Saving Money and Taxes with Indexed Universal Life

By StevendrahozalUncategorized

What is Indexed Universal Life Insurance (IUL)?

Indexed Universal Life Insurance (IUL) combines permanent life insurance protection with an investment feature. It has a unique way of linking the policy cash value growth to a stock market index (like the S&P 500). You participate in the gains but not the losses. It is a flexible life insurance policy designed to serve you for your entire lifetime and can be changed over time to meet your future needs.

Why would I want to buy it?

One of the popular uses of IUL is to create an opportunity for you to have an additional source of money to help you throughout your life. You can become your own banker. Because it is a flexible premium life insurance policy designed to last your entire life, you could use it to:

  • Finance your home, car, boat, jet ski, or other recreational vehicles.
  • Supplement or finance your ideal retirement lifestyle.
  • Cover unplanned major expenses.
  • Pay off a mortgage early.
  • Help your children qualify for college financial aid.
  • Pay for higher education costs.
  • Have premium payment flexibility.

You share in the gain, not the loss

When your policy’s cash value uses an index strategy, you share in the gain of the index. Due to a cap rate, participation rate, or spread rate, you may not get the full value of the index when it is positive. On the other hand, in years when the index is negative, you do not lose money but instead get zero percent (0%) or the floor (minimum) rate.

How does this work?

Much like a deposit into a bank account, you pay a premium into your Indexed Universal Life insurance policy. A portion of the money pays for the insurance, and the balance is added to the cash value portion of the policy. The cash value earns either a fixed rate of return or a return based on the performance of an index.

  • Fixed Account – Is the account that is tied to the insurance company’s general account, and it earns a fixed rate of return based on what the insurance company earns on its general account.
  • Index Account – Pays a variable rate return based on the positive performance of one or more stock indexes, with a minimum (floor) of 0% or 1% rate of return in negative years. You can grow your money based on the index’s positive performance, but without the risk of losing it in a year with a loss (negative index performance).

Your money stays with the insurance company

The insurance company keeps your money safe and does not place it directly into the market. Instead, the insurance company credits interest based on the index’s performance using its hedging strategy and options. The insurance company takes the risk, not you.

For Example, here is how an index account might work:

Let’s assume a yearly cap rate of 9% on the index, or 9% is the maximum your cash value could earn in a year. At the end of:

  • Year 1, the index is +8% (up), and your cash value is credited 8%.
  • Year 2, the index is +21% (up), and your cash value is credited 9%.
  • Year 3, the index is -15% (down), and your cash value is credited 0%.
  • Year 4, the index is +3% (up), and your cash value is credited 3%.

In this example, your policy cash value shares the gain up to 9% (the cap rate) but not the losses. Many people prefer the downside protection IUL offers over investing directly in the stock market, where there is the potential for loss due to negative performance.

You do not get all the up

You share in the gains in a positive market but not the losses in a negative market. “Share” means there are limits to what you can receive. In most policies, these maximums are determined by the strategy used by the index, such as:

  • A cap or maximum you can earn.
  • The participation rate or the percentage you can earn.
  • A spread or fee that is paid first, then you earn the rest.
  • Some combination of Cap, Participation Rate, or Spread.

Most insurance companies reserve the right to adjust these index strategy limits over time. Working with a large, highly rated, reputable company might be in your best interest.

IUL Tax Advantages

Life insurance has a few key tax advantages that appeal to people. For most individuals, IUL offers four key tax advantages:

  1. At death, beneficiaries receive tax-free death benefits.
  2. There are no taxes on the cash value growth in the policy as it accumulates on a tax-deferred basis.
  3. You can withdraw all the premiums you paid tax-free, but taxes would be due on any gains withdrawn.
  4. Loans are not considered taxable income while the policy is in force and ultimately are paid off at death with the tax-free death benefit.

The ability to make tax-free withdrawals during your lifetime can be very appealing.

Be Aware of 7702

Section 7702 of the Internal Revenue Code requires a life insurance policy to have a certain ratio of the death benefit to the premiums paid. In other words, to keep the tax-advantage withdrawals and loans, there are limits to what you can pay into your policy. Otherwise, your policy could become a Modified Endowment Contract (MEC) and lose its favorable tax treatment or withdrawals and loans, with the addition of a 10% tax penalty under age 59½. A knowledgeable financial professional should be able to provide you with guidance on the limitations of any IUL policy you purchase.

