What Happens If You Take Too Much Money Out of an IUL in Retirement?

One of the biggest attractions of indexed universal life insurance is the ability to access policy values during retirement through policy loans.

But here’s the question that doesn’t get asked enough:

What happens if you borrow too much?

Because an IUL isn’t an unlimited ATM.

You can build substantial cash value. You can potentially access that value through policy loans. A properly structured and maintained non-MEC policy can potentially provide very tax-efficient access to those values.

But every loan creates an obligation inside the policy.

Borrow too aggressively, let the loan balance grow too large, or experience policy performance significantly below what was originally illustrated, and you can put enormous pressure on the policy.

In a worst-case situation, that can contribute to a policy lapse and potentially create a tax problem at exactly the wrong time in retirement.

There’s another wrinkle with the IUL JUMP Strategy.

We intentionally use policy loans during the accumulation phase as part of the strategy.

That might sound contradictory.

Why would I warn you about excessive policy loans while using loans to potentially improve the strategy?

Because not all borrowing is being used for the same purpose.

Understanding that difference is one of the most important parts of understanding JUMP.

First, What Actually Happens When You Borrow From an IUL?

A policy loan isn’t the same thing as withdrawing money from a checking account.

You’re borrowing against the policy according to the insurance contract’s loan provisions.

The loan carries interest.

The outstanding indebtedness affects the economics of the policy and can reduce the amount ultimately available to you or your beneficiaries.

If the balance gets too large relative to the policy’s available values, the policy can come under increasing pressure.

That’s why the question isn’t simply:

“How much can I borrow?”

The better question is:

“How much can this policy reasonably support over the rest of my life under both favorable and unfavorable assumptions?”

There Are Two Very Different Reasons Someone Might Have an IUL Loan

This distinction is especially important with the IUL JUMP Strategy.

Imagine two people each create a $30,000 policy loan.

The first person takes the $30,000 and buys a boat.

The second person uses a $30,000 Matching Indexed Participating Loan as part of the JUMP Strategy and redeploys the loan proceeds back into the policy.

Both people have a policy loan.

Both loans have a cost.

But economically, they aren’t doing the same thing.

The first person removed the borrowed money from the retirement strategy and spent it.

The second person redeployed the borrowed dollars into the policy, where those dollars have the same indexed-crediting potential under the applicable indexed strategy as the client’s original funded dollars.

That doesn’t make the second loan free.

It doesn’t guarantee a profit.

And it doesn’t eliminate the risks associated with accumulating policy debt.

But it explains why we don’t look at every policy loan as though it’s doing the same job.

Think About JUMP as Two Buckets

The easiest way to understand the structure is with two buckets.

Bucket One is your money.

Those are the dollars you’ve personally contributed to the policy.

Bucket Two is the Matching Indexed Participating Loan money.

Those are borrowed dollars that are redeployed back into the policy rather than taken out and spent.

Under the indexed strategy we’re discussing, both buckets have the potential to receive indexed crediting subject to the applicable 10% cap and 0% indexed-crediting floor.

Bucket Two has an additional consideration.

It carries the policy-loan cost.

With the policy structure we currently use for the IUL JUMP Strategy, the applicable loan rate is currently 5%, with a contractual maximum loan rate of 6% for the applicable loan feature.

The 5% current rate should not be interpreted as a guarantee that the rate will remain at 5%.

The 5% Loan Charge Isn’t Simply Subtracted From the Indexed Account

This is an important mechanical distinction.

The borrowed-and-redeployed dollars can participate in the applicable indexed-crediting strategy while the policy loan itself carries a separate loan charge.

So if the indexed-crediting calculation produces 6.87% in an example and the applicable loan rate is 5%, it would be misleading to say:

“The carrier takes 5%, so your account earns 1.87%.”

That’s not what we’re describing.

The crediting and loan mechanics are separate.

The 1.87 percentage points represent the modeled economic spread between the 6.87% historical indexed-crediting result used in the example and the current 5% loan cost.

That’s what we’re referring to when we talk about potential positive arbitrage.

Where Does the 6.87% Example Come From?

The 6.87% figure isn’t the historical return of the S&P 500.

It comes from a historical indexed-crediting analysis.

For the example we’re discussing, annual S&P 500 price changes from 2006 through 2020 were evaluated without dividends.

The policy isn’t directly invested in the S&P 500. It doesn’t own the underlying stocks and doesn’t receive their dividends.

The index is used as the external benchmark for determining indexed crediting according to the applicable policy formula.

