In this article, we’re going to look at variable universal life and indexed universal life (VUL vs. IUL) in terms of which is better at accumulating cash value in the most reliable manner. It could be a no-questions-asked loan or even a retirement income stream. There are tons of options for what you could do with that extra cash and all of its tax advantages.
Let’s get started.
Table of contents
- Both types of life insurance are under the umbrella of universal life
- VUL invests directly in the stock market, making the returns more volatile
- IUL ties cash value growth to the stock market indexes and has floors, making the growth more stable and preventing you from losing money
Universal Life Insurance – What is it?
Universal life is a type of permanent life insurance. It lasts for your entire life as long as you make your premium payments.
The primary focus of this area of insurance is on building cash value. Normally that means you want the smallest death benefit possible, so your premiums build the policy cash value fast.
The tax code does not tax life insurance in most cases. The proceeds are non-taxable, and any loans against the cash value are loans and, therefore, not taxed.
The strategy to maximize your cash accumulation works like this:
- Buy as little death benefit as possible to minimize fees
- Contribute the highest premium allowed to maximize cash growth
- Goal: Max-funded policy with minimal fees and the highest potential growth
- This may seem confusing, but that’s where we can help. We will design your policy to maximize your cash value.
One big advantage of using universal life insurance is that you can access the cash in the policy through loans. There is no age limit, like your 401(k), where you have to be age 59.5+ to avoid penalties and taxes.
I’ve used policy plans to purchase a new car for my family instead of a car loan. This way, my policy becomes the bank. I can pay back the loans to my policy and have all of my money back in my policy to make another future purchase.
That’s just one example of how it’s useful. Since it is your money, your credit score doesn’t matter. It also doesn’t matter if you’re working. The money in your policy belongs to you. You can use it for anything you want. No questions asked.
If you don’t repay the loan, it’s subtracted from your death benefit when you pass.
You’ll likely want to pay back your loans while you’re younger to avoid taking away from the future retirement income stream. In the future, having access to retirement distributions from your policy is a ig part of why this strategy is so attractive.
Both types (VUL and IUL products) have sub-accounts that the cash value growth is based on.
In the case of a VUL policy, that subaccount invests directly in the stock market, often mutual funds with their higher management fees. The subaccount rises and falls with the market. So if it’s a bad year like 2022, where the S&P 500 dropped 19.44%, then your subaccount drops 19.44%. Scary.
It’s the more aggressive of the two cash value life insurance building strategies. The main criticism is, particularly with the subaccount management fees of the investments, that you may as well buy term life insurance and invest the difference.
Indexed universal life, on the other hand, ties the growth of the sub-account to a stock market index like the S&P 500. However, the insurer does not invest it directly in the market. They have their own investment mechanics, which you can read more about here.
Since your IUL cash value isn’t tied to the market, you get the major advantage (minimal investment risk) of having a floor. Many companies have a 0% floor, but some even offer a 1-2% growth floor.
That means that no matter what the index does, the cash value account in IUL policies doesn’t lose money.
Remember Warren Buffet’s #1 rule of investing? It’s “don’t lose money.”
That means in a year like 2022, when the S&P 500 dropped 19.44%, if your money were in a VUL it would have dropped around 19.44%. But if it were in an IUL, the cash value wouldn’t have dropped at all.
But here’s the best part.
The next year, when it grows. You don’t have any losses to make up, which (if you recall 2008) can take years. With an IUL, you only lost a year of investing time and no money. With a VUL, you lost money and much more time, depending on how much the market dropped.
Both policies also have no-lapse guarantees through the cash value.
That means if you had a bad financial year (a tree fell on your house, your car engine died, and you lost your job), your cash value could cover the life insurance premiums to prevent the policy from lapsing.
Why is the Cash Value Important?
In a word, taxes.
There aren’t many investment options that avoid taxes. Life insurance is one of the few.
