Turning a dollar into 4 or 5 --tax free*

All About Indexed Universal Life Insurance for Cash Accumulation

Indexed universal life is a permanent life insurance policy with a unique cash value accumulation structure. The policy lasts for your entire lifetime, unlike term. However, many people take advantage of it for the cash value growth benefits, in addition to the death benefit.

With the recent volatility in the stock market, clients are looking at alternative places to grow their money without risk.

The retirement vehicle of choice for many is the 401(k). However, a 401(k) has market risk, postpones taxes to the future, and does not allow you to use your own money without penalties and taxes until you are age 59.5. It’s not the ideal retirement solution.

Insurance companies created IUL to give you the tax advantages of growing money in a life insurance policy, plus the best features of growth without the potential for loss.

Consumers are flocking to the safety of indexed universal life insurance as the product had $2.3 billion in sales for 2019.

Why Do You Want Life Insurance as Part of Your Portfolio?

 Most people who look into IUL policies will use them as part of their retirement strategy. Tax-free loans from the policy make this particularly attractive if you expect tax rates to increase in the future. If you do not pay the loan back – no problem. The loan is paid back by being subtracted from the death benefit when you pass.

Some people looking into an indexed universal life policy use it as a supplemental wealth-building tool to their more traditional investments. There are no age restrictions on loans, unlike a 401(k) and IRA, so it allows for a more liquid wealth-building tool.

Avoid Stock Market Risk

Most people with investing knowledge can tell you that the stock market return averaged over its history is right around 8%. The lesser-known statistic is most investors average around 4% or half of the actual market returns.

 A variety of factors combine to account for this minuscule growth. The biggest factor is emotion. Investors panic and sell when the market drops. Then they are not in the market when it goes back up. Timing the market is tough. Many investors buy high and sell low.

Warren Buffett says that the first rule of investing is to never lose money. The second rule of investing is not to forget rule #1. An IUL does not lose money due to stock market drops.

IULs have a growth floor, usually between 0% and 2%. For example, if you have $100,000 in a regular stock account and it drops 15%, you will be down to $85,000. If you had the same amount in the cash value of an IUL and the index drops 15%, you still have $100,000 (minus fees) because of the floor.

But here’s the best part. In our example, let’s say that same index grows 15% the next year. In your stock account, you would have $97,750 – almost back to where you started. But in your IUL, which didn’t lose any money the previous year, you would be up to $115,000.

The floor on the IUL prevents you from losing money, and more importantly, losing the time trying to regain your losses whenever the market drops.

This is a graph of how the money would have grown in an index compared to actually being in the S & P 500 (Index of the 500 largest U.S. publicly traded companies) over the past 20 years.

 Compare the growth of money in the S&P to money in the S&P 500 index with a floor of 0 and cap of 12%. You would have earned $131,255.98 more being in the index with cap and floor.

Both the indexed growth (blue line) with the cap and floor and the actual S & P growth (red line) start at $100,000. You can see that when the actual S & P has a down year, the index does not go down and is protected with the 0% floor.

You can see the difference in saving $100,000 in the S&P compared to an IUL with a 12% cap and 0% floor over the last 20 years. You would have earned $131,255.98 more with the IUL. The IUL growth is tax-deferred and tax-free when you take it out.

When the S&P has a negative year, the floor of 0% prevents a loss of principal. When the S&P has a gain, the IUL receives the same gain up to the cap.

Over time, protecting your downside, makes a big difference in your accumulated savings.

 No Taxes

Most qualified plans, such as a 401(k), will be subject to income taxes when you take income from your account. IRA’s have the same tax problem.

In an IUL, you have a tax-free death benefit that will pass on to your heirs. If your estate is large enough to trigger estate taxes, your life insurance policy can be put into a trust to avoid these taxes.

Loans are not income, according to the IRS. Since you are borrowing the money from your IUL, and not taking income from it, you won’t pay income taxes on this money.