How do I get to my Money?

Over time, after accumulating some cash value in your IUL, you might want to use it for a major purchase. Rather than borrowing from the bank, you borrow from yourself. You can generally borrow up to 95% of the cash value and pay yourself back the principal and interest. Loan rates vary between insurance companies but are usually between 4% and 8% simple interest. Meanwhile, the cash value can continue compounding on the full amount.

How do I make this happen?

The key to a successful IUL is how you use it. To use your policy like a bank and/or for retirement, you will want to:

  • Overfund the policy and minimize the cost of insurance.
  • Borrow tactically when it is in your best interest.
  • Repay the loans, but you choose the timeframe, not the bank.

Example: Retiring with an IUL

When using your Indexed Universal Life insurance policy for retirement, you must keep it in force for the rest of your life or risk making the loans taxable. But here is how retirees live on money from their IUL:

  1. When you retire and want to use your IUL for income, you start by withdrawing the premium you paid into the policy using tax-free withdrawals.
  2. To avoid paying taxes on the cash value gain (interest earned above the premium paid), you now withdraw by taking loans. You continue to draw money off by borrowing from the cash value and allowing the loan to pay for itself.
  3. When you die, the tax-free death benefit pays off the loan tax-free, with any remaining death benefit paid to your beneficiaries.

Not everyone can qualify

While all this might sound great, because there is underwriting for the life insurance portion, not everyone will be able to qualify. Your health is what buys the coverage. Good health and you get reasonable rates. Not such good health might cost more, or you might be unable to purchase coverage.

For the $200,000 or more wage earner

Banks provide loans for a nicer home. But did you know that they will also provide funds to supplement your retirement savings? Supplemental funds can provide the potential for 60% to 100% more than your savings could achieve alone. This kind of leverage is not available to everyone, and only a few IUL insurance companies offer a plan. A knowledgeable financial professional can provide you with more information so you can make an informed decision.

Some other things to consider:

Like any financial product, IUL has some negative features (possible Cons) you should consider:

  • Slow Growth – It takes a few years to save a proper amount to borrow from.
  • Surrender Charges – There are penalties for early withdrawal or cancellation, usually in the first 10 years, but not for loans.
  • The cost of insurance is charged to the premium or cash value.
  • How strong is the insurance company that you chose?
  • Index cap rates, participation rates, and spread rates can change.
  • Uncertain long-term performance.
  • Potential to lapse the policy if the cash value gets too low.
  • It is a complex product to understand.
  • Some insurance companies have additional fees that could affect your performance.

Know your Insurance Company

The insurance company’s financial strength and claims-paying ability help secure the interest rate performance and guarantees. Therefore, it may be in your best interest to choose a large, highly rated company. You can check insurance ratings from sources like AM Best, Fitch, Moody’s, and Standard and Poor’s.

In Conclusion:

There are many reasons you might want to consider an Indexed Universal Life (IUL) policy:

  • You share in the gains of a stock market index when it is up.
  • You do not share in the losses of a stock market index when the market is down.
  • Cash Value Growth is tax-deferred, and you can make withdrawals tax-free.
  • You have access to the cash value on a tax-favored basis.
  • The premiums you pay are flexible.
  • The coverage can last a lifetime or for a shorter time if so desired.
  • The cash value and withdrawals have no impact on your Social Security payment.
  • When you die, your beneficiaries typically receive a tax-free death benefit.

If your goal is to grow your cash value, work with a financial professional who designs IUL policies with minimum costs and focuses on maximizing cash value growth.

Finally

These are the highlights of how an Indexed Universal Life (IUL) insurance policy works when an individual is purchasing it. Business and pension-owned coverage may be treated differently for tax purposes. All IULs are different, and you should consider these differences when applying for coverage. Please consult a knowledgeable Financial Professional before purchasing an Indexed Universal Life Insurance policy.

If you have any questions, please get in touch with us at info@themapc.com or (810) 632-9932.