For this historical analysis, negative annual index changes were treated as 0% for purposes of the indexed-crediting calculation, while positive annual changes above 10% were limited by the 10% cap.

Applying that framework to the historical period analyzed produced a 6.87% historical average indexed-crediting result.

That historical result doesn’t predict what the policy will earn in the future.

It simply gives us a historical scenario we can use to understand the mechanics.

So What Is Positive Arbitrage?

Using that historical example:

6.87% historical average indexed-crediting result

minus

5.00% current applicable loan rate

equals

1.87 percentage points of modeled positive spread.

That’s the potential arbitrage we’re talking about.

But here’s something you absolutely need to understand before using a strategy like this:

Positive arbitrage isn’t guaranteed.

If indexed crediting is 0% during a period while the applicable loan still costs 5%, those borrowed dollars aren’t producing positive arbitrage for that period.

The 0% indexed-crediting floor doesn’t eliminate the loan charge.

And it doesn’t mean the overall policy can’t lose value.

Insurance costs, policy charges, loan costs and other contractual expenses continue to exist.

Why Does JUMP Intentionally Accumulate Loans?

Because the objective isn’t to borrow the money and immediately pay the loan back.

The objective is to redeploy the borrowed dollars into the policy so those dollars can participate in the indexed-crediting strategy while the corresponding loan remains outstanding.

Under the JUMP design we’re discussing, the strategy generally does not plan on requiring the client to pay the applicable JUMP loan charges out of pocket each year.

Instead, the strategy is modeled with the applicable loan charges carried forward.

And when another JUMP occurs, the old loans aren’t paid off.

The loans accumulate.

That is an intentional part of the strategy.

But it’s also exactly why the loan balance has to be watched carefully.

Here’s How the Accumulating JUMP Loans Can Look

Let’s use the simplified example of someone contributing $10,000 per year.

The client isn’t suddenly writing a $60,000 check in Year 11.

In this simplified example, they’re still contributing $10,000 out of pocket.

The additional amount comes from the Matching Indexed Participating Loan structure.

But the matching loans from prior years haven’t magically vanished.

They’ve been accumulating.

That’s why looking only at the amount being funded into the policy can give you an incomplete picture.

You also need to see the outstanding indebtedness sitting on the other side of the equation.

Why Are the Death-Benefit JUMPs Part of This?

The increasing matching-loan levels require the policy design to accommodate increasing funding.

At the planned JUMP points, the strategy seeks additional death benefit designed to create the additional funding capacity needed while maintaining the intended non-MEC structure.

A Modified Endowment Contract, or MEC, receives different tax treatment when money is accessed during the insured’s lifetime.

So the death-benefit changes aren’t there simply to make the policy look bigger.

They’re an integral part of the intended funding design.

But the next JUMP isn’t guaranteed.

You Have to Qualify for Each Future JUMP

When a planned JUMP requires additional death benefit, the insured has to apply and receive carrier approval for that increase.

The underwriting can consider factors such as:

• Health
• Income
• Employment
• Financial justification for the requested insurance amount
• Driving history
• Occupation
• Hazardous job duties
• Risky hobbies or activities
• Other applicable underwriting requirements

That creates a real risk.

Someone might qualify for the original policy and several successful JUMPs, then suffer a heart attack before the next one.

Or their income could fall.

They could lose their job.

Their occupation or other underwriting circumstances could change.

Any of those things could potentially affect approval for the next requested death-benefit increase.

What Happens If You Can’t Make the Next JUMP?

This is an important distinction.

Under the JUMP structure we’re discussing, failing to qualify for the next increase doesn’t automatically mean the matching-loan level you’ve already reached disappears.

Suppose you’ve successfully reached a $30,000 annual Matching Indexed Participating Loan level.

With your $10,000 annual contribution, the simplified example is now showing:

$10,000 from you + $30,000 matching loan = $40,000 of annual policy funding.

If you don’t qualify for the next JUMP, you can remain at that previously established $30,000 matching-loan level under the structure we’re describing.

You may then have the opportunity to apply for the next increase again at a future policy anniversary.

So the progression can potentially be paused without automatically resetting everything you’ve previously established, subject to the actual policy contract and carrier rules.

That’s helpful.

But it doesn’t eliminate the risk.

If the original retirement projection assumed future JUMPs that never happen, the eventual retirement-income result could be lower than originally illustrated.

Now We Get to the Big Question: How Much Is Too Much to Borrow?

There isn’t one magic dollar amount that works for every policy.

A $100,000 loan could be manageable inside one policy and dangerous inside another.