Also, because they are not taxable income, your yearly IUL loan in retirement won’t bump you up to a higher tax bracket. The distributions from your IUL are not reported on your tax return. As a result, this money also will not affect your social security taxes nor your medicare.

Death Benefit

IUL is a permanent life insurance policy. This means that you will not outlive the death benefit, whereas you probably will with a term policy.

If something unexpected happens, your IUL will pay out a life insurance death benefit to your heirs. If your agent designed the IUL correctly, the death benefit grows as you fund the policy.

The death benefit pays out tax-free. This provides unbeatable peace of mind for you and your loved ones.

IUL Fees are Less Than Other Options

One of the most common myths about Indexed Universal Life insurance is that it is exorbitantly expensive. You’ll read this a lot from advisors who don’t want to lose your money to an IUL. IULs indeed have higher fees initially. For the first 5-10 years, depending on someone’s age and health, the IUL will have higher fees than other financial vehicles. However, you may have this policy to age 80, 90, or beyond. If you’re 40 years old now, this policy may be with you for the next 50-60 years.

Fees are front-loaded in an IUL. They start higher and then decrease. After the first 10 years or so, the IUL fees begin to become less than the prices in other options. When you look at the costs over 30-40 years or more, the total IUL fees are much less than other options over time.

The other point is that “fees are only a problem in the absence of value.” I personally don’t mind paying fees if I’m getting more in return than what I pay. Think about what you are receiving for the expenses in an IUL:

• Tax-free distributions (this alone is worth much more than the fees)
• Guaranteed protection from a stock market drop
• Life insurance tax-free death benefit
• Unstructured loans
• Indexed growth
• Creditor Protection (varies by state law)
• Living benefits

The IUL Loan Structure

The tax-free loans are one of the most compelling reasons to use an IUL for retirement income planning. Yet few advisors educate consumers on how these loans work.

IULs offer different types of loans that you can take advantage of. The one I want to focus on is called an Indexed or Participating loan. When you need money from your policy, you call the insurance company and tell them how much to send you.

Indexed universal life loans don’t require applications. If you have the cash value in your account, you can borrow money.

Remember, this is your money in your policy. You can access it wherever you want. You don’t have to apply for a loan or worry if you’re working or not. If you don’t want to pay back the loan, then the balance is subtracted from your death benefit when you pass.

When accumulating funds in the policy, you’d typically want to pay back the loan. That way, you can use the money in the policy again and again. The IUL is a great option for a car purchase, home remodel, or any other large purchase.

I go over the math behind why I used my indexed universal life insurance policy to buy a car here. At the end of the loan, I have my car paid off and all of my money back in my policy. It’s much better than paying back a bank and only having your depreciated car at the end of the loan.

The great thing about a participating loan is that the loaned amount stays in your policy earning compound interest. The money that the insurance company loans to us comes from their general account. There is usually an interest rate to borrow this money. It could be 5 – 6% or some companies peg their loan rate to an index, such as Moody’s corporate bond rate.

Let’s say the insurance company charges 5% on these loans. Your money is still in your policy earning indexed interest. Some years, you may earn 10% interest on your policy. If you are paying 5% and making 10%, you receive a 5% positive arbitrage on your loan. That’s pretty awesome for wealth-building.

Other years, if your policy earns 0% interest, then that 5% interest will come out of your cash value. If you look at the average rate of return on these policies, which is currently 6-9%, you will statistically earn a positive arbitrage more years than not.

This will allow your money to continue growing in the policy, even when you are borrowing money for purchases. By the time you reach your retirement years, you may have quite a bit of cash built up in your policy that you are earning interest on.

When you start taking retirement distributions from the policy, you may earn more in interest than the distribution you are taking out. That is why these policies can provide income longer than other options.

The other great thing about IUL loans is that you can pay it back (if you want to) on your terms. If you want to take 3, 5, or 15 years to pay back the loan, it’s entirely up to you.

