Indexed Universal Life (IUL) vs. Variable Universal Life (VUL)

Indexed universal life (IUL) and variable universal life (VUL) insurance both provide lifelong coverage while allowing policyholders to build cash value. Their distinction comes from how that value grows. IUL policies credit interest based on the performance of a stock market index, typically with a cap and a floor to limit gains and losses. VUL policies, on the other hand, invest directly in separate accounts that fluctuate with market performance, creating higher potential returns along with greater risk. Each offers flexible premiums and adjustable death benefits tailored to different financial goals.

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

What Is Universal Life Insurance?

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.

Permanent life insurance generally comes in two main forms: whole life and universal life. Both offer lifelong coverage and a cash value component that grows over time. Whole life policies grow at a fixed, guaranteed rate, while universal life policies have flexible premiums and a cash value that can earn interest based on market rates, which can fluctuate.

While whole life premiums are 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 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. The cash value also grows on tax-deferred basis. Policyholders can access cash value through loans or withdrawals, often without immediate taxation, though taxes may apply if withdrawals exceed the amount paid in premiums or if the policy lapses.

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% participation 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 cash value will earn 60% of 10% or 6%.

However, these policies also often have caps on the maximum return. If the same policy had a cap of 5%, returns would be limited to 5% even if the index gained more.

In addition, indexed universal life policies often have floors that describe the minimum return the policy will generate. A 1% floor ensures at least a 1% credited interest rate, even during a market decline.

Pros of Indexed Universal Life (IUL)

IUL policies provide both a death benefit and the opportunity for tax-deferred cash value growth. Policyholders can borrow or withdraw from the accumulated value without immediate taxation, and contributions are not limited by annual caps like those found in IRAs or 401(k)s. This flexibility can appeal to individuals seeking additional ways to build and access long-term savings.

Cons of Indexed Universal Life (IUL)

Potential drawbacks include participation rate limits and caps on credited returns, which can restrict earnings during strong market periods. IULs also carry higher fees and administrative costs compared to low-cost investments such as index funds or ETFs. Additionally, if the policy lapses or is surrendered, outstanding loans or withdrawals may trigger taxable income.

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 can be allocated to separate accounts that invest in mutual fund–like portfolios of stocks and bonds. Variable universal life policies do not have participation rates, cap rates or floor rates as indexed universal life does.

The cash value’s return in a variable universal life policy reflects the actual performance of its investments. 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 (VUL)

Variable universal life insurance offers lifelong coverage while giving policyholders the chance to earn market-based returns. The policy’s cash value grows on a tax-deferred basis, and funds can be borrowed or withdrawn under favorable tax rules. In addition to investment flexibility, beneficiaries receive a death benefit that is generally exempt from income taxes.

Cons of Variable Universal Life (VUL)

Because the cash value is tied to investment performance, results can fluctuate. Strong markets may boost growth, but downturns can reduce account value. These policies also tend to be more expensive than indexed universal life due to fund management charges and other administrative costs.

IUL v. VUL: Which One Is Better?

Both types of policies can play a role in a long-term financial strategy, offering lifetime coverage and tax-deferred cash value growth. The decision between the two comes down to your comfort with investment risk and how you plan to use the policy, whether for stable supplemental savings or as a more growth-oriented tool with insurance protection.

When an IUL May Be Better

An IUL policy may appeal to someone who wants both growth potential and protection against market downturns. The cash value earns interest linked to a market index, but it also includes a minimum rate that prevents losses when the market declines. IUL policies provide flexibility in premium payments and death benefits, allowing policyholders to make adjustments as their financial situation evolves.

When a VUL May Be Better

VUL policies are better suited to individuals with higher risk tolerance and a desire for greater market participation. The cash value is invested in subaccounts similar to mutual funds, so performance depends on market results. This can lead to stronger returns in good markets but also exposes the policy to potential losses. Managing a VUL often requires a more active approach and an understanding of investment fluctuations.

Bottom Line

Both indexed and variable universal life insurance provide lifetime coverage with flexible premiums and tax-deferred cash value growth. IULs limit both gains and losses by linking returns to a market index, while VULs invest in market-based accounts with the potential for higher growth and greater risk.

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. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve 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.
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