What matters is the relationship between several things:

• Total policy cash value
• Total outstanding indebtedness
• Current and future loan charges
• Actual indexed-crediting results
• Cost of insurance
• Other policy charges
• Future planned JUMPs
• Future premiums
• Retirement distributions
• Remaining death benefit
• Age and longevity

That’s why I don’t like rules such as:

“You can safely take X% from every IUL.”

The policy has to prove that it can support the proposed distribution strategy.

What Changes When Retirement Begins?

During accumulation, the JUMP loans we’re discussing are being used to redeploy additional capital into the policy.

Retirement changes the objective.

Now you want the policy to help produce spendable cash flow.

That means money may begin leaving the strategy for you to live on.

This is where borrowing too aggressively can become dangerous.

If you take a retirement policy loan and spend the proceeds on groceries, travel, housing or normal living expenses, those dollars aren’t being redeployed back into the policy.

They’re gone from the strategy.

The loan remains.

The loan cost remains.

And the policy still needs enough value and future performance to support everything else.

That’s very different from the accumulation-phase JUMP loan.

What About Taking Around 12% a Year in Retirement?

In some of the JUMP models we’ve evaluated, retirement distributions have been modeled at approximately 12% of policy value per year.

That number should not be interpreted as a universal safe withdrawal rate for IUL.

It isn’t.

The ability of a particular policy to support a distribution level like that is affected by its accumulated values, outstanding loans, future crediting, policy costs, loan rates, age, longevity and other assumptions.

The reason we’ve been able to examine larger modeled distributions in certain JUMP scenarios is tied to the entire structure that came before retirement, including the additional borrowed-and-redeployed funding and the modeled economics of the successful JUMPs.

But the policy still has to survive the distributions.

If it doesn’t, the projected income number doesn’t mean much.

Why the 14% to 17% Numbers Need to Be Explained Carefully

You may see historical JUMP examples showing modeled effective results reaching approximately 14.48% at the Year 7 JUMP and 17.35% at the Year 9 JUMP.

Those numbers do not mean the index account itself is earning 14% or 17%.

They do not mean the S&P 500 is earning those percentages.

And they aren’t guaranteed policy returns.

They represent modeled effective results attributed to the JUMP structure under the assumptions used in the historical analysis, including successive Matching Indexed Participating Loans and the modeled positive-arbitrage effect.

The underlying historical example uses the 6.87% average indexed-crediting result discussed earlier and the current 5% loan rate.

Policy charges, cost of insurance, loan costs and other factors still have to be accounted for.

That’s exactly why I don’t want someone saying:

“This policy earns 17% and I only take out 12%, so it can never fail.”

That’s not a responsible way to evaluate an insurance policy.

You have to model the actual policy values, actual loan balances and less favorable scenarios.

What Happens If You Take More Retirement Income Than the Policy Was Designed to Support?

This is where things can start going wrong.

Imagine your retirement illustration was built around a particular level of annual income.

Then retirement happens.

You decide to take more.

Maybe you buy an RV.

Maybe you help a child with a house.

Maybe you have a major home renovation.

Maybe medical or long-term care expenses show up.

One large loan may not destroy the policy.

But larger distributions mean larger outstanding loans.

Larger loans mean more loan costs.

More loan costs can put more pressure on the policy.

And if actual indexed crediting also comes in below what was originally illustrated, the gap can become even larger.

The Dangerous Combination Is Large Loans Plus Poorer Performance

Consider what happens when several unfavorable things occur together.

You take more retirement income than originally modeled.

The policy experiences several lower-crediting periods.

The loan rate rises from the current 5% toward the contractual maximum we’re using in our analysis.

Insurance costs and other policy charges continue.

Meanwhile, you’re getting older and still need income.

That’s the scenario that needs to be stress-tested.

Not just the pretty illustration where everything goes according to plan.

What Happens If the Loan Balance Gets Too Close to the Policy Value?

As policy indebtedness becomes large relative to the policy’s available value, the policy can become increasingly fragile.

There may be less room to absorb unfavorable crediting, loan charges, insurance costs and additional distributions.

At some point, corrective action may be necessary under the policy’s actual circumstances.

That could mean reducing future distributions, contributing additional money, repaying part of the outstanding indebtedness, changing how policy values are allocated when permitted, or taking other actions available under the contract.

The available choices need to be evaluated against the actual policy at that time.

The worst approach is to ignore the loan balance for twenty years because the original illustration looked good.

Can an Overloaned IUL Lapse?

Yes.

