How Does It Work?
Permanent Life Insurance has a primary benefit of providing a tax-free death benefit. But it also offers the ability to build tax-deferred cash value overtime.
This value can be accessed while the individual is still alive in the form of loans or withdrawals. If structured correctly this can effectively create a “tax-free” income stream during retirement years.
At death these “loans” are then deducted from the death benefit reducing amount of the death benefit. If the insured dies prematurely, his beneficiaries have the benefit of the full death benefit effectively replacing his income.
In Section 7702 of the Internal Revenue Code, the IRS defines a life insurance contract and lays out a number of (rather complicated) criteria the policy funding must meet to maintain its status as a life insurance contract, and as a result, its tax-advantaged status.
With these programs, the policyholder’s mindset changes. Instead of viewing the premiums as a cost they are trying to maximize (“max out”) the amount they can contribute to a policy while remaining “life insurance” in the eyes of the IRS.
The good news is insurance carriers keep a close eye on contributions and will ensure you don’t fund your policy in a way that jeopardizes its tax status. In fact they have been known to not accept your money if your contributions would put you over any statutory limits.
How does the cash value grow?
Conceptually think about every month (or year or whatever you set up) your premium amount goes into two buckets: One is to pay your cost of insurance (e.g. pay for the death benefit) & the other is in an interest accruing account.
The non-insurance or interest-accruing account is typically tied to one or more “indexes.” Often this is an equity index such as the S&P 500® .
With most policies the individual has some flexibility in changing index strategies and within limits even contribution amounts.
Is it safe?
It is an insurance contract so insurers are required to maintain very substantial reserves. In fact those requirements are much higher than with banks.
The amount of interest that is credited will vary but it will never be negative (you can’t lose). If the index goes down you will either get zero interest (just in that period/month/year/etc.) or in some cases a small contractually guaranteed rate.
In most all contracts there will be a “cap” on the amount of index that will be credited. So if the index experiences a very high rate of return you will not be credited with all of the gain. You give up some upside potential in the market in exchange for safety.
The whole “indexing” concept has been explained simply as, “if the market goes up you share in the gain; if it goes down you don’t lose.”
Who is this type of policy ideal for?
The reality is anyone that can reasonably qualify medically for coverage and wants to take advantage of the many advantages of Indexed Universal Life is a viable candidate. It is effectively being used used by older people (60’s, 70’s, even early 80) and those with some substandard “ratable” health issues. When it is properly funded the higher cost of insurance can be more than offset by the many advantages in the product design.
It’s flexible design also means it can be used for more than just taking money out later as distributions (“Tax Free Retirement”). It can be used simply and elegantly as a cost efficient way of maintaining permanent (death benefit) life insurance.
Within the IUL marketplace there are a number of different types of IULs — some designed for asset/cash accumulation — some primarily for a permanent death benefit. It is important that you work with an agent that understands these differences an puts you into a policy that meets your objectives.
Who doesn’t IUL make sense for?
Simply put, someone that can’t afford the premiums and/or doesn’t appreciate that it is a long term contract (& commitment). You don’t want to get into a policy you don’t understand. You also don’t want to be in a position where you let the policy lapse. There is a great deal of flexibility in premiums, but if you aren’t comfortable with them you aren’t a good candidate for an IUL at the stage in your life. Hopefully the professional you are working with will tell you as much.
