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A universal life insurance policy can accumulate cash value in addition to providing a death benefit. There are two basic types of universal life insurance policies you should know about. With indexed universal life insurance, the cash value can increase based on the performance of a market index. With variable universal life insurance, on the other hand, a policyholder directly invests the cash value into securities.

A financial advisor can help you determine how life insurance fits into your financial plan.

Universal Life Basics

Universal life insurance is a kind of permanent life insurance. Permanent life insurance differs from the other main variety of life insurance, term life insurance, in that permanent life insurance does not expire and part of the premium is used to build up cash value in a subaccount. Term life insurance generally costs less and is for a limited number of years but provides only a death benefit, without any cash value feature.

There are two major varieties of permanent life insurance, including whole life insurance as well as universal life insurance. With both types the cash balance in the subaccount can increase, but with whole life the growth is based on a fixed interest rate while with universal life the growth rate can vary.

Whole life premiums are also fixed. A universal life policyholder can opt to pay a lower premium during a period when cash flow is tighter, or pay more to build cash value. These policies also may also include other features, including long-term care coverage and other living benefits.

Favorable tax treatment is an important characteristic of permanent life policies. The death benefit is free of income taxes. Funds in the cash value subaccount also grow tax-free, and policyholders can withdraw funds or take loans against the cash value while still alive without owing taxes on the proceeds.

Indexed Universal Life

Indexed universal life is one of the sub-types of universal life. With an indexed universal life policy, the cash value can grow based on the performance of a stock market index. This allows for a potentially higher return than a whole life policy with a fixed return.

Indexed universal life policies typically have participation rates describing the return’s relationship to the index. A 60% return rate means the cash value will earn 60% of the return posted by the tracked index. If the index returns 10%, in this case, the subaccount will earn 60% of 10% or 6%.

However, these policies also often have caps on the maximum return. In the previous example, if the policy had a cap of 5%, the subaccount would earn 5% instead of 6%.

In addition, indexed universal life policies often have floor rates describing the minimum return the return will post. A floor of 1% means the policy will return 1% even if the index posts a negative return.

Pros of indexed universal life include the ability to get a death benefit along with tax-free growth and distributions. Policyholders can also contribute unlimited amounts and use the money at any time, which are useful advantages compared to retirement accounts such as IRAs.

Cons of indexed universal life include caps on returns along with sales, administrative and other fees which are typically higher than other investment options such as exchange-traded funds. Also, withdrawals from the cash value subaccount may become taxable if the policy is surrendered or lapses.

Variable Universal Life

Another type of universal life insurance is variable universal life. It shares many of the features of indexed universal life, including tax treatment and the ability to pay flexible premiums and accumulate cash value in a subaccount. The primary difference is how funds in the subaccount are handled.

Instead of tracking an index, the cash value in a variable universal life policy subaccount can be invested directly in securities, such as stocks and bonds. Variable universal life policies do not have participation rates, cap rates or floor rates as indexed universal life does.

The return on a variable universal life policy cash value will reflect the actual performance of the securities, without any limits up or down. This means it is possible to get a higher return than with an indexed universal life policy but also to get a lower return as well as to lose money.

Pros of variable universal life policies include the possibility of a higher return while still getting favorable tax treatment and a death benefit. Cons include the possibility of a lower return or actual loss. Variable universal life policies also typically have higher fees than indexed universal life due to the added costs of managing the investments.

IUL v. VUL: Which One Is Better?

As outlined above, there are positives and negatives for both products. Which one is best for you will largely depend on what you want to get out of your life insurance policy.

Indexed universal life can be a good choice for someone who wants a death benefit as well as flexibility in paying premiums and the prospect of a somewhat better return on the cash value than is offered by a whole life policy. Indexed universal life buyers tend to be more risk-averse than variable universal life policyholders, who are willing to take the chance of higher returns in exchange for the possibility of a loss.

The Bottom Line

Indexed universal life and variable universal life are two types of permanent life insurance that let policyholders pay varying premiums and accumulate cash value. Indexed universal life cash value can grow based on the performance of a stock index. Variable universal life cash value can be invested directly into securities. Indexed universal life typically limits both gains and losses, while variable universal life offers the opportunity for higher gains as well as losses.

Life Insurance Tips

• Life insurance can be an important part of a financial plan. A financial advisor can help you select which type of life insurance works best for your situation. SmartAsset’s free tool matches you with up to three vetted financial advisors in your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• SmartAsset’s investment calculator shows you how much your investment will be worth over time assuming a constant rate of return and regular contributions.

Mark Henricks
Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.