Case Study of an IUL Compared to Other Financial Vehicles

There are many places to save money for the future. In my opinion, it is important to save some money in a vehicle that protects it from market and tax risk. Due to the tax advantages and liquidity, an IUL beats a taxable account (stock account), tax-deferred account (401(k)/IRA), and tax-free account (Roth IRA).

IUL’s are versatile so that they can meet your needs. You can completely fund an IUL in as little as five payments, or you can fund it for a lifetime or to retirement.

Is Indexed Universal Life Insurance Too Good To Be True?

Families have used permanent life insurance to build wealth for over 100 years. It’s not just the wealth within the cash value. You can use the loans at any time for any reason. You can use it to pay for vacations or cover a financial emergency, instead of depleting your savings. If an investment opportunity presents itself, you have the liquid capital to take advantage of it. Some people even use it to fund their businesses.

During the Great Depression in the 1920s, JCPenny was facing bankruptcy – closing its doors and putting even more people out of work. James Peny took out a loan from his life insurance contract instead of shutting down his store like so many others. It kept the lights on until the store could become profitable again.

The story of how McDonald’s turned into the popular franchise it is today has been the subject of several docu-dramas over the past few years. Yet few people know that a life insurance loan provided the capital to get it off the ground.

Because this particular style of life insurance offers growth that’s sheltered from taxes, it becomes an excellent vehicle to build up liquid assets.

When you have your million dollar idea, you don’t need to beg for venture capital and compete against the 15 other pitches that day. You can do anything with the money: Take that dream vacation. Pay for your children’s college tuition. The insurance company doesn’t care what you do with the money, and they don’t ask.

Tax Code 7702, TEFRA, DEFRA, TAMRA

I don’t want to bore you with the details, but these are IRS Codes that explain what qualifies as life insurance and how life insurance is taxed. As life insurance policies have evolved over the years, the IRS has added these new laws.

Life insurance is an incredible tax shelter. Naturally, the IRS wants to have their say in the plan. These IRS codes set limits on the amount of cash value in the policy compared to the death benefit.

They also established rules on the abuse of life insurance and how it can become taxable. These laws also created the MEC rule and 7-pay test, which we’ll discuss below.

Is this a bad thing? No. Life insurance still has some fantastic tax benefits, but you need to play by the rules.

MEC Rule

In the 80s, using life insurance as a wealth-building vehicle was so popular that the legislature had to impose new restrictions to prevent a massive tax loophole. Now, life insurance policies must pass a 7-pay test. If they fail, the IRS considers them a Modified Endowment Contract (MEC) and are subject to taxes. A MEC is very similar to how a 401(k) or IRA is taxed.

Before the MEC rule, you could fund an entire policy with a single payment. Now you have to pay premiums over at least 5 years to maintain all of the tax benefits listed above.

This tricky rule is one of the primary reasons it’s wise to work with an insurance agent who has experience in designing indexed universal life policies. They need to know how to avoid the MEC classification. They also need to understand how to maximize the growth of the cash value rather than follow whole life or term policy design.

How The Cash Value Works – Technical Description

Never losing money on your cash value still sounds a little too fantastic to be real. Below are the internal mechanics of how the life insurance company hedges the risk to make sure that you never lose money, and that they can credit your account with the gains analogous to the index that it’s tied to.

Hedging Example:

Let’s say you pay a $1,000 premium into your IUL policy.

• The insurance company puts $950 into high quality, investment-grade bonds. This $950 will grow back to $1,000 at the end of the year. This is how the insurance company protects the downside.
• $50 is used to purchase options. Let’s say the S&P has a 10% cap. When the S&P hits 10%, the option is exercised. This will provide the 10% upside on the index. 

A $1,000 premium is split between the general portfolio (protects the downside risk) and options (for upside potential).

A common myth I hear is that the insurance company keeps the gains over the cap. For instance if the S & P returns 15% and there is a cap of 10%, the insurance just made 5% on your money. Not true!

