# Introduction
Indexed universal life insurance (IUL) and indexed annuities are two popular insurance products that offer returns linked to market performance. Both aim to provide some upside potential while limiting downside risk.
IUL is a form of permanent life insurance that builds cash value. Part of the premium goes toward the cost of insurance, while the rest goes into indexed accounts that earn interest based on gains in stock market indexes.
Indexed annuities are insurance contracts that function similarly to CDs or bonds. Money is invested and earns interest, but returns are calculated based on performance of an external market index. Annuities offer guaranteed minimum returns regardless of market conditions.
Both IUL and indexed annuities provide benefits like principal protection, tax-deferred growth, beneficiary payouts, and downside caps to limit losses when markets decline. But there are also key differences in how the products work. This article will examine the similarities and differences between IUL and indexed annuities to help consumers understand which may be a better fit for their financial goals.
## What is Indexed Universal Life Insurance?
Indexed Universal Life (IUL) insurance is a type of permanent life insurance that provides lifelong death benefit coverage. Like other permanent life insurance policies, IUL offers cash value that grows on a tax-deferred basis.
The key feature that distinguishes IUL from other permanent life insurance is how the cash value is credited interest. With IUL, the cash value is tied to the performance of a major market index, such as the S&P 500. This provides the potential for cash value growth linked to positive index performance.
How it works is a portion of the premium payment is placed into fixed interest and index-linked accounts. The insurance company credits interest to the index-linked accounts based on the performance of the chosen index or indexes, subject to caps and floors. This allows cash value to earn potentially higher returns compared to a traditional whole life policy with only fixed interest crediting.
The death benefit, access to cash value through withdrawals and loans, and other standard whole life insurance features still apply to IUL. It offers permanent coverage along with cash value that has the possibility of upside through index-based interest crediting. The downside risk is also limited by not fully participating in index losses.
## What are Indexed Annuities?
Indexed annuities are contracts issued by insurance companies that provide returns based on the performance of financial market indexes, like the S&P 500. The contract value is linked to market performance, but guarantees that you won't lose your principal or credited interest due to downturns.
Annuities offer a variety of crediting methods to determine interest earnings. Some common methods are annual point-to-point, monthly sum, monthly average, and daily average. The chosen crediting method impacts how much interest is credited each year.
With indexed annuities, your funds are allocated to fixed accounts that earn interest at a set minimum guaranteed rate, even if the index performs poorly. Many annuities also offer the option to allocate a portion of funds to indexed-linked accounts with no downside risk but potential for higher upside earnings.
The major benefit of indexed annuities is the opportunity for index-linked growth while protecting against losses if the market declines. Annuities provide guaranteed lifetime income options as well. Drawbacks are limited liquidity, high fees, and caps on earnings from index gains.
## How IUL and Indexed Annuities Are Alike
One key similarity between indexed universal life insurance and indexed annuities is that they both offer some upside potential tied to market gains. This sets them apart from traditional universal life insurance and fixed annuities which provide fixed returns.
With both IUL and indexed annuities, the growth potential comes from linking the gains to a market index like the S&P 500. Interest crediting is based in part on the performance of the index. So if the index goes up, your cash value or account value may be credited with a portion of those gains. However, there are limits in place to cap the upside.
The linking to a market index provides the advantage of potential growth compared to products with fixed returns. But the downside is also capped to limit risks. So IUL and indexed annuities offer a middle ground between fixed products and direct stock market exposure.
## How IUL and Indexed Annuities Differ
One of the biggest differences between IUL and indexed annuities is the type of protection they offer. IUL is a form of life insurance, so it provides a death benefit to beneficiaries. The death benefit from an IUL policy can be used to pay estate taxes, funeral costs, and provide ongoing income for dependents. With an indexed annuity, there is no death benefit. Instead, indexed annuities guarantee lifetime income through annuitization. Annuities allow retirees to convert a lump sum of money into a stream of payments over a number of years or for life. This provides income that cannot be outlived.
IUL offers both a death benefit and potential cash value growth. Indexed annuities offer guaranteed income for life. So while both offer growth potential tied to market indexes, IUL offers protection for loved ones through a death benefit while annuities provide protection against outliving retirement savings. The type of protection that is most important will depend on an individual's financial situation and goals. Those concerned about leaving an inheritance or covering estate taxes may prefer IUL. Retirees who want to maximize lifetime guaranteed income may favor annuities. But some may find benefit in using both products for a layered approach.
## Tax Treatment
One of the biggest considerations when choosing between an indexed universal life insurance policy (IUL) and an indexed annuity is the tax treatment.
IUL policies allow your cash value to grow tax-deferred. This means you don't pay taxes on the gains each year. Instead, the gains accumulate tax-deferred until you make a withdrawal or surrender the policy. At that point, withdrawals up to your cost basis are tax-free and any gains are taxed as ordinary income.
