IUL Myths vs. Facts: Cost, Commissions, Funding and Risk, Explained in Plain English

Key facts: IUL pairs a lifetime death benefit with a cash value you can borrow against, withdraw or surrender. · Cash value grows tax-deferred, the death benefit is generally income-tax-free, and policy loans generally aren't taxed unless the policy is a MEC or ends with a loan. · Illustrations are limited by NAIC Actuarial Guideline 49-A; non-guaranteed values are not promises, so read the guaranteed column.

Indexed universal life, or IUL, gets strong opinions online. This guide skips the opinions and sticks to what regulators, the IRS and the tax code say, in plain language. It covers what an IUL is, four common myths, and the terms you're likely to hear in a sales conversation.

What an IUL Is

IUL stands for indexed universal life. It is permanent life insurance, meaning it is designed to last your whole life as long as the policy stays funded.

It has two parts:

• Death benefit: the money paid to the people you choose (your beneficiaries) when you die.
• Cash value: a savings account inside the policy that you can use while you're alive.

The NAIC Life Insurance Buyer's Guide groups universal life with whole life as "cash value insurance." Term insurance, it says, "generally does not build up cash value."

How the Cash Value Works

When you pay a premium (your payment), the insurer takes out its charges first. The main one is the cost of insurance, which is the price of the death benefit. Other fees are listed in the policy. The buyer's guide says universal life premiums "(less expense charges) go into a policy account that earns interest," and "charges are deducted from the account."

The "indexed" part is how that interest is calculated. FINRA says the policy "follows a set stock index (such as the S&P 500)" and is "generally not considered a security." The index works like a measuring stick: the insurer checks how the index did and credits interest using a formula with a floor (the lowest rate you can be credited) and limits such as a cap (the highest rate) or a participation rate (the share of the index gain that counts).

Hypothetical example, made-up numbers: You pay $200. Charges take $70, and $130 goes to cash value. If the index rises 12% and your cap is 9%, you're credited 9%. If the index falls 20%, you're credited the floor rate instead of a loss.

What you can do with the cash value, according to the buyer's guide: borrow against it with a policy loan, use it to supplement retirement income or pay for "a child's tuition without canceling the policy," or surrender (cancel) the policy for its cash value. Universal life also "lets you vary your premium payments" and adjust the death benefit.

Myth 1: "IULs Are Too Expensive"

The myth: IUL costs far more than it's worth.

What the facts say: A permanent policy costs more than term for the same death benefit. The buyer's guide explains why: to build cash value "you must pay higher premiums in the earlier years," and term coverage gets more expensive each time you renew it as you age. IUL charges (cost of insurance, fees, and early-year surrender charges) are real and should be listed for you.

The reason people choose IULs: The higher price buys two things term doesn't: coverage meant to last for life and a cash value you can use. Because premiums are flexible, you can choose a funding level that fits your budget, as long as the policy stays funded.

Myth 2: "IULs Are Designed for Commissions"

The myth: The product exists to pay agents.

What the facts say: Agents are typically paid a commission by the insurer, like most insurance sales. Selling insurance requires a state license, and the NAIC Producer Licensing Model Act sets disclosure rules: an agent who represents the insurer must disclose that they'll be paid by the insurer, and an agent who also charges you a fee must disclose the amount or how it's calculated. Rules vary by state.

The reason people choose IULs: How an agent is paid doesn't decide whether a policy fits you. The policy's charges, guarantees and illustration are what matter, and regulators limit how those illustrations can be shown (see AG 49-A below). You can ask any agent how they're paid and verify their license with your state insurance department, as FINRA suggests.

Myth 3: "You Need a Lot of Money to Fund One"

The myth: IUL is only for people with large sums to put in.

What the facts say: There's no single required amount. Universal life lets you vary premiums within the policy's rules, and federal law sets the upper limits (see IRS rules below). The trade-off is that the buyer's guide says paying more "means that you build up more cash value," and if premiums plus interest fall short of charges, the account shrinks.

The reason people choose IULs: Flexibility. You can pay more in good years and less in tight years, and a healthy cash value can help cover charges. The key is funding it enough to stay in force, which an annual in-force illustration can help you check.

Myth 4: "You Can Lose All Your Money"

The myth: A market crash can wipe out your cash value.

What the facts say: Your money isn't invested in the index. When the index falls, the floor means your interest credit doesn't go negative, so index losses aren't subtracted from your cash value. Two things can still reduce it: policy charges, which come out every month, and loans or withdrawals. If cash value drops too low, the buyer's guide says coverage can end (lapse) unless you pay more or lower the death benefit.

The reason people choose IULs: The floor gives protection from index declines that a direct stock investment doesn't, while still allowing index-linked interest in up years, within the cap. Keeping the policy funded and reviewing it yearly addresses the main risk, which is lapse, not a market crash.

