Should You Consider Indexed Universal Life Insurance?
In short, if you’re offered Indexed Universal Life Insurance (IUL), you should consider it very carefully, and then probably trap it at your six o’clock and light the burner to make your escape. But what is Indexed Universal Life Insurance and why should you be wary of it?
Indexed Universal Life Insurance 101
You’re probably familiar with Term Life Insurance (TLI). You pay a monthly premium for a term, often 20 years, and in return if you pass away your beneficiaries receive a tax-free lump sum—the face value of the policy. If you live through the term, the insurance expires so you need to have a plan (such as becoming self-insured through wealth-building investments) for the absence of that insurance. Some policies may allow you to convert expiring TLI into permanent life insurance.
There are as many names and types of permanent life insurance as there are salesmen trying to separate you from your wallet, but the most basic is Whole Life Insurance (WLI). With a WLI policy, you pay a larger premium than TLI, and you usually keep paying it until you die, or you’ve paid the face value amount, e.g., $500,000. Whole Life Insurance masquerades as a savings vehicle too because part of your premium gets separated into a savings account within the insurance policy and earns a stated rate of interest.
Indexed Universal Life Insurance lives somewhere in the middle. It’s meant to be kept until you die, it builds some cash value, the premium is usually lower than WLI, and the savings component is tied to an investment index like the S&P 500. The promise of IUL is that it can provide index investment-like returns, tax-free loans from the cash value, permanent coverage, and lower premiums than WLI. What’s not to like?
IULs advertise a minimum rate (floor) of the target index that you’ll receive, such as 0% or in the case below, .75%. However, IULs won’t give you the actual positive returns in a good year, for the index. Instead, you’ll be capped at certain rate such as 13.75% in example below.
IULs are sold as never providing negative returns, which could be true for the cash value but is never true for your actual invested dollars.
A Shout Out to Personal Finance Club
One of my favorite blogs (and Instagram feeds) is Personal Finance Club. It’s host, Jeremy Schneider gives great free personal finance information in an accessible format without being a shill for any large corporation.
Recently Jeremy wrote a lengthy Blog and even guest hosted the Stay Wealthy Podcast to cover his own personal experience buying a IUL policy for the sole purpose of evaluating what he was sold versus what he bought. The title of his article? “Is IUL a Scam? Yes.”
His article is lengthy, but if you’re considering IUL or one of its cousins sold as “Infinite Banking” or “Bank on Yourself,” it’s must-read. Jeremy breaks down 10 reasons why he thinks IUL is a scam and while I won’t just repeat his observations, I’ll hit the highlights and add some considerations he left out.
What’s unique about Jeremy’s article is that, unlike most detractors of policies like IUL, Jeremy essentially went undercover to experience (and record) the sales process from two different life insurance salesmen, actually bought a policy (he didn’t need) and then went line-by-line through the 91-page policy contract to compare the sales pitch versus the contract he received. In other word’s Jeremy’s experience isn’t just another person shouting from outside the octagon. He entered the fight.
Reasons to Reconsider Index Universal Life Insurance
- The sales material will most likely cherry-pick a set of years to compare the IUL’s returns versus the stock index… and conveniently forget to mention the topic of dividends. Jeremy’s policy tracks the S&P 500 and the sales material showed a series of years where the IUL beat the S&P 500.
- Problem #1: The data was cherry picked to take advantage of the index floor of .075% during a period where the S&P 500 had multiple years of negative returns. IUL policies champion the feature that the cash value never decreases due to negative returns in the index. Jeremy’s policy had a floor of .75% which sounds comforting in years like 2008.
- Problem #2: Since IULs don’t invest in the underlying stocks of an index, they do not receive or pay dividends and therefore cannot reinvest dividends as most investors do. This is enormous for compounding and in Jeremy’s case, it resulted in the IUL’s advertised performance being about 1% below, not above the S&P 500.
- The fees. Since the core decision when considering “buy Term and invest the rest” or purchasing a franken-investment by combining an insurance policy with an investment is whether you’ll have more money with a pure investment (e.g., index fund) or with the insurance policy? It’s crucial to look at costs.
- Buying a mutual fund, exchange-traded fund (ETF), or stock at a large, low-cost brokerage these days usually has the following costs:
- Account opening: $0
- Ongoing account maintenance: $0
- Purchase or sale of investment: $0 You get the picture…
- Jeremy’s IUL had a $200 per month premium and the following fees are deducted from that before investing into the cash value:
- $4.50 cost of insurance (increases over time with age)
- $12 (6%) premium expense charge (to cover insurance company costs and taxes)
- $12 policy fee
- $59 fee associated with the size of the policy
- 491% surrender charge fee that declines from years 11 to 16 of the policy (paid if you surrender the policy early)
- .72% annualized fee to cover costs of indexing (taken from the cash value versus the premium)
- This results in fees of $87.50 out of $200, a -44% instant return compared to $200 invested directly into the index fund.
- If the policy is kept into advanced age, the fees can dwarf the premium as the cost of insurance rises. This means that the cash value begins to erode to pay the premium.
- The punchline of the fees when compared to an investment directly into an S&P 500 index fund from 1982 to 2021 is that the IUL would return 5.4% versus 11.9% for the index fund. The cash value?
