How Much Tax-Free Retirement Income Could You Build?

What “tax-free retirement income” from an IUL actually means

It means two specific transactions under current federal tax law: withdrawing up to the total premium you have paid, and then borrowing against the policy. Neither is taxable income while three conditions hold — the contract qualifies as life insurance under IRC §7702, it is not a modified endowment contract under IRC §7702A, and it stays in force until death. Break any one of them and the phrase stops being true.

The mechanics are worth understanding because the conditions are the whole story. Under IRC §72(e), amounts not received as an annuity from a life insurance contract are treated as coming first out of your investment in the contract — your basis — and only then out of gain. So the first tranche of money you take is a return of your own premium. Once basis is gone, further withdrawals would be taxable, which is why the strategy switches to loans. A loan is borrowed money, not income. At death, the loan is settled out of the death benefit, and the death benefit is generally excluded from gross income under IRC §101(a). The IRS states that life insurance proceeds received as a beneficiary because of the insured’s death generally are not includable in gross income.

The failure case is specific and it is the one that should worry you. If the policy lapses or is surrendered while a loan is outstanding, the gain in the contract becomes taxable income in that year — see IRS Publication 525 on surrender of a policy for cash. You can end up with a tax bill on money you never received, in the same year you lose the death benefit. That is not a remote scenario; it is what happens when an underfunded policy is over-drawn, and the calculator above will show you the age it happens at your numbers.

How an indexed universal life policy actually works

An IUL is a permanent life insurance policy with a flexible premium and a cash value account whose interest credit is linked to a market index — commonly the S&P 500 price index — subject to a cap, a participation rate and a floor. You are not invested in the index. The insurer buys options to replicate part of the index move and keeps the rest to pay for the guarantee, the charges and its own margin.

Where each premium dollar goes

A premium dollar is not a deposit. First a premium load is deducted. What is left goes into the account value. Then the insurer takes a flat policy or administrative fee and a cost of insurance charge. Only the remainder participates in the index credit. This ordering is why the first years look so poor and why the calculator above shows the year-one figure explicitly rather than burying it.

Cost of insurance — the charge that decides everything

The cost of insurance is charged on the net amount at risk: the gap between the death benefit and your account value. The rate per thousand dollars of that gap rises every year, because the probability of death rises every year. Early on the gap is large but the rate is small. Later the rate is large, and if you are drawing income the account value is falling, which widens the gap again. Those two curves moving in opposite directions are what causes late-stage IUL policies to fail.

Two structural facts keep the charge from ever disappearing. First, the death benefit cannot collapse toward the account value: under the cash value corridor in IRC §7702(d), the death benefit “at any time” must be at least an applicable percentage of the cash surrender value, and the statutory table runs from 250% at attained age 40 or below down to 100% at age 95, decreasing ratably each full year in between. Second, the charge is deducted whether or not the index went up. A flat year credits nothing and still costs you the fee and the cost of insurance.

Caps, participation rates and the floor

The credited rate is the index move multiplied by the participation rate, then limited by the cap and the floor. A 0% floor means a negative index year credits zero rather than a loss — but the account value still declines that year because the charges come out anyway. Caps and participation rates are declared by the insurer and can be changed on an in-force policy within the limits written into the contract, which is the single most important sentence in this section: the terms you are shown at sale are not necessarily the terms you will have in twenty years.

You also do not receive the dividends paid by the companies in the index, because you do not own the index. Over long periods dividends have been a meaningful share of total equity return, so the gap between “the index went up X” and “the policy credited Y” is wider than the cap alone suggests.

What an illustration is — and what Actuarial Guideline 49-A does about it

An illustration is a projection produced by a carrier under regulated assumptions. It is not a guarantee, and the difference is regulated precisely because illustrations were once used to promise things products could not deliver. The NAIC Life Insurance Illustrations Model Regulation (#582) governs illustrations generally, and Actuarial Guideline XLIX-A applies that model regulation to policies with index-based interest.

AG 49-A applies to policies sold on or after December 14, 2020. Amendments took effect for policies sold on or after May 1, 2023, and a further set of revisions adopted by the NAIC on December 11, 2025 adds disclosure requirements for policies sold on or after April 1, 2026. What it constrains, in plain terms:

• The maximum illustrated crediting rate is benchmarked to a hypothetical index account with a 0% floor, a 100% participation rate and annual point-to-point crediting, so a carrier cannot illustrate an exotic account at a flattering rate.
• Bonuses, multipliers and similar enhancements may not be used to inflate that benchmark rate.
• Illustrated loan arbitrage is limited: the illustrated loan crediting rate may not exceed the illustrated loan interest rate by more than 50 basis points. This matters directly to a retirement-income illustration, because loan arbitrage is what makes an aggressive income projection look sustainable.
• For policies sold on or after April 1, 2026, illustrations may not present historical index returns side by side with maximum illustrated rates, and must carry a statement that historical index changes are not indicative of future returns.