The insurance company must exercise the hedge at the cap and does not make any money on the difference.

None of your money is ever directly invested in an index. The insurance company uses the index as a measurement for how much interest to credit to your policy.

How IUL Compares as an Accumulation Asset

Indexed universal life is unique among its insurance counterparts. It has different purposes than other types of insurance, and its own set of quirks.

How an IUL Compares to Other Types of Insurance

Term Life

Term life focuses exclusively on the death benefit. The length of the term typically matches the duration of a mortgage or the years until young children become financially independent.

Think of term as renting insurance. It will cover you for the duration of the term, usually 10 – 40 years. Then the term ends. It does not build up cash value.

The life insurance portion of an IUL lasts for your entire life, and it builds up tax-free cash.

Whole Life

Whole life insurance stays in place for your entire life. It still ranks #1 in terms of popularity today, despite term life being a better choice for many families. Current whole life policies offer a cash value accumulation, making it a predecessor to indexed universal life.

The main difference between the two is the cash value in whole life grows through the insurer paying dividends to their policyholders. Dividends are declared annually based on the overall performance of the insurance company.

While many whole life insurance companies have a long track record of paying dividends, these dividends are not guaranteed. The interest rate declared by the dividends has been trending down for a long time.

Both whole life and IUL last for the entire lifetime of the insured. Both have a cash value (CV) accumulation component. The main difference is the CV of an IUL is tied to an index, usually the S&P 500, whereas the CV on a whole life policy is based on less transparent dividends.

I believe IULs have a better chance of earning a higher rate of interest than their whole counterparts. IULs also have lower expenses and are more transparent with their fees.

The other big advantage of IULs, in my opinion, is that IULs have flexible premiums. You can pay less if you need to and can catch up premiums in the future.

Universal Life

Universal life and indexed universal life are similar. They both have remarkable flexibility, allowing you to adjust the policy after you’ve taken it out as your financial situation changes.

The biggest difference is indexed universal life grows the cash value based on an index. Universal life grows the cash value based on a declared interest rate by the insurance company.

Guaranteed Universal Life policies are great if you want a lifetime policy with a smaller premium and no cash value.

Variable Universal Life

Variable Universal Life policies are the riskiest type of permanent life insurance policy. While they may not have a cap on the growth, they also don’t have a floor. If the market goes down, your principal can go down. 

I don’t recommend VUL and feel that an IUL has the best combination of growth and protection.

Why Some Advisors Don’t Recommend Indexed Universal Life

If you google “indexed universal life insurance,” you will find strong opinions—a few in favor of, but many firmly against it. Even the financial talk show hosts have extreme views about IUL policies.

Their advice doesn’t apply to you

Consider whether you fall into the top 25% of income earners ($81,000/year +) in this country when weighing these opinions. Most people (The bottom 75%) have an income problem, not a tax problem.

Wealth building advice for the bottom 75% typically boils down to: pay off your debts, contribute to your qualified retirement accounts up to your employer match, and don’t spend more than you earn. They do not need help minimizing their tax burden.

General audience advice from insurance experts online and talking heads on TV, focuses on this larger audience. It’s the smart business decision for their businesses.

The higher you climb in income, the more specialized advice you need. A CEO will need different tax minimization strategies than his employees. So ask yourself, “are these people talking to me?”

IUL with Living Benefits

If you make it to age 65, there’s a pretty good chance that you will live into your 80s – especially if you are married. Longer living means a health issue is more likely to appear at some point. Some indexed universal life insurance policies offer living benefits to policyholders.

Living benefits are free riders that allow you to access your death benefit if diagnosed with a qualifying illness. This is usually an acceleration of the death benefit. If your policy has a $2,000,000 death benefit, and you use $500,000 for living benefits, then your heirs will receive $1,500,000 when you pass.

