Posted on July 9th, 2021
Part of our research involved sending our 22-year-old intern into the trenches to find out more. In a discussion with an insurance broker, they told her she was a great candidate for a $2,000 a year plan despite having no dependents and being (hopefully) far from dying, retirement, or paying for a child's college. They wouldn't disclose any fees or clear financial information when she asked, and they might've invited her to join a cult. (We kid about the cult thing, but the whole process felt super shady and opaque.)
We've broken down what we learned below.
Life insurance is purchased to provide beneficiaries with a large sum of money upon the insured's death. There are various types of life insurance, but the reason this insurance was created was to provide payments for families in the case the breadwinner dies.
Like other types of insurance, you pay premiums every month or year. The money from the premium pays any fees and costs associated with running your account, and the rest of the money goes into the cash value of your account. You earn interest based on whatever index your plan is tied to on the cash value of your account.
The main benefit compared to other types of investment accounts is that you don't lose money when the market goes down. If the market goes down you will not earn negative returns, but you won't earn any interest for that time period. On the flip side, most IUL plans have a cap on the percentage you can earn in returns each year. These caps vary from plan to plan, but during good years they prevent you from earning as much as you would have invested directly in the market or in a 529 plan.
IULs have no contribution limits. You can withdraw funds from an IUL at any time, so if you are planning to use an IUL as retirement or college savings fund, you can contribute as much as you need to the account.
IUL insurance policies grow tax-free, and you do not pay capital gains on the plan's increase in value over time. You are also able to take loans from your IUL without paying taxes or penalties for early withdrawals.
You can use the funds at any time for any reason without paying a penalty or taxes. There are no minimum age requirements.
The beneficiaries of your plan receive a tax-free death benefit. There are no income or death taxes on the benefits your beneficiaries receive.
Life insurance is not reported on your FAFSA as an asset. This means any assets held in your IUL will not affect your expected family contribution.
Most plans have a limit to how much you can earn within the plan. Index caps set a limit to the rate of return you can earn, which means an index can perform really well but you're only earning a portion of those returns on your IUL funds. The plans protect you in a down market, but if the market has a good year you will earn less money than if you invested directly in the market. IULs serve their purpose as a type of life insurance. If you are planning on using funds from an IUL for another purpose besides life insurance, investing directly in index funds or retirement accounts with no earning limits is a better option.
Index funds also have participation rates. These vary from plan to plan, but a participation rate affects how much of the returns you earn. For example, if your participation rate is 70% and the index earns 10% that year, you would earn 7% on the cash value of your plan.
While IULs grow tax-free, if you close the plan before it matures, or the policy lapses because you stop paying the premiums, the money you have withdrawn from the plan becomes taxable. If you plan on withdrawing funds to pay for college or retirement before the plan matures, make sure you realize that you're committing to paying the premiums on this account for the long haul.
If the value of the index your plan is tracking goes down, there is no interest on the cash value of the plan. This means your policy doesn't grow if the value of the index your plan is tied to goes down.
Although flexible premiums might seem like a perk, these are really non-guaranteed premiums. You can skip payments, but the insurance company can raise your premiums and require more money to cover costs that grow over time. As a policy-holder ages, they become more expensive to insure. So over time, more of your premium dollars go towards costs and fees and less go towards the cash value of your IUL. Eventually, these fees can drain the value of the policy, especially in years where the market is down and companies are losing money. The policy can raise its premiums to cover rising costs. You can choose to pay the higher premiums or give up the policy. But remember if you give up the policy you will likely owe taxes on the earnings of the plan.
Many insurers and insurance agents are not selling you IULs with your best interest in mind. They are not obligated to protect you and often sell extremely complicated plans without disclosing some of the potential risks. They often also provide projections of a policy that make it seem like it will be costless in the future, but these projections are not guaranteed and can cause customers to pay a lot more than they were expecting for life insurance. Think of IUL salespeople like car salespeople- they are trying to get the biggest sale out of you, so you need to do your research first.
Most life insurance plans are 40 years or more- they're meant to last for your lifetime. This can be great with typical life insurance with steady premiums because the family of the insured will receive the benefits for a long time. For IULs this can be a bad thing. Policies often have significantly more expensive premiums over time and can eat away at the cash value of the plan. Remember that you have to hold on to these plans or face tax implications, so be sure that you are committed to having this plan for the long haul and potentially paying more as premiums increase over time.
Unlike stocks and options, IULs are not regulated by the Securities and Exchange Commission (SEC). This commission is to ensure that companies and brokers are honest when reporting financial information. Stockbrokers need to undergo rigorous training to sell products tied to indexes, whereas insurance salespeople do not have the same standards. The only requirement for insurance brokers is to be licensed by the state.
IULs can be very complicated depending on your plan. Each plan has different premiums, rules for withdrawals, maturity dates, etc. so be sure to read the fine print when setting up an account. Cap rates and earning limits are commonly included in plans, so make sure you are shopping around for a plan that isn't meant to limit the growth of your money and pass on earnings to the insurance company.
Another complication is the fee structure. IUL policies can have very high fees that are not always clear upfront. Common costs include premium expense charges, administrative expenses, riders, fees and commissions, and a surrender charge. Most plans have four types of fees: the premium load, the monthly charge, the expense charge, and the mortality charge. Make sure to understand these fees upfront. Keep in mind that these fees aren't factored in when a company tells you your returns, so make sure to do your own research.
Also, be sure you know which index your money is tied to. Some IULs are tied to the S\&P 500 and other well-known indexes, but others are tied to less established indexes that could be higher-risk.
Investing is scary, but just because IULs promise you won't lose money when the market goes down doesn't mean these plans are the best investment option. There are major downsides to these plans including growing premiums and capped returns. Plus the complicated nature of these plans means you should strongly consider using a financial advisor to help you set up a plan and make sure it's the right fit for you.
There is no hack to college savings. A 529 plan was designed to do the job best. It is simple, has low fees, and offers better returns than an IUL. If you are planning on using an IUL for college savings, remember that you'll have to continue paying the premiums long after your child goes to college, and that could cost you. A 529 plan also offers you the flexibility to contribute when you can and put your money elsewhere when you can't.
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