Read that list as what it is: a ceiling on what may be shown, not a floor on what will be paid. A compliant illustration can still be wrong. The guideline text as adopted is posted by the NAIC here (PDF). When you receive an illustration, ask for the guaranteed column — the one built on the maximum charges and minimum crediting the contract permits — and read that column first.

IUL vs. 401(k) vs. Roth IRA

A 401(k) and a Roth IRA are retirement accounts; an IUL is a life insurance contract that can be borrowed against. They differ on how contributions and distributions are taxed, whether there is a contribution limit, whether required minimum distributions apply, what happens in a market decline, and whether anything is paid to your family at death. Here they are side by side on the terms that actually differ.

Contribution limits and RMD ages change with legislation and are indexed for inflation, so the current figures live on the IRS COLA page rather than here, where they would go stale. For a longer treatment of either comparison, see IUL vs. 401(k) and IUL vs. Roth IRA.

The MEC line — the rule that voids the whole strategy

A modified endowment contract is a life insurance policy funded too quickly, and MEC status removes exactly the tax treatment this page is about. Under IRC §7702A, a contract entered into on or after June 21, 1988 is a MEC if it fails the 7-pay test: the cumulative amount paid at any time during the first seven contract years exceeds the sum of the net level premiums that would have made the policy paid up after seven level annual payments.

The consequences are the mirror image of the strategy. Distributions from a MEC are taxed income-first under IRC §72(e)(10), and a loan against a MEC is treated as an amount received under §72(e)(4)(A) — so a policy loan becomes a taxable distribution to the extent of gain. Amounts includible in income can carry an additional 10% tax under §72(v) unless an exception applies. MEC status is permanent, and it follows the contract through a §1035 exchange. The death benefit stays income-tax-free; the living benefits do not.

This creates the central tension in designing an IUL for income. Cash value performance improves as you push premium up relative to death benefit — and the 7-pay limit is the ceiling on how far you can push. Only the carrier can compute your limit, because it depends on your age, health class and death benefit. Enter it in the calculator if your illustration shows it.

Who this strategy fits, and who it does not

It fits people who have already exhausted their tax-advantaged retirement space, have a genuine need for permanent death benefit, and have stable surplus income they can commit for decades. It does not fit people who still have an unused employer match, high-interest debt, no emergency fund, or any chance of needing to stop funding within the first ten years.

Reasonable candidates

• High earners already maxing a 401(k) and either ineligible for a Roth IRA or already funding one, with income they cannot shelter anywhere else.
• Business owners and families with an estate liquidity need, where permanent death benefit is the primary purpose and cash value is the secondary benefit.
• People who specifically value the absence of required minimum distributions and want a source of retirement cash flow that does not add to provisional income.
• People who will fund the policy fully, on schedule, for the entire funding period, and who understand they are buying insurance first.

Poor candidates

• Anyone leaving an employer match on the table. That match is a return no policy can beat.
• Anyone carrying credit card or other high-interest debt.
• Anyone whose income is variable enough that a missed premium is plausible — an underfunded IUL is the most likely version of this to fail.
• Anyone who might need the money back inside a decade. Surrender charges and early-year costs make that expensive.
• Anyone buying it as an investment substitute rather than as insurance. If you do not need the death benefit, you are paying for something you do not want.

Questions to ask before you sign anything

Ask for the guaranteed column, the full charge schedule, the 7-pay limit, and a projection run at a rate well below the illustrated one. An agent who cannot produce all four is not equipped to sell you this product.

• What does the guaranteed column show? That column uses maximum charges and minimum crediting. If the policy fails there, you are relying entirely on non-guaranteed elements.
• What is the cost of insurance at age 75 and age 85? Not the current-year figure — the whole table. This is the number that ends policies.
• Can the carrier change my cap or my cost of insurance after issue?Within the contract’s limits, usually yes. Ask what those contractual limits are.
• What is my 7-pay limit? If the design is close to it, ask what happens if you ever want to pay more.
• What happens if I miss a premium in year six? Ask for it re-run, not described.
• Re-run the income projection two percentage points lower. If the sustainable income collapses, the plan was resting on the assumption, not the product.
• What is the surrender charge schedule? And in what year does it reach zero?
• How are you compensated on this? A fair question with a factual answer.

Frequently asked questions

Is an IUL a good investment?