Indexed annuities also grow tax-deferred. However, when you start receiving income from an annuity, the full amount of each withdrawal is subject to ordinary income taxes. You don't recover any cost basis first before gains are taxed like you do with an IUL.
The tax-deferred growth feature allows your money to accumulate faster in both IULs and indexed annuities. But IULs have an advantage when it comes time to access those funds, since you can withdraw your cost basis tax-free. Annuity withdrawals face immediate taxation.
## Fees and Costs
One of the biggest factors to consider when choosing between an indexed universal life insurance policy and an indexed annuity is the fees and costs associated with each product. Here are some key differences:
Mortality Charges - IUL policies include mortality charges which are based on factors like age, gender, and health class. These fees pay for the life insurance component. Indexed annuities do not have mortality fees since there is no death benefit.
Surrender Charges - Both IULs and indexed annuities often impose surrender charges if you withdraw or surrender your policy or contract within the first 10 years or more. These fees are highest in early years and decline over time. IUL surrender charges are typically more expensive than annuity surrender fees.
Expense Fees - There are annual expense fees charged for policy administration and management expenses. IUL expense fees are generally higher than indexed annuity expense fees. Expense fees on IULs can range from 1-2% whereas indexed annuities are usually less than 1%.
Asset-based Fees - IUL policies deduct asset-based fees each month based on a percentage of your account value. Indexed annuities do not have asset-based fees.
Commissions - Both products pay a commission to the selling agent. IUL commissions are usually larger than annuity commissions. This can influence recommendations from some agents.
When evaluating costs, be sure to take a close look at the fee structure. IUL policies tend to have higher overall fees than comparable indexed annuities in most cases.
## Liquidity
Indexed universal life insurance policies allow policyholders to access their cash value in several ways, making IUL policies quite liquid. Policyholders can take out loans against their cash value, make partial withdrawals, or fully surrender their policy. This gives IUL policyholders flexibility in using the cash value for supplemental retirement income or other financial needs.
Indexed annuities are not designed to provide liquidity like IUL policies. While annuity holders can take withdrawals from an indexed annuity, withdrawals taken before age 59 1/2 will incur a 10% early withdrawal penalty from the IRS in addition to being taxed as ordinary income. Many annuities also have surrender charges if the annuity is cashed out early. Annuities are intended to provide guaranteed income during retirement, not function as liquid savings accounts.
The liquidity of IUL policies gives them an advantage for policyholders who want access to cash value without penalties. The illiquidity of indexed annuities may work well for those who want to maximize annuity income and not tap into principal. But for financial flexibility, IUL policies offer more liquidity options than indexed annuities.
## Rider Options
Indexed universal life insurance policies and indexed annuities both offer optional riders that provide added benefits and flexibility. When comparing the two, it's important to look at what riders are available and how they work.
Some key riders to consider include:
Chronic Illness Riders
- Allows accelerated death benefit if diagnosed with chronic illness
- Offered on some IUL policies
- Not typically offered with indexed annuities
Long-Term Care Riders
- Provides LTC benefits from the death benefit
- Available on many IUL policies
- Less common on indexed annuities
Guaranteed Income Riders
- Provides guaranteed lifetime income withdrawals
- Offered on indexed annuities
- Not available on IUL
Disability Income Riders
- Pays out monthly income if disabled
- Can be added to some IUL policies
- Not offered on indexed annuities
When choosing between IUL and indexed annuities, compare the riders offered to see which additional benefits suit your needs. IUL policies tend to have more flexibility with LTC and disability riders, while annuities offer guaranteed income options.
## Which Is Better: Indexed Universal Life or Indexed Annuities?
When deciding between an indexed universal life insurance policy (IUL) and an indexed annuity, there are a few key factors to consider determining which option may be better suited for your financial situation and goals. The main difference often comes down to whether you need life insurance coverage and a death benefit, or if you are more focused on guaranteed lifetime income in retirement.
In general:
- IUL policies are ideal if your priority is leaving a death benefit for beneficiaries. IUL combines lifetime insurance protection with cash value growth potential.
- Indexed annuities are better suited if you are looking for guaranteed lifetime income in retirement. They provide principal protection, tax-deferred growth, and annuity payout options to create an income stream.
Other factors to weigh include:
- Liquidity: IULs typically offer more liquidity and access to cash value through loans and withdrawals. Annuities have set surrender charge periods if accessed early.
- Fees: IUL policies tend to have higher fees and insurance costs factored into payments. Indexed annuities have lower fees overall.
- Growth potential: IULs offer unlimited upside growth potential in cash value. Annuities cap returns but protect against market losses.
- Payout options: IULs pay out death benefits to beneficiaries. Annuities offer lifetime income payouts through various annuitization options.
The choice depends on your financial priorities. Work with a qualified financial advisor to evaluate your needs for insurance protection, income, growth, taxes, and more. Neither product is inherently "better" - the right solution depends on your
personal financial situation and goals.