IUL for Retirement Income: Loans, Lapse Risk and MEC Rules

You can use an indexed universal life (IUL) policy for retirement income by withdrawing up to what you have paid in and then borrowing against the cash value. If the policy is not a modified endowment contract (MEC) and stays in force, that income is generally not taxed. The catch is that loans and interest grow while policy charges keep coming out, and if the cash value runs out, the policy can lapse and create a tax bill.

IUL is life insurance first. It can add a source of tax-favored cash in retirement for some people, but it works best as a supplement, not a replacement, for a 401(k), IRA or pension. If you are still weighing the product itself, start with our IUL pros and cons.

How does IUL retirement income work?

Most IUL income plans follow the same pattern: fund the policy heavily for years, then take money out in retirement while keeping enough in the policy to cover charges for life.

1. Build cash value. You pay premiums well above the minimum, usually for many years, so the cash value can grow.
2. Withdraw your basis first. Under 26 U.S.C. § 72(e), amounts taken from a life insurance policy that is not a MEC are generally taxable only to the extent they exceed your investment in the contract, which is roughly what you paid in premiums.
3. Switch to policy loans. Once withdrawals would become taxable, you borrow against the cash value instead. Loans from a non-MEC policy are not treated as taxable distributions while the policy stays in force.
4. Keep the policy alive. The loan and its interest are subtracted from the death benefit when you die. The policy must stay in force for the tax treatment to hold.

Withdrawals usually reduce the death benefit, and taking them during the surrender charge period can trigger fees.

What types of IUL policy loans are there?

Policies generally offer one or both of two loan designs, and the difference matters for risk.

With an indexed loan, a year when the policy credits 0% while you owe, for example, 5% loan interest widens the loan balance faster than the cash value grows. The NAIC's Actuarial Guideline 49-A limits how rosy this can look in a sales illustration: the illustrated rate credited on borrowed value can't exceed the loan interest rate by more than 0.5 percentage point. On the alternate scale that must appear beside the main illustration, it can't exceed the loan rate at all.

Why can policy loans make an IUL lapse?

Loans can cause a lapse because the loan balance compounds while charges keep reducing the cash value that secures it.

Here is a hypothetical example with round numbers. You borrow $20,000 at the start of each year for 15 years, at a 5% loan interest rate that is added to the balance each year.

• Total borrowed: $300,000.
• Loan balance after 15 years, with interest: about $453,000.
• If you stop borrowing and let interest build for 10 more years: about $738,000.

The policy must keep enough cash value to stay ahead of that balance and pay the cost of insurance, which rises with age. If credits come in lower than illustrated, the margin can disappear years before you expected.

The SEC explains in its bulletin on variable life, another cash value product, that loans reduce cash value and can make a lapse more likely, and that if a policy terminates with a loan outstanding, you may owe federal income tax on the loan. The same basic tax rule applies to IUL. In that situation you could lose the coverage and owe tax in the same year, with no cash from the policy to pay it.

State regulators have seen this play out. The New York Department of Financial Services warned in 2019 that many universal life owners who paid for years found their policies had lapsed with little or no value, or needed large extra premiums. Wisconsin's insurance commissioner issued a similar alert in 2021.

What is a MEC, and why does it matter for IUL income?

A modified endowment contract (MEC) is a life insurance policy funded faster than federal tax law allows, and it loses the favorable tax treatment of loans and withdrawals.

Under 26 U.S.C. § 7702A, a policy entered into on or after June 21, 1988 becomes a MEC if it fails the 7-pay test. The test compares what you have paid at any time in the first 7 contract years with the level annual premiums that would have been paid by that point if the policy were paid up after 7 level annual premiums. A policy received in exchange for a MEC is also a MEC.

Here is a hypothetical example. If a policy's 7-pay limit is $10,000 a year, the total you pay can't be more than $10,000 in the first year, $20,000 by the second, and so on. Paying $35,000 in the first two years would fail the test.

If a policy becomes a MEC, the rules in § 72 change:

• Withdrawals and loans are treated as distributions, taxed as gain first before your basis comes out.
• Taxable amounts are generally hit with an extra 10% tax if taken before age 59 and a half, unless an exception applies, such as disability.
• The death benefit is still generally income-tax-free to your beneficiaries.

Two more rules matter for planning:

• A material change, such as increasing the death benefit, can restart the 7-pay test.
• Reducing the death benefit within the first 7 years means the test is applied as if the policy had been issued at the lower amount, which can turn an existing policy into a MEC.

The law also lets an insurer refund excess premium, with interest, within 60 days after the end of the contract year to keep the policy from failing. Ask your insurer to confirm your 7-pay limit before making large or extra payments. For the broader tax rules, see whether life insurance is taxable.

How does AG 49-A limit IUL retirement income illustrations?

AG 49-A caps the index credit and the loan leverage an insurer can show, so illustrated retirement income can't rest on unlimited assumptions.

According to the NAIC, AG 49 was adopted in 2015 and replaced by AG 49-A for policies sold on or after December 14, 2020. Revisions to AG 49-A took effect in 2023 to tighten illustration limits and in 2026 to enhance consumer-protection disclosures. Under the guideline:

• The illustrated rate for the benchmark S&P 500 option can't exceed the lower of a long-term historical lookback average and 145% of the insurer's net investment earnings rate.
• Loan illustrations can show at most a 0.5-point advantage between the rate credited on borrowed value and the loan rate.
• An alternate, lower-rate ledger must appear next to the main one with equal prominence.
• For policies sold on or after April 1, 2026, the illustration must say, in substance, that historical index changes are not indicative of future returns.

These limits make illustrations more consistent, but the income column still depends on non-guaranteed rates. Look at the alternate scale and the guaranteed column before you judge how much income a policy can support.

Should you use IUL for retirement income?

IUL retirement income may fit people who need permanent life insurance, have already used their other tax-advantaged options and can fund a policy heavily for many years.

It may not fit if you:

• Haven't captured an employer 401(k) match yet; see IUL vs. 401(k).
• Are eligible for a Roth IRA and haven't used it; see IUL vs. Roth IRA.
• Might stop paying premiums in the early years, when surrender charges are typically highest.
• Need predictable income, since loan capacity depends on future credits and charges.

If you mostly need coverage for a set number of years, IUL vs. term life insurance walks through the "buy term and invest the difference" approach. More guides are in our IUL hub.