Imagine you’re retired, and your Medicare premiums are tied to your income. Social security only covers so much (not enough to live on if you live in a major city or one of the coasts.) Plus, there are always years when investments do poorly. Index funds dropping and damaging retirement savings is just one example. That’s just part of the cycle. If you take out income during a downturn in the cycle, you’re losing all of the growth too from that money which packs a wallop on your portfolio.
What if you could have money coming in that wasn’t technically income?
When you take loans from your life insurance, that’s money coming in that the IRS does not count as income. You don’t pay taxes on it. Life insurance loans are not reported to the IRS.
You can let your retirement portfolio recover by letting that grow and using your life insurance cash value instead. You can potentially even keep your Medicare premiums down a tax bracket or two.
It’s good news all around.
Differences Between IUL and VUL Policies
There are three big differences between IUL and a variable universal life insurance policy.
- IUL policies have caps and floors
- VUL products are higher risk
- VUL insurance has higher fees
Let’s expand on those.
The caps and floors on an IUL create a more stable environment in which your money grows. The floors, as we mentioned above, prevent major and minor losses in your portfolio. It can take years for someone’s portfolio to recover from a major recession. And the news seems to promise recessions almost every year now, even though most of them don’t appear as foretold. But they are regular, even if unpredictable.
The floors save you time. You don’t have to wait for a portfolio to recover. It’s like a backup plan for your normal retirement account. They also save you stress. Nobody likes watching their account fall, even if they’re holding fast to the knowledge that if they just wait it out, the market recovers.
The flip side of that coin is the ceiling.
Usually between 12-16% growth, the ceiling is the insurance company’s balance to the floor. Sure, you don’t lose money in your account, but if an index has a stellar year, you cap out on that growth.
For example, in 2021 when the S&P 500 grew 26.89%, your IUL would have only gained 16%.
Many IULs use uncapped indices, which can mitigate the ceiling offered by an index with a cap.
This brings us to our second point, VULs are higher risk.
Your cash value, as you know by now, is directly invested in equities and often mutual funds. That means you have both market risk and management risk. Sometimes the stock market drops. Most mutual funds just don’t perform as well as the market does.
CNBC reported in 2022 that in the previous year, 21% of portfolio managers managed to outperform the market. That’s just one year. The New York Times found that over a 5-year study, not one single mutual fund managed to outperform the market.
Not only does variable life insurance expose you to market risk, but you’re also hoping the portfolio manager’s asset allocation can at least match the market – unlikely.
Which also puts your life insurance policy at risk too. If you’re having a bad financial year and the market is having a bad year, will your sub-account have enough cash value to cover the premiums so you don’t suffer a policy lapse?
Indexed universal life insurance doesn’t have those risks. As long as you pay your premiums, your cash value accumulation is protected. If you have a bad year, your cash value can cover the premiums because it doesn’t matter if the stock market is also having a bad year.
Finally, variable universal life has higher fees.
Universal life policies can have fees beyond the premiums, so always double-check the illustration with your agent.
In the case of variable universal life insurance, you have to pay the mutual fund management fees for your sub-account. That can really eat into the growth of your cash value. The average mutual fund management fee is typically just under 1% of your entire portfolio every year.
Which Strategy is Better?
So which is better: VUL vs. IUL?
That will primarily depend on your risk tolerance and long-term financial strategy. But for the vast majority of people, an indexed universal life insurance policy is the better choice.
The fees and higher risk of VUL policies don’t make sense for how volatile the stock market is becoming. Another good option to minimize risk might be buying term insurance and investing the amount of money you would have spent on a VUL directly in the market or maxing out your retirement contributions.
Most families who have their retirement accounts funded to the max can benefit from the tax advantages of building cash value in an indexed universal life insurance contract. However, as always, it’s wise to review your investment objectives with your financial advisor and an insurance agent who has experience with these types of life insurance products.
If you are looking to maximize your tax-free wealth building, I recommend looking at the Kai-Zen strategy.
If you have any questions at all or want to see an illustration tailored to your financial goals, give us a call at (858) 703-6178 today.