INDEXED UNIVERSAL LIFE
Indexed Universal Life insurance is a type of cash value life insurance that can provide coverage permanently or for a fixed period of years. Any excess of premium payments above the cost of insurance is credited to the cash value of the policy, which in turn is credited each month with interest. Excess cash funds are typically tied to an index such as the S&P 500 or the NASDAQ. Since funds grow inside an insurance policy and are not placed directly in the stock market, growth is more secure and less of a risk. In fact, most IUL policies will provide a cap to the amount of growth the policyholder can participate in, but partner that cap with a floor that prevents any loss of excess cash value buildup. Guaranteed Indexed Universal Life (GIUL) policies offer the same features, with the added benefit of a guaranteed minimum growth on all cash value.
A portion of paid premiums goes toward the costs of an Annually Renewing Term product (the policy face value). Excess funds are credited to the cash value and grow tax-deferred, with growth tied to an index selected by the policyholder. The value of the selected index is recorded at the beginning of the month and compared with the value at the end of the month. If the index increases during the month, the interest is added to the cash value. The index gains are credited back to the policy either on a monthly or an annual basis. The resulting interest is added to the cash value, up to the cap. If the index goes down instead of up, no interest is credited to the cash account.
The IRS sets a limit on how much growth can occur before these funds become taxable. If growth inside an insurance policy exceeds the limits set by the IRS, a Modified Endowment Contract is created. When a MEC is created, excess funds become taxable in that year. Flexible-premium policies (like IULs) must pass the seven-pay test in order to avoid MEC status. This test limits the amount of premium that can be paid into a flexible-premium policy over a period of seven years, a standard set by the federal government to limit the potential to misuse such policies as large scale tax shelters. To keep buyers informed and protected at the time of purchase, most companies will provide guidance on how much can be paid into a policy each month, above and beyond the minimum premium needed to keep the policy in force. For any life insurance policy to avoid being classified as an MEC, there must be a defined “corridor” of difference in dollar value between the death and the cash value of the policy, meaning an established gap in the value of the two pools of money. Illustration software will provide these numbers for an agent to review with their client.
IUL plans make it easy to withdraw funds, as distribution is penalty-free at any age. Many people choose to utilize IUL policies to grow funds to use during retirement. These funds can be rolled into an annuity, another tax-advantaged vehicle, tax-free utilizing a 1035 Exchange. Retirement planning is a common goal met by Indexed Universal Life plans, but college savings for children, key person insurance, business Buy-Sell agreements, “Term to 65” and employer-funded plans take advantage of the accumulation potential, flexible face value and flexible coverage years.
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