This article was updated on May. 18, 2016.
Indexed universal life insurance plans are an interesting twist on traditional universal life insurance. Indexed universal plans (like all universal life insurance) carry a death benefit and a separate cash value that increases over time, but differ in how the non-insurance part of the plan is structured. In short, the premiums paid go toward the life insurance cost, fees, and with the rest going toward the cash value of the policy. The twist is that the cash value pays a return based on increases in an equity index, like the S&P 500, versus a fixed rate as with standard universal life insurance plans.
If you're considering indexed universal life insurance, you're probably already familiar with the details of universal life insurance, so let's skip an in-depth look at these plans and review some of the pros and cons that you should factor into your decision.
- Tax-deferred growth of cash value.
- No contribution limit on policy contributions can make them attractive for tax purposes because of tax-deferred growth.
- Exposure to stock market indices may offer better long-term growth versus other universal life plans.
- Premiums can be lower than traditional universal life insurance plans.
- Lower risk than stock investing, since cash value won't decrease if the target index falls.
- May offer better returns than other universal plans in a strong stock market.
- Since the insurer makes its money by keeping a portion of the gains, returns will always trail the index.
- May pay lower returns than other universal life plans in a poor stock market environment.
- Depending on your situation, the total costs paid may net less long-term benefits versus other insurance and separate investing alternatives.
Foolish bottom line
Universal life insurance plans, including indexed universal life, frankly, aren't good choices for the vast majority of people. There are some tax benefits, but they are almost only of real value for high-wealth/high-income earners or business owners, and often come at too high a cost with too low of potential returns for the tax benefits they provide.
There are other downsides, including caps on potential returns that can make them poor ways for the average person to build long-term wealth and have adequate life insurance, versus separate investment accounts and life insurance policies.
In summary, just like any financial instrument, what makes sense for one person may not be right for you. Take the time to understand the benefits and risks, as well as to look closely at alternatives that may be a better fit.
Before buying complicated insurance products like universal and indexed universal life insurance, make sure you're taking full advantage of other tax-deferred investing alternatives such as traditional or Roth IRAs, combined with stand-alone term life insurance first. For most people, this will be a more affordable choice, and potentially a better long-term value.
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