Indexed Universal Life (IUL) insurance is often promoted for its tax-advantaged features, making it an attractive option for wealth accumulation, retirement planning, and estate transfer. However, the intersection of life insurance and taxes—especially under IRS scrutiny—can be complex.
Whether you are a policyholder, financial advisor, or exploring IULs for the first time, this FAQ guide will help you understand how taxes interact with IUL policies.
FAQ #1: Is the cash value growth in an IUL policy taxed?
No, the cash value growth inside an IUL is not taxed while it remains in the policy. This is one of the most powerful tax advantages of IULs. As your cash value grows—based on the performance of a market index like the S&P 500—it accumulates tax-deferred. You only face potential taxes when you take distributions, and even then, proper structuring can keep those tax-free.
Why this matters: Over time, tax-deferred growth can significantly increase your net returns, especially in long-term strategies like retirement or college funding.
FAQ #2: Are withdrawals from an IUL taxable?
Withdrawals are tax-free up to your cost basis. The cost basis is the total amount of premiums you have paid into the policy. If you withdraw less than or equal to that amount, it’s not taxed. However, if you withdraw more than your basis, the excess is taxed as ordinary income.
For example, if you’ve paid $100,000 into your policy and withdraw $90,000, it is tax-free. If you withdraw $120,000, the first $100,000 is tax-free, and the remaining $20,000 is taxed.
FAQ #3: Are policy loans from an IUL taxable?
Generally, no. Policy loans are not taxable as long as your policy is:
- Not classified as a Modified Endowment Contract (MEC)
- In good standing (i.e., hasnotlapsed)
You can borrow against your policy’s cash value without generating a taxable event. The loan is considered a debt rather than income. However, interest is charged on the loan, and if the policy lapses while a loan is outstanding, the IRS will treat the borrowed amount as taxable income.
It is important to note that if your IUL becomes a MEC, loans can be taxed.
FAQ #4: What is a Modified Endowment Contract (MEC), and how does it affect taxes?
A MEC is a life insurance policy that has been overfunded beyond limits set by the IRS under the 7-pay test.
MEC Consequences:
- Withdrawals and loans are taxed as income
- 10% early withdrawal penalty applies if you are under age 59½
- Distributions follow LIFO (last-in, first-out) tax treatment
To ensure your IUL does not become an MEC, work with a professional to structure your IUL properly to avoid triggering MEC status.
FAQ #5: Is the death benefit from an IUL subject to income tax?
No, the death benefit is generally income tax-free to your beneficiaries. This applies whether the policy is a MEC or not. However, the death benefit may be included in your estate for federal estate tax purposes if:
- You are the owner of the policy at death
- You didn’t transfer ownership of the policy to a trust or another individual
You can use an Irrevocable Life Insurance Trust (ILIT) to keep the death benefit outside your taxable estate.
FAQ #6: Can IULs help reduce estate taxes?
Yes, if structured correctly. While the death benefit is income tax-free, it can be included in your gross estate, potentially increasing estate tax liability. Using a properly structured ILIT (Irrevocable Life Insurance Trust) allows you to:
- Transfer ownership of the policy
- Keep the death benefit out of your taxable estate
- Use the payout to cover estate taxes or pass assets to heirs tax-efficiently
The use of ILIT is a common strategy for high-net-worth individuals with estates over the federal exemption (which is over $13 million as of 2025).
FAQ #7: What happens if my IUL policy lapses with an outstanding loan?
If your policy lapses or is surrendered while a loan is outstanding, the IRS considers the loan a taxable distribution.
You will owe income tax on the full loan amount, even though you did not take that money as income. Plus, if you are under age 59½ and the policy is a MEC, a 10% penalty applies.
To ensure this does not happen keep your policy in force by ensuring it has enough cash value to cover costs, especially if you have loans.
FAQ #8: Are premiums paid into an IUL tax-deductible?
No. Premiums paid into an IUL are not tax-deductible. This applies whether you are an individual or a business owner (with some exceptions for business-owned policies used for employee benefits).
However, the trade-off is that the cash value grows tax-deferred and can potentially be accessed tax-free, and the death benefit is also tax-free to beneficiaries.
FAQ #9: What IRS rules apply to funding limits in IULs?
The IRS uses Section 7702 and 7702A to define funding limits:
- Section 7702: Determines if the policy qualifies as life insurance
- Section 7702A:Determines MEC status through the 7-pay test
These rules limit how much premium you can put into a policy relative to the death benefit. If you overfund, you risk the policy becoming a MEC, which affects tax treatment of loans and withdrawals.
For this reason, funding must be strategically managed to remain within IRS guidelines and maximize tax benefits.
FAQ #10: How does the IRS view income from IULs in retirement?
When used properly, income from an IUL in retirement can be tax-free. Most retirees use a combination of:
- Withdrawals up to basis
- Policy loans after basis is exhausted
Since loans are not considered taxable income (if the policy is not a MEC and remains in force), this creates a stream of tax-free retirement income.
This advantage makes IULs attractive for tax diversification—especially when compared to 401(k)s and traditional IRAs, which are fully taxable in retirement.
Indexed Universal Life Insurance(IUL) policies have a lot of features that can potentially provide a safety net for you and for your loved ones. You should check out this video on how to safeguard your future and that of your loved ones against unforseen circumstances like job loss or illnesses.
Conclusion
Indexed Universal Life insurance can be a powerful tool for tax-advantaged growth, income, and legacy planning—but only if you understand how taxes impact the policy at every stage.
From premium funding and cash value growth to distributions and death benefits, IULs are closely governed by IRS rules. A policyholder who understands the basics—or works with a qualified professional—can legally leverage these rules to build tax-free income and leave a tax-efficient inheritance.
The key is proper policy design and ongoing management to avoid MEC pitfalls, lapse scenarios, and IRS-triggered taxes. You can book a free strategy session with us at Seventi102 Life. We will be glad to be of assistance and help you navigate the intricacies of your policy to tailor it to your specific needs and avoid mistakes that might make the venture unprofitable.
Reading about the tax aspects of Indexed Universal Life (IUL) insurance policies has been eye-opening. I now have a better grasp of how tax-deferred growth and tax-free death benefits work, and what to watch out for when it comes to surrendering a policy or taking out loans. This information is invaluable as I consider how an IUL policy might fit into my broader financial plan.
Reading this guide on IUL and taxes gave me a clearer understanding of how powerful Indexed Universal Life insurance can be when used properly. I finally grasp how tax-free loans, tax-deferred cash value, and death benefit exemptions actually work in practice—not just in theory. What stood out most to me was how the IRS guidelines shape what’s possible, and how easy it is to lose those benefits if a policy isn’t structured correctly. This has helped me look at my financial planning through a sharper, more strategic lens.