Terms You'll Hear, Explained

Infinite Banking and "Be Your Own Banker"

These are strategy and marketing names, not legal or regulatory terms. They describe building cash value in a permanent policy (whole life or IUL) and borrowing against it instead of using a bank loan. A University of Nebraska–Lincoln extension article describes it as "simply borrowing against the cash value of the policy."

What it can offer: access to money without a credit application, with the cash value as collateral and flexible repayment. The limits, per the same article and the buyer's guide: loans charge interest, unpaid loans reduce the death benefit, and too much borrowing can cause a lapse, which can create a tax bill.

"Million Dollar Baby" Policies

This is a marketing name for a permanent policy (whole life or IUL) bought on a child, usually funded to build cash value over decades. It isn't a standard product or a government program, and the name doesn't mean $1 million is guaranteed. Life insurance on children is regulated by the states. In Washington, for example, the Office of the Insurance Commissioner says only parents or legal guardians can usually buy coverage on children under 17, others need written parental consent, and insurers can limit the amount.

AG 49 and AG 49-A

These are NAIC rules for IUL illustrations (the charts showing projected values). AG 49-A applies to policies sold on or after December 14, 2020. It sets the maximum crediting rate an illustration can show, "limits the policy loan leverage shown in an illustration," and requires a side-by-side illustration and extra disclosures. The NAIC notes non-guaranteed values "are not guaranteed or determined at issue."

IRS Rules: Section 7702 and MECs

To get life insurance tax treatment, a policy must meet the definition in IRC § 7702. One way is a "cash value corridor": the death benefit must be at least a set percentage of the cash value, starting at 250% through age 40 and stepping down with age. The law also sets guideline premium limits on how much can go in.

A separate rule, IRC § 7702A, applies a seven-pay test. A policy funded faster than that test allows becomes a modified endowment contract (MEC). It's still life insurance, but loans and withdrawals are taxed less favorably (see below).

Minimum Death Benefit / Maximum Accumulation

This is a design approach, commonly described in the industry rather than defined in law. The idea: set the death benefit near the lowest amount IRC 7702 allows for the premiums you plan to pay, so less goes to cost of insurance and more goes to cash value, while staying under the MEC limit. Whether it fits depends on how much death benefit you actually need.

IUL vs. Whole Life

Sources: NAIC buyer's guide, FINRA.

Tax Treatment ("Tax Leverage")

• Growth: Cash value growth isn't taxed each year while it stays in the policy. If you surrender, IRS Publication 525 says you include in income only what you get above your cost, which is generally the premiums you paid.
• Death benefit: The IRS says proceeds paid because of death generally aren't taxable, with exceptions.
• Loans: A policy loan generally isn't treated as taxable income while the policy stays in force and isn't a MEC. For a MEC, IRC § 72(e)(10) treats loans like withdrawals, taxed gains first, and § 72(v) can add a 10% additional tax before age 59½.

The Fine Print: If a policy lapses or is surrendered with a loan outstanding, IRS Publication 525 counts unrepaid loans in figuring your cost, so you could owe tax without receiving cash. Talk to a tax professional before letting a policy with a loan end.

Before You Buy: Questions to Ask

1. What are the floor, cap and participation rate, and which can change?
2. What do the charges add up to each year, and what's the surrender charge schedule?
3. Can I see the guaranteed column and the AG 49-A disclosures?
4. How much do I need to pay to keep it in force, and will my plan create a MEC?
5. What's the loan interest rate, and what happens if the policy lapses with a loan?

Bottom Line

IUL offers lifetime coverage, flexible premiums, index-linked interest with a floor, and federal tax advantages. Those benefits depend on keeping the policy funded and understanding its charges and non-guaranteed elements. Whether it fits depends on your goals, budget and timeline, so review it with a licensed agent and a tax professional.

Your one move: before you sign, ask for the guaranteed values and the full list of charges, and if you'd like help understanding them, send us your questions.

This is general education, not insurance, tax, legal or investment advice. No returns are promised or implied. Policies and rules vary by insurer and state.

Sources:

• NAIC: Life Insurance Buyer's Guide (PDF)
• NAIC: Life Insurance Illustrations
• NAIC: Actuarial Guideline XLIX-A (PDF)
• NAIC: Producer Licensing Model Act (PDF)
• FINRA: Insurance
• Washington Office of the Insurance Commissioner: Life Insurance on Children
• University of Nebraska–Lincoln: Risks for Farmers and Ranchers Using Infinite Banking
• IRS: Life Insurance & Disability Insurance Proceeds
• IRS Publication 525
• 26 U.S. Code § 7702 (Cornell LII)
• 26 U.S. Code § 7702A (Cornell LII)
• 26 U.S. Code § 72 (Cornell LII)