lose money when and if the market tanks (something we've seen happen in recent years).

Talking to an experienced life insurance agent or broker can help you decide whether indexed universal life insurance or another type of life insurance makes the most sense for you and your family.


Melissa Brock is the founder of College Money Tips and a full-time freelance writer and editor. She loves helping families navigate their finances and the college search process. Check out her FREE essential timeline and checklist for the college search!

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