A policy with excessive indebtedness can potentially lapse if there isn’t enough value to support the policy’s ongoing requirements.

And that’s where an IUL loan problem can turn into a tax problem.

Policy loans themselves generally aren’t treated the same way as ordinary taxable withdrawals when a properly structured non-MEC policy remains in force and applicable requirements are satisfied.

But if a policy with outstanding indebtedness lapses or is surrendered while there is taxable gain in the contract, the tax consequences can be very different.

You could potentially have taxable income even though you don’t receive a new check at the time of lapse.

That’s one reason policy monitoring becomes so important later in retirement.

What Happens to the Loans When You Die?

Outstanding policy loans don’t simply disappear without affecting the policy.

Policy indebtedness generally reduces the net amount payable under the contract.

In the JUMP scenarios we’ve evaluated, policy values have often been modeled to remain sufficient to account for substantial outstanding indebtedness while still maintaining death-benefit value.

But I would never tell someone:

“Don’t worry. The cash value will always cover every loan and your family will still get the full death benefit.”

Actual results can be different.

If someone takes substantially more money during life than originally modeled, if policy performance is weaker, if loan costs are higher, or if other assumptions change, the net amount ultimately available to beneficiaries can be reduced.

Life insurance death benefits are generally received income-tax-free under current federal law, subject to applicable exceptions and individual circumstances.

How Can JUMP Produce Up to 300% More Projected Retirement Income If Loans Are a Risk?

This is actually the right question.

If loans can create risk, how can a strategy built partly around loans potentially produce substantially more retirement income?

Because the answer isn’t simply:

“Borrow more money.”

The JUMP model uses the loans differently during accumulation.

The borrowed dollars are redeployed into the policy instead of immediately consumed. Those dollars have indexed-crediting potential under the applicable strategy while the corresponding loan carries its cost.

Successful future JUMPs can add additional borrowed-and-redeployed capital.

When indexed crediting exceeds the applicable loan cost, positive arbitrage can potentially contribute to the economics of the strategy.

Then retirement distributions, taxes, policy costs, market exposure and longevity all affect the final comparison.

In certain modeled comparisons we’ve evaluated, the IUL JUMP Strategy has produced up to approximately 300% more projected retirement income than the 401(k), Traditional IRA or comparable tax-deferred retirement strategy being evaluated.

That’s not 300% more return.

It’s not a guaranteed outcome.

And it’s not a reason to blindly buy an IUL.

It’s a reason to ask:

“Show me exactly where the difference comes from.”

Borrowing More Doesn’t Automatically Create More Retirement Income

This deserves its own section because it’s an easy conclusion to get wrong.

If the JUMP Strategy uses policy loans and can potentially produce more projected retirement income, you might think:

“Then why not borrow as much as possible?”

Because borrowing itself isn’t the magic.

The strategy requires a relationship between:

• How much is borrowed
• Where the borrowed money goes
• What the loan costs
• What indexed crediting actually occurs
• How much policy value exists
• What policy charges are being assessed
• How much retirement income is being taken
• How long the policy needs to last

Break that relationship and the same loan that was intended to help the strategy can become one of its biggest risks.

The Number I Care About Isn’t Your Maximum Loan

If you’re 60 years old and planning for a retirement that could last 30 years, I don’t care nearly as much about how much the policy lets you borrow today as I do about what the policy looks like at 75, 85 and 95.

That’s where the real questions live.

Will the income still be there?

How large is the loan balance?

What happens if crediting is lower?

What happens if loan costs are higher?

How much death benefit remains?

What happens if you need an extra $100,000 one year?

What happens if you live ten years longer than the original projection?

Those are retirement questions.

Not just insurance questions.

This Is Where the Emotional Side of Borrowing Gets Dangerous

Retirement changes the way people think about money.

While you’re working, a mistake can often be repaired with more income and more time.

At 62 or 67, you may not feel like you have that luxury.

You start thinking:

“What if we mess this up and regret it?”

You don’t want to become dependent on your children.

“I don’t want to ask my kids for help.”

And even when retirement gets complicated, there’s often a strong instinct to handle it privately.

“We should be able to handle this ourselves.”

That independence is valuable.

But it can also cause people to avoid asking questions when something inside the policy starts changing.

If your loan balance is growing faster than expected, that’s not the time to avoid looking at the statement because you don’t like what it says.

That’s the time to rerun the math.

How We Stress-Test IUL Loans Before Retirement

At FPP Financial, we use our Retirement Math Method™ because I don’t want you making this decision from one illustration.

If we’re evaluating a JUMP strategy, I want to see what happens under several scenarios.

