Indexed universal life insurance is a unique product that offers many advantages for Infinite Banking. These advantages are similar to whole life insurance, but with a bit more risk and potential for higher returns.
Depending on your appetite for such risk, it could be a useful tool to incorporate into your infinite banking strategy. IUL insurance policies are complicated products that require an in-depth understanding for effective utilization. This guide explores the pros and cons of index universal life insurance and determines whether such a policy is suitable for growing your wealth.
What is Indexed Universal Whole Life Insurance?
Let’s start with explaining universal life insurance, how it compares to whole life insurance policies. Then we will look at the effects of indexing universal life insurance.
Universal Life Insurance Explained
Universal life insurance is a long-term wealth management strategy whereby customers pay a premium each month. Those contributions go towards both a death benefit and a cash value, which earns dividends. The cash value grows tax-deferred, and policyholders can use it as collateral for low-interest loans. Based on just this, universal life insurance looks very similar to whole life insurance.
The difference is their premium structures. With whole life insurance, policyholders pay a set life-long premium and receive a guaranteed death benefit. Universal life insurance is a more flexible option where policyholders increase or decrease their premiums depending on their financial situation. During affluent periods, premiums are higher, building up the cash value faster. While premiums lower during leaner times to protect policyholder liquidity.
Unfortunately, that flexibility also works in the insurance company’s favor. They can raise premiums as you age. This accounts for a higher risk that they’ll need to pay out the death benefit in the near future. Also, the death benefit adjusts accordingly as you pay more or less in premiums. Universal life insurance provides less certainty, which is why it’s not as commonly used for infinite banking.
Indexed Universal Life Insurance
While universal life insurance provides for flexibility in premiums, indexed universal life insurance offers exposure to risk and opportunity for higher returns. With indexed universal life insurance, policyholders designate a certain percentage of their cash value to be linked to a market index.
These indexes, like the S&P 500 or Russell 2000 track the value of hundreds, or even thousands, of U.S. companies. By tying your universal life insurance policy to these indexes, its growth will rise and fall with the U.S. economy. Indexed universal life insurance is a sensible alternative for customers that are more risk tolerant and less concerned about consistent growth. Indexed universal life insurance sees lower returns than direct market investment, but offers increased safety and a death benefit–with consistent premium payments.
Whole life insurance offers significant tax-benefits. Similarly, universal indexed policies offer a tax-advantaged environment for your money to grow, but without the withdrawal penalties and income limits associated with traditional 401ks and Roth IRAs. However, the manner in which these policies grow is much more complex than whole life insurance. Without a full understanding of their investment strategies, policyholders could realize less growth than whole life insurance policies.
Investing with Indexed Universal Life Insurance
Contrary to what the name might imply, indexed universal life insurance policies do not invest in index funds. Linking your policy to the index isn’t the same as investing in them, as many mutual funds and ETFs do. With an IUL, the cash value is “linked” to the index, but not invested in it. What exactly does that mean?
With whole and universal life insurance, policyholders receive a return on the cash value held by the insurance company. With an indexed policy that return is invested in options contracts. Options are financial derivatives allowing a person or an insurance company to pay a premium for the opportunity (but not the obligation) to buy or sell securities at a given price. They’re a popular method for investment firms to hedge against market volatility, since the options price is set weeks or months in advance.
With indexed universal life insurance, the company buys options. Then if the market goes in the predicted direction, they make a profit and distribute some of the proceeds to policyholders. If the market goes in the other direction, the options contract becomes worthless but doesn’t leave the holder with significant losses.
As such, the policy’s cash value doesn’t depreciate, since options were purchased with funds that would have been returns.. There’s a floor to their losses – a 0% rate of return. There are never negative returns with indexed universal life insurance and there’s always a clean slate for making new investments the next year.
The Hidden Costs of Indexed Universal Life Insurance
While indexed universal life insurance may appear to offer only upside potential, its complexities hide several costs and limitations.
Policyholders’ returns are usually capped each year. Companies often impose caps of 10-12%, regardless of the options contracts returns. These caps prevent policyholders from fully capitalizing on unusual market upswings. Leveraged life insurance differs in this way as it allows policyholders to potentially achieve higher returns without annual caps, giving them a greater share of market gains.
Additionally, indexed policies have something called a participation rate, the percentage of the capped return available to the policyholder. Even if the insurance company earns a 15% rate of return on an indexed policy, it might cap the policyholder’s returns at 10%, and with an 80% participation rate, the policyholder would actually receive only an 8% return.
Moreover, the intricate nature of this type of policy translates to higher fees compared to whole life insurance. These fees substantially diminish the growth potential of the policy, potentially rendering it less lucrative than anticipated.
Does that mean you should always choose whole life insurance over an indexed universal life insurance policy? Not exactly.
Indexed Universal Life Insurance Pros and Cons
Whether whole or IUL insurance is best for you depends on your financial situation and appetite for risk. Consider these important points before purchasing a policy.
Pros:
- Indexed universal life insurance policyholders can leverage policy loans against their cash value to invest outside the insurance policy, maintaining liquidity and flexibility.
- Indexed universal life insurance provides a middle ground for investors seeking exposure to the stock market, while mitigating risks associated with direct market investments.
- Despite market links, policy returns maintain tax-deferred status , akin to whole life insurance, enhancing overall gains.
- Premiums offer flexibility within certain limits, allowing policyholders to adjust their contributions accordingly with financial circumstances.
Cons:
- Indexed universal life insurance is a complex financial product with variable fees and limited growth potential
- For those pursuing infinite banking strategies, the certainty of minimum growth provided by whole life insurance may outweigh the allure of market exposure with indexed universal life insurance.
- The intricacies of indexed universal life insurance may deter investors from fully understanding its mechanisms, leading to suboptimal decision-making.
Choosing the Right Insurance Policy with Wise Money Tools
Infinite banking is a conservative financial strategy that relies on long-term growth through a life insurance policy. Whole life insurance is a simpler product that requires minimal input from policyholders once they choose the initial plan. Indexed universal life insurance offers a conservative approach relative to direct market investments. However, it presents opportunities for enhanced gains (or diminishing returns).
Whether whole life insurance or indexed universal life insurance is the right choice for you hinges on your financial goals and appetite for risk. While indexed universal life insurance gives exposure to the market, it does so within the confines of options contracts, mitigating downside losses and eliminating the chance of negative return on your cash value.
However, capped returns and high fees prevent indexed universal life insurance from being as stable of a path to wealth and increased cash flow. Whole life insurance is a safer option with more predictable returns. With whole life insurance, you introduce risk (and the potential for high returns) only during the investment stage, using policy loans backed by your steadily-growing cash value.
Here at Wise Money Tools we offer personalized guidance to navigate the nuances of choosing an insurance policy. By understanding your unique financial situation and risk tolerance we can tailor solutions that align with your long-term goals. Our free toolkit teaches you the basics of infinite banking and provides you with the baseline knowledge necessary to choose an insurance policy to fund this financial strategy. If you find yourself needing more personal advice, contact us and we can walk you through the process.