- IUL: $320K
- Index fund: $1.797M
- Taxation. My $.02 is that the Jeremy could have presented the taxation pros and cons a little cleaner. Rather than comparing tax effects of purchasing an IUL versus purchasing an index fund in a taxable brokerage account, he muddies the water a bit by adding in the tax benefits of purchasing the index fund in a qualified retirement account.
- Buying a mutual fund, exchange-traded fund (ETF), or stock at a large, low-cost brokerage these days usually has the following costs:
Since you can’t buy the IUL inside of many qualified retirement accounts (or any IRA), it’s best to look at the tax ramifications of a taxable brokerage account versus and IUL.
Using Jeremy’s table, after 20 years, the IUL would have $68,330 of cash value and the index fund would have $204,878. Let’s assume that you need $30,000 to fund a goal.
- Taking $30K from the IUL as a loan results in no immediate tax effect. With some policies, you’ll actually still receive returns as though the $30K was still in the policy, however you’ll likely accrue interest on the loan commensurate with the return, pay fees to process the loan, and deal with stipulations of the insurance company on the speed of the loan.
If the loan is never repaid, the interest could eventually cause policy lapse.
- Taking $30K from index fund will result in taxation. In fact, the index fund will likely result in taxation each year you own it. The actual taxation will vary based on many factors, but let’s look at a reasonable scenario:
- 2% dividend yield. If the index fund pays an average of 2% in dividends each year, and most of the dividends are tax-qualified, then you’ll pay 15% on that 2%. In the example year 20 above, the bill might be $615. That doesn’t count the taxes you might have paid in the previous 19 years.
- Capital gains distributions. Because indexes change the underlying stocks infrequently, capital gains distributions should be minimal, but they could be non-zero.
- Capital gains tax on sale of $30K from the index fund. This is where things get even more complicated. Let’s assume a basis of about $60K on the $204,878 of the index fund investment. What would the tax bill be to pull out $30K? It depends.
- If there are underlying share lots with losses, using tax-loss harvesting could result in a tax savings rather than a tax bill.
- If using FIFO or LIFO (first or last in… first out) methods, the tax bill will be based on the gain over the basis of the various share lots.
- If selling specific share lots, it will be possible to sell the highest basis shares in order to minimize the tax effect.
- If using the average cost method, then it might be reasonable to assume gains of 70% of $30K, so $21,500. At 15% capital gains rates, that’s an additional tax bill of $3,150.
- Second and third order effects of capital gains taxes. While capital gains taxes won’t increase your ordinary income rate, they will increase your exposure to the following adverse tax consequences:
- Tax on Social Security Benefits
- Medicare Tax (IRMAA)
- Net Investment Income Tax (NIIT)
- Tax deduction and credit phaseouts
So, the question could be looked at as, would you rather pay $3,765 to have $204,878 or $0 to have $68,330? Even that isn’t a great comparison because it only looks at the cost of accessing the $30K at a single point in time and doesn’t consider the taxes paid annually on the index fund investment.
Going back to the overall costs of an IUL policy versus a stand-alone index fund, Jeremy found that over 40 years, the cost of his $100K face value IUL was $78,729 with an expected cash value of $320K. The cost of the index fund purchased with the same $200 per month was only $44,030 with an expected cash value of $1.797M.
That question might be the better one to ask if you’re not really interested in policy loans—would you rather pay $78K to get $320K or $44K to get $1.8M?
- Other considerations. This last part is a grab bag of other things to consider about IUL:
- Fees and rates probably aren’t static. Jeremy’s policy allowed the company to change both fees and the returns that he could earn. Neither the .75% floor or 13.75% ceiling were permanent.
- To borrow from an IUL, you must either wait decades for the policy to build useful value or dump loads of extra cash into it in the form of paid-up additions. Those will suffer fee-drag too.
- While not necessarily advisable, it’s possible to take a loan against an investment account. Like all loans this would be tax-free.
- As with nearly all permanent life insurance, when you die, your beneficiaries receive the face value, not the cash value. If you build up $320K on a $100K face value policy, your family gets $100K and insurance company keeps the $320K. If you truly hold this policy until death, you need a plan to rescue the cash value.
Cleared to Rejoin
Indexed Universal Life Insurance is a complex product. It’s designed to be sold as a sophisticated tool for avoiding taxes and building wealth. Jeremy Schneider does a great job exploring the delta between what he was sold and what he actually bought and the devil was in 91 pages of details.
If you’re considering using life insurance as an investment, you may want to explore the following questions before writing that first check:
- Am I willing to part with a lot of cash over several years to avoid a bank loan?
- Am I willing to generously compensate an insurance company to avoid compensating a bank?
- Am I willing to wait years, potentially decades, to start accessing loans against my own money?
- Am I willing to pay more for an underperforming investment than I must for a better performing investment?
- If I need loans, have I accurately compared all the ways I can access loans?
- Have I interviewed people that have successfully employed IUL that aren’t affiliated with the insurance industry?
- Will my 85-year-old self be savvy enough to avoid leaving more to the insurance company than to my family?
You can imagine that the list goes on. At the end of the day, Caveat Emptor—Buyer Beware.
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