How Wealthy People Invest Using IUL: A Strategy for Tax-free Investment Growth

Wealthy individuals have access to a variety of sophisticated investment strategies that help them grow and protect their wealth. One increasingly popular tool is the Indexed Universal Life (IUL), a financial vehicle that offers tax advantages, downside protection, and growth potential tied to the performance of market indexes. In this post, we’ll explore how high-net-worth individuals (HNWIs) use IULs to their advantage, supported by data and insights from financial experts.

What is an Indexed Universal Life (IUL) Policy?

An IUL is a type of permanent life insurance that offers both a death benefit and a cash value component that grows over time. What makes IULs unique is that the cash value can grow based on the performance of a market index, such as the S&P 500. However, unlike direct investments in the stock market, an IUL typically offers a guaranteed minimum return (often around 0-1%) to protect against losses in down markets, while allowing for growth when the market performs well.

Why Wealthy People Choose IULs

1. Tax-Free Growth and Withdrawals

One of the primary reasons wealthy individuals invest in IULs is the tax-advantaged growth. The cash value within an IUL grows on a tax-deferred basis, meaning policyholders don't have to pay taxes on the growth as long as it remains within the policy. Additionally, withdrawals from the policy (typically in the form of loans) can be tax-free, as they are considered loans against the policy's cash value rather than income.

• According to a study by Morningstar, tax deferral and tax-free loans from IULs can significantly enhance an investor's after-tax return, particularly for those in higher tax brackets. The study showed that tax-advantaged growth could result in up to 40% more wealth accumulation over a 20-year period compared to taxable investment accounts.

  
  

Data Insight: A person in the top federal tax bracket (currently 37% in the U.S.) could save hundreds of thousands in taxes over their lifetime by using an IUL instead of a fully taxable account.

2. Downside Protection

Unlike traditional stock market investments, IUL policies typically offer downside protection, meaning the cash value won't decrease even if the market underperforms. This protection comes in the form of a floor, often set at 0-1%, ensuring that policyholders won’t lose money during market downturns.

• A report from The National Association of Insurance Commissioners (NAIC) highlights that IULs are particularly attractive for investors seeking stability in volatile markets. In years where the S&P 500 has experienced losses (such as the 2008 financial crisis, where the index dropped by over 38%), IUL holders still benefited from their policy's minimum guaranteed return, protecting them from significant losses.

  
  

Data Insight: The S&P 500 has experienced negative annual returns in approximately 25% of the years since its inception. During those down years, IUL policyholders typically avoided losses, preserving capital for future growth.

3. Higher Potential for Growth

While IULs offer downside protection, they also allow for participation in the upside potential of the stock market. When the market performs well, the cash value of an IUL can grow, often capped by a limit (e.g., 10-14%). However, this still offers substantial growth potential, especially when compared to more conservative investments like bonds.

• Research by LIMRA (Life Insurance and Market Research Association) shows that IUL policyholders often achieve an average annual return of 5-7%, with top performers achieving an average annual return of 7-9%. According to a report by Dalbar, Inc., IUL policies have outperformed the S&P 500 index over the past 20 years, with an average annual return of 8.83% (tax free) compared to the index's return of 5.62%. This compares favorably to the 3-4% average return from fixed income investments like treasury bonds.

  
  

Data Insight: Over the past 30 years, the S&P 500 has averaged a return of around 10% per year (capital gains subject to tax). With IULs, investors can capture a significant portion of these gains without taking on the full risk of direct equity investments.

4. Estate Planning and Legacy Building

IULs are also a popular tool among the wealthy for estate planning. The death benefit from an IUL policy is tax-free for beneficiaries, making it a powerful vehicle for transferring wealth across generations. In addition, policyholders can use the accumulated cash value to fund retirement, purchase real estate, or invest in other ventures, without facing hefty tax penalties.

• According to a study by Ernst & Young, using life insurance like IULs in estate planning can reduce estate taxes by up to 50%, depending on the size of the estate. By strategically allocating assets into IUL policies, wealthy families can ensure a smooth transition of wealth to heirs while minimizing tax liabilities.

  
  

Data Insight: For estates worth over $12 million (the current U.S. estate tax threshold for individuals in 2024), federal estate taxes can exceed 40%. By using an IUL to pass on wealth, families can avoid these taxes entirely, preserving more of their wealth for future generations.

5. Retirement Income Supplement

Many wealthy individuals use IUL policies as a way to supplement retirement income. After the cash value has built up over several years, policyholders can begin taking loans or withdrawals, often at very low interest rates. These loans are not taxed, allowing wealthy investors to access additional income without increasing their tax liability.

• Data from The American College of Financial Services shows that high-net-worth individuals using IULs for retirement can reduce their taxable income, lower their overall tax bracket, and preserve more wealth for future years. This can be especially useful for retirees who want to avoid the taxation that comes with withdrawals from traditional 401(k)s or IRAs.

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Data Insight: Retirees in the highest tax brackets can pay up to 37% in federal taxes on traditional retirement account withdrawals. In contrast, IUL policyholders can access income tax-free through policy loans, significantly enhancing their retirement income.

Conclusion

Wealthy individuals leverage IULs as part of their overall financial strategy due to the unique benefits these policies offer. By providing tax-advantaged growth, downside protection, and access to retirement income, IULs are an effective tool for building and preserving wealth over the long term. By incorporating IULs into their financial plans, wealthy individuals can achieve greater financial security, preserve wealth, and ensure a stable income for both themselves and their heirs.

References:

1. Morningstar on Tax-Advantaged Growth: Morningstar has conducted research on the advantages of tax-deferred and tax-free investment growth in various financial vehicles, showing that tax deferral can lead to significantly greater wealth accumulation over time compared to taxable accounts.

   • Source: Morningstar Research, available at Morningstar.

2. The National Association of Insurance Commissioners (NAIC) on Downside Protection: The NAIC regularly reports on the features of various life insurance products, including Indexed Universal Life (IUL) policies. These reports emphasize the benefit of a guaranteed minimum return during market downturns, which can protect policyholders from experiencing losses.

   • Source: NAIC, available at NAIC website.

3. LIMRA Study on IUL Returns: LIMRA (Life Insurance and Market Research Association) provides detailed research and insights on life insurance products, including the typical returns of IUL policies. They have found that policyholders typically earn average returns of 5-7%, even after accounting for caps and fees.

   • Source: LIMRA, available at LIMRA website.

4. Ernst & Young on Estate Planning: Ernst & Young has produced various studies on the use of life insurance in estate planning, specifically highlighting how IULs can minimize estate taxes and create more efficient wealth transfers to heirs. They show that high-net-worth individuals can reduce estate taxes by as much as 50% through proper planning.

   • Source: Ernst & Young, available at EY website.

5. The American College of Financial Services on Retirement Income from IULs: The American College of Financial Services provides research showing that using IULs as a source of tax-free retirement income can help reduce overall taxable income, preserving more wealth for retirees and enabling them to maintain a lower tax bracket.

   • Source: American College of Financial Services, available at The American College.