Show me the current 5% loan rate.

Then show me the contractual maximum loan rate we’re evaluating.

Show me favorable indexed crediting.

Then show me weaker crediting.

Show me the successful JUMPs.

Then show me what happens if a future JUMP isn’t approved.

Show me the planned retirement income.

Then show me what happens if you take more.

Show me the loan balance at 70.

Then 80.

Then 90.

Show me the projected policy values.

Show me the net death benefit.

And show me what happens if you live longer than expected.

That’s how you find out whether a retirement-income number has a reasonable foundation behind it.

Don’t Ask an IUL to Prove How Much You Can Borrow

Ask it to prove how much it can reasonably support.

Those aren’t the same question.

A big projected policy loan at age 65 doesn’t impress me if the policy becomes fragile at 82.

A big projected retirement-income number doesn’t impress me if it only works under one favorable set of assumptions.

And an up-to-300% projected income comparison doesn’t mean much if nobody can show you where the difference came from.

The number isn’t the reason to buy it. The assumptions behind the number are what you need to understand.

That’s why I don’t try to sell you on the strategy.

I make the strategy prove itself with the math.

Want to See How Much Retirement Income Your Policy Could Reasonably Support?

If you already own an IUL or you’re considering the IUL JUMP Strategy, we can model the policy around the retirement income you’re actually trying to create.

We’ll look at the contributions, Matching Indexed Participating Loans, accumulated indebtedness, loan rates, indexed-crediting assumptions, policy charges, future JUMPs, retirement distributions and longevity.

Then we’ll compare the numbers against the retirement strategy you’re using now.

No guessing.

No assuming that because an illustration shows a number, the number has to happen.

Let the math do the talking.

Schedule Your Tax-Free Retirement Strategy Meeting

Explore More

• Can an IUL Lapse in Retirement?
• What Happens If IUL Loan Rates Go Up in Retirement?
• What Is a Matching Indexed Participating Loan in an IUL?

Disclosure

This material is for educational purposes only and is not intended as individualized investment, tax, legal or insurance advice. Indexed universal life insurance is a long-term life insurance product with policy charges, cost of insurance, surrender considerations, underwriting requirements and other contractual provisions. Policy loans and withdrawals reduce available cash value and death benefits and may increase the risk of policy lapse. A lapse or surrender of a policy with outstanding loans may create taxable income. Modified Endowment Contracts are subject to different tax rules.

Matching Indexed Participating Loans are policy loans, not free contributions, bonuses, guaranteed gains or direct investments in a market index. The strategy described here intentionally distinguishes between policy-loan proceeds redeployed into a policy and policy-loan proceeds removed and spent. Redeploying borrowed funds does not eliminate loan costs, guarantee positive arbitrage, guarantee policy growth or eliminate the risk associated with accumulated policy indebtedness.

References to indexed crediting, historical results, positive arbitrage, modeled effective results, projected retirement income, approximately 12% modeled retirement distributions, the 6.87% historical example, the current 5% loan rate, the contractual maximum loan rate, approximately 14% to 17% modeled effective results, or up to approximately 300% more projected retirement income are illustrative and are not guarantees of future performance, policy durability or retirement income.

The historical 6.87% indexed-crediting example described in this article is based on the historical analysis discussed for the 2006 through 2020 period using annual S&P 500 price changes, excluding dividends, and applying the stated 10% cap and 0% indexed-crediting floor. Historical results do not predict future policy crediting or performance. Actual indexed-crediting results are governed by the applicable policy terms and may be affected by caps, participation rates, spreads, crediting methods and other contractual provisions.

The S&P 500 is an external market index. An indexed universal life policy does not directly invest in the S&P 500, does not own the underlying stocks and does not receive index dividends. A 0% indexed-crediting floor does not guarantee that overall policy value cannot decline. Insurance costs, policy charges, loan costs and other policy mechanics continue to apply.

Future JUMPs and death-benefit increases are subject to carrier approval and applicable medical, financial and other underwriting requirements. A projected JUMP schedule should not be interpreted as a guarantee that every future increase will be approved. Failure to complete a future planned JUMP may materially change projected policy values and retirement-income results.

Policy-specific loan provisions, treatment of unpaid loan charges, loan rates, guarantees, nonguaranteed elements, policy expenses, death-benefit provisions, underwriting requirements and other contractual terms should be verified against the current carrier-approved illustration and actual insurance contract. Tax treatment varies with individual circumstances and policy status. Consult qualified tax and legal professionals regarding your individual situation.