The benefit is unrestricted, depending on the company, and available for any expense. Expenses might include, but are not limited to:

Household expensesAdult Day CareHome modificationsRegular BillsNursing home careTrip around the world

Living benefits usually include the following riders:

1. Terminal Illness
2. Chronic Illness
3. Critical Illness

Terminal Illness

A terminal illness is an illness that will result in death within 12 to 24 months. The duration varies by state law.

Chronic Illness

A chronic illness is when you are unable to perform two out of six “activities of daily living” for a period of at least 90 days or are cognitively impaired.

Activities of daily living include:

Bathing Continence Dressing Eating Toileting Transferring

According to Genworth’s Cost of Care survey, the average cost of a private room in a nursing home is $102,200 per year. Statistics show that 70% of people over age 65 will need some form of assisted care.

If you don’t plan ahead for this, it will be a shock to your retirement income plan. Including living benefit riders or having extra accessible cash in your IUL can help you navigate this risk.

Qualified retirement plans, such as your 401(k) do not offer options like this.

Critical Illness or Critical Injury

This rider provides funds if diagnosed with one of the following illnesses (qualifying illness varies by company).

Critical Illness May Include:

ALS (Lou Gehrig’s disease) Aorta Graft Surgery Aplastic Anemia Blindness CancerCystic Fibrosis End Stage Renal Failure Heart Attack Heart Valve Replacement Major Organ Transplant Motor Neuron Disease Stroke Sudden Cardiac Arrest

Critical Injury May Include:

Coma Paralysis Severe Burns Traumatic Brain Injury

According to the CDC, someone in the United States has a stroke every 40 seconds. That means each year, more than 795,000 people in the United States have a stroke. About 610,000 of these are first or new strokes.

We hope you never experience any of these issues. Just in case you do, living benefits can provide peace of mind and money to help you survive.

Indexed Universal Life Insurance Warnings

If indexed universal life seems like it may fit with your financial plans, there are a few pitfalls to watch.

The two biggest issues I have seen are:

1. Agent does not design the policy properly
2. Client does not fund policy as they intended

Policy Design

When using the policy to maximize tax-free income, your agent must design the policy to be maximum-funded. Maximum funded means the death benefit is as small as possible based on the premium going into the policy. When I set up an IUL for you, I work with a team of people and software set up to maximize the funding related to death benefit, cash accumulation and the IRS code.

Client Funding

I’d like to say that every client who starts an IUL pays every premium as intended. In reality, that does not always happen. Life happens: job loss, emergencies, health issues, etc. The client intended to save $20,000/year for 20 years, but 10 years in something happens, and they cannot save.

Life insurance is just like any other financial vehicle. The more you save, the more you’ll have later in retirement. If you don’t save as much, you won’t have as much. It’s not the policy’s fault, so don’t blame the IUL.

The good thing is that IUL’s have flexible premiums. That means if life happens and you don’t save as much, the policy won’t necessarily blow up and lapse. It means you won’t get quite as much income as you expected in the future.

As long as you have some cash built up in the policy, you can skip payments if you need to. Then play catch-up later, if you are able. This is another reason why I prefer IUL over whole life insurance. If you miss a Whole Life payment, that missed payment may become a loan against the policy. Then it will drag down the performance of the policy even more.

Caps, participation rates and spreads will change over time

Every insurance company offers different index options for their IULs. The one commonality is that these policies can’t be credited with negative interest in a down year. This is the floor, which is 0%.

When the market is down 30%, and your policy only receives a 0%, this is great because you don’t have to make up that principal loss. We say, “Zero is your Hero.”

Each index may have a cap, spread, or participation rate on the upside growth. These rates will change over time. When interest rates are down, these rates tend to be lower. When rates increase, they trend upward.

These changes are not because the insurance company is trying to make more money. It has to do with the cost of options within the hedging explained above.

Every policy anniversary, you have the option to change the indices your IUL is invested in. If one drops, and you have a hunch that another will perform better, you can change to another option.

Again, this isn’t a bad thing, because the floor of 0% is guaranteed. Just know that the rates will change slightly, up or down, from year to year.

