In the following article we will pit whole life vs indexed universal life insurance against each other, considering both the similarities and differences between the two different life insurance products.
In other articles we covered our picks for the best whole life insurance companies and best indexed universal life insurance companies.
Here, our goal is to help you understand why one might be superior to the other for financial protection based on your specific goals and objectives, as we focus on illuminating the utility of both products.
Indexed Universal Life vs Whole Life
While it is true that indexed universal life (IUL) differs in significant ways from whole life insurance (WL), there are nevertheless a number of similarities to be found when comparing IUL vs whole life. So, we will first begin by comparing these two different types of life insurance policies.
IUL vs Whole Life Similarities
Permanent Coverage
Unlike term life insurance, which only provides death benefit protection for a set period of time, both indexed universal life insurance and whole life insurance are a type of permanent life insurance policy, also known as cash value life insurance. A Permanent life insurance policy provides you with continuous death benefit coverage throughout your lifetime, with a cash value account that grows over time.
Tax Free Policy Loans
Both indexed universal life insurance policies and whole life policies allow the owner to take out a loan, whereby you can effectively act as your own banker by borrowing against your life insurance policy’s cash value, while simultaneously earning interest on your entire cash value account balance. Life insurance loans are tax free and can be used for whatever you choose.
Tax Free Withdrawals (Up to Basis)
In addition, cash value withdrawals from an indexed universal life policy and whole life insurance are free from taxes as long as the amount you withdraw as a partial surrender of the cash value account doesn’t exceed your basis in the policy.(Source)
Tax Deferred Cash Value Growth
Interest credited to the cash value accounts, either from dividends if you own dividend-paying whole life insurance, or from an stock market-linked subaccount if you own an indexed universal life policy, grows income tax free in a true compound interest environment.
Tax Free Death Benefit
Other benefits of life insurance apply as well for both indexed universal life insurance and whole life insurance, including the tax-free transfer of wealth via the death benefit payout to the beneficiaries of the policy.
Depending on your state, there are protections for your cash value from legal judgements and creditors.
And the ability of both universal life insurance policies and whole life insurance policies to serve as additional savings vehicles when it comes to building up cash for retirement or other purposes, such as creating a life insurance retirement plan.
IUL vs Whole Life Differences
IUL Provides More Flexibility
Universal life insurance policies are more flexible than whole life, and offer different design features, such as indexed universal life that we are focusing on in this article, and also variable universal life insurance, which uses the cash value account to invest in subaccounts linked to the stock market, similar to mutual funds. Variable universal life insurance is beyond the scope of this article but for more on how it compares to other universal life insurance options, see our article IUL vs VUL.
As a type of universal life insurance, IUL insurance offers greater flexibility than whole life in allowing policyholders to alter the amount of premium they pay and to allow premiums to be paid out of the cash value of the policy itself.
Just know, for a period of time whole life insurance premiums can be taken from the cash value or paid via dividends, so whole life does have some flexibility when it comes to premium payments. But it does lack the flexibility of IUL, where as long as your cash surrender value is on the plus side, you will not have mandatory premiums to make.
An indexed universal life insurance policy allows you to lower your death benefit, which is beneficial if you need to lower your insurance premium payment.
IUL Provides Higher Potential Returns
A benefit of indexed universal life is it offers more options in terms of the types of subaccounts your cash value can be allocated towards. Unlike whole life, IUL offers subaccounts linked to various stock market indexes, such as the DJIA, NASDAQ, S&P 500, Russell 2000, Euro Stox 50 and Heng Seng Index.
If these respective markets perform well, these subaccounts can earn higher credited rates of interest than dividend-paying whole life insurance policies will typically receive.
Currently, whole life insurance dividends from top companies are in the 5% range. With an IUL policy you have the opportunity to earn larger returns, without taking part in negative market returns.
However, it should be noted that these subaccounts are subject to participation and cap rates which can prevent you from earning as much as the market index your subaccount is linked to.
For instance, if your subaccount linked to the S&P 500 index earns 12% in a year, but your cap rates limits the maximum the account can earn in a single year to 10%, then you would be credited 10% instead of 12%. If the subaccount’s participation rate was 75%, then you would receive 75% of 12%, or 9%.