The Cost of Insurance Could Change

It is possible, though highly unlikely, that the insurance company could change the insurance cost within the policy. The insurance company can’t single you out and change your cost of insurance only. They would have to change it across the entire block of business.

Unless the insurance company has a great reason to do so, I don’t see this happening. It would have to be something crazy, like millions of policyholders from that one company all dying at once.

The other reason I don’t see this happening is that you can cash out of these policies. Nothing stops you from taking your surrender value and walking away with it.

There is a surrender charge for the first 10 – 15 years for most companies. This is an amount of cash that you would leave behind if you walked away. However, if your agent designed the policy properly, you may have more cash in your policy than you put in, including the surrender charge, after 5 – 7 years.

The insurance company wants to keep these policies in force for many years. This is how they earn money. If a bunch of policyholders canceled their policies, it would hurt the profitability of the insurance company.

What if the market has a series of bad years?

If the stock market is down many years in a row, that is all the more reason to have an IUL in your portfolio.This is a worst-case scenario for the first few years you hold the policy. You are paying to build the cash value and it’s sitting right around the growth floor.

However, what is the alternative? If your money is in the market, without the floor of 0%, you’ll be losing much more than just the cost of insurance. You’ll lose your principal. When you lose principal, you have to gain a lot more to get back to where you started.

The following chart shows what interest rate you need to earn to get back to even after a loss.

Remember that it’s better to protect your downside than take the risk of hitting a home run.

An IUL will protect your downside. So what happens if we have many bad years in a row? It’s bound to happen with the volatility of the market. If we look back at the last 20 years of the S & P, there was a period when the market was down 3 years in a row (2001-2003).

Here is chart from one specific IUL showing the Historical S&P 500 returns and Hypothetical Examples of different Indexed Account Options Returns. For an Assumed index Cap Rate of 11% with a 0% floor. From 2000-2019 the average was 6.60%. From 2010-2019 the average was 8.29%.

As you can see, you would have been better off with a cap and floor than getting all of the upside and downside of the market. None of us know what the future holds.

I don’t recommend having all of your eggs in one basket. Have some money in the market and some in a safe vehicle, such as an IUL. When the market is down, you’ll feel relief with the safety of your IUL bucket. If the market has a great year, your money in the market will do great, and your IUL will still do good relatively speaking.

Increase Growth on Cash Reserves for Business Owners

For businesses that are fortunate to have cash reserves set aside, they can utilize permanent life insurance to get a much higher return vs. what is commonly found in bonds, CDs or money market accounts.

Take a look at the scenarios below to get a better understanding.

Cash Reserve Scenario A

• Business has $1,000,000 in cash reserves
• Reserves are held as an asset on the balance sheet to maintain current valuation (value of the business used for future acquisition opportunities)
• Reserves are earning 1% in money market account.
• Reserves are liquid in the event of an emergency

Cash Reserve Scenario B

• Business has $1,000,000 in cash reserves.
• Business purchases indexed universal life insurance with early cash value and waiver of surrender riders.
• Policy remains an asset dollar for dollar on the balance sheet to maintain current valuation (value of the business used for future acquisition opportunities)
• Historic performance averages 6%.
• Fixed account offers 4% guaranteed.
• Reserves are liquid in the event of an emergency
• Policy cash value is worth $1,000,000+ with a tax-free death benefit of $8,000,000.
• Which scenario do you think a business owner would want to utilize?

Increase Performance of Required Reserves

Similar to the example listed above, many businesses have cash reserve requirements to maintain certain types of bonds (i.e. construction companies)

These are perfect examples of businesses that can benefit from the cash accumulation in an indexed universal life insurance policy.

*This is not tax advice. Consult with a certified tax professional regarding any tax consequences. IULs set up for an income stream in retirement can return 4 to 5 times the contribution into the plan if set up and funded properly.

Adapted from: https://abramsinc.com