Whole Life Returns More Predictable
In contrast, whole life insurance, while it doesn’t offer the potential upside of different equity based index-linked growth, it does offer more predictable interest crediting than indexed universal life insurance, which depends on the stock market moving higher to deliver elevated returns.
One of the many benefit of whole life insurance is that you pay a fixed premium which doesn’t change for the life of the policy, meaning your cost for insurance doesn’t rise as you get older because it was already factored in.
Additionally, whole life also offers a guaranteed death benefit and a guaranteed fixed premium. And while not guaranteed, the annual dividend payment can greatly increase your returns in a high interest rate environment.
The steady growth of the cash value in a dividend-paying whole life policy, means that you can have a high level of confidence that your policy will produce consistent returns for you long term.
The Consistency of WL vs the Unpredictability of IUL
While indexed universal life insurance offers the potential for higher returns vs whole life, due to the stock market-linked subaccounts it offers, this may also contribute to more unpredictability with IUL than whole life.
Essentially, this unpredictability lies within the equity markets themselves, which can turn in positive results one year only to lose money the next. IUL policies typically feature floor rates set at no less than 0%, so you don’t have to worry about losing money in your cash value account if the stock market declines.
However, if you funded your cash value account based on a projected return that doesn’t materialize, it could place your policy at risk of under performing, potentially even lapsing. This is partly due to the fact that your cost for insurance rises as you age, requiring higher payments from your cash account to cover the increasing cost of insurance (COI).
Sales illustrations that demonstrate high returns from IUL policies should be approached with caution, as there are no guarantees that the rosy projections they often show will actually occur.
For instance, if an indexed universal life insurance illustration projected that you would earn an 8% interest rate in your cash account, but the market only returned 4%, this lower-than-expected return could result in your policy not living up to its billing.
In the worst-case scenario, this could result in your policy lapsing if you can not come up with the necessary additional funds. If your policy lapses, you may need to re-qualify for insurance, particularly if you purchase another policy at some point.
Even if less-than-expected returns in an IUL subaccount don’t cause a policy to lapse, they can significantly impair the ability of the policy to meet the financial objectives you have set for it.
Note, if you plan on using an IUL to supplement your income in retirement, or to take loans from using an infinite banking approach, lackluster stock market returns can significantly reduce the amount of funds available to you for this purpose.
As a result of these factors,
individuals looking for more certainty in regard to the projected buildup in their cash value account and their ability to maintain insurance coverage for their beneficiaries are typically better served by whole life insurance.
While whole life dividends paid by participating insurance policies may fluctuate to some degree in response to changes in the profitability of the insurance company, any such fluctuations are likely to be much less dramatic than the sharp changes in returns stock market-linked subaccounts in IUL policies are subject to.
So, while whole life products typically illustrate cash value growth more slowly than IUL policies, this is offset by the guarantees whole life policies offer, which include a guaranteed death benefit, a guaranteed fixed premium and a guarnateed growth in the cash value account.
One method that can be used to lessen the risk of poor subaccount performance causing an IUL insurance policy to lapse and to increase the likelihood that the cash account will be adequately funded is to overfund your life insurance policy.
Overfunded life insurance allows you to store away money into your policy as a reserve (while still earning interest) so that when you may need it, you have it.
IUL vs Whole Life Conclusion
To be frank, IUL policies can illustrate very well, although I would caution against any illustrations that show a return greater than 6%. In the right market you can see some very good returns.
Further, the 0% floor on an indexed universal life insurance policy makes the IUL very attractive for anyone who wants to benefit from stock market gains, while avoiding negative returns.
In contrast, participating whole life insurance is a safe bucket asset that allows you to get consistent, guaranteed returns plus annual dividends. Since it is a non-correlated asset, the highs and lows of the stock market do not affect it, which provides peace of mind in even the most turbulent of economic times.
Next Steps
To determine the best route you need to know what routes are even available. If you are on the fence about which type of policy between universal life insurance and whole life will work best to help you achieve your goals please give us a call for a complimentary strategy session.