An indexed universal life policy is not an investment — it is a life insurance contract with a cash value account, and the distinction matters legally and practically. It is not registered as a security, you do not own the index, and you do not receive the dividends paid by the companies in the index. Whether it is a good use of your money depends on whether you need permanent death benefit, whether you have already used your 401(k) match and your tax-advantaged contribution room, and whether you can fund it fully for decades. For someone with an unused employer match or unfunded Roth space, an IUL is very hard to justify. For a high earner who has exhausted qualified plan limits, already needs permanent coverage, and has stable surplus cash flow, it can be a reasonable addition. Anyone who tells you it is universally better than a 401(k) is selling, not advising.

What are the downsides of an IUL?

The main downsides are cost, complexity, carrier discretion and lapse risk. Cost of insurance charges are deducted from the cash value every month and they rise as you age, so the policy gets more expensive to carry exactly when you are drawing income from it. Caps and participation rates limit your upside and the insurer can change them on an in-force policy within contractual limits. A 0% floor protects the index credit but not the account value — in a flat year the charges still come out and the balance falls. Illustrations routinely make the strategy look better than it will perform. And if you overdraw the policy in retirement, it can lapse with a loan outstanding, which triggers income tax on the gain in a year you receive no cash and simultaneously wipes out the death benefit. Underfunding is the most common way this happens.

How does tax-free retirement income from life insurance actually work?

It works in two stages, and it is conditional rather than automatic. First you withdraw up to your cost basis — the total premium you have paid. Under IRC section 72(e), amounts not received as an annuity from a life insurance contract are treated as received first from investment in the contract, so withdrawals to basis are a return of your own money and are not taxable. After basis is exhausted you switch to policy loans. A loan is not income because it is borrowed money secured by the policy. The conditions attached are strict: the contract must not be a modified endowment contract under IRC section 7702A, it must qualify as life insurance under IRC section 7702, and it must remain in force until death, at which point the death benefit settles the loan and is generally excluded from gross income under IRC section 101(a). If the policy lapses or is surrendered with a loan outstanding, the gain becomes taxable in that year.

How much retirement income can an IUL actually produce?

There is no honest single answer, and any figure quoted without a full set of assumptions is marketing. The output depends on your issue age and health class, the premium and how many years you pay it, the death benefit you are forced to carry, the premium load and policy fees, the cost of insurance table, the cap and participation rate, the loan interest rate, and how long the income has to last. Change the assumed crediting rate by two percentage points and the sustainable income can move by a third. The calculator on this page solves for the largest level annual distribution the policy survives to your chosen age, and it makes every one of those variables an input so you can see how much of the answer is your assumption rather than the product.

Is an IUL better than a 401(k) or a Roth IRA?

Usually not first, and rarely instead. A 401(k) with an employer match returns money you cannot get anywhere else, and both a 401(k) and a Roth IRA carry no cost of insurance, no premium load, no surrender charge and no lapse risk. The genuine advantages of an IUL are that it has no statutory contribution limit, it is not subject to required minimum distributions, it pays a death benefit that is generally income-tax-free to beneficiaries under IRC section 101(a), and it has a floor that limits index-credit losses. The honest sequence for most people is employer match first, then high-interest debt, then tax-advantaged contribution room, and only then consider permanent life insurance for the job it is actually good at — death benefit and estate liquidity — with cash value as a secondary benefit. Compare the two side by side in the calculator rather than taking either side's word for it.

What is Actuarial Guideline 49-A and why does it matter to me?

Actuarial Guideline XLIX-A is the NAIC guideline that limits what an indexed universal life illustration is allowed to show. It applies to policies sold on or after December 14, 2020, was amended effective May 1, 2023, and carries further disclosure requirements for policies sold on or after April 1, 2026. It caps the illustrated crediting rate by benchmarking it to a hypothetical index account with a 0 percent floor and a 100 percent participation rate, bars bonuses and multipliers from inflating that benchmark, and limits illustrated loan arbitrage — the illustrated loan crediting rate may not exceed the illustrated loan interest rate by more than 50 basis points. It matters to you because it is the reason illustrations became less optimistic than they were a decade ago, and because it is a limit on what may be shown, not a promise about what will be paid.

Can you lose money in an indexed universal life policy?

Yes. The 0 percent floor applies to the index credit, not to your account value. In a year when the index is flat or down, you are credited nothing while the premium load, the policy fee and the cost of insurance are still deducted, so the account value falls. Surrendering in the early years usually means taking a loss, because acquisition costs and surrender charges come out first. You can also lose the whole thing: if the account value is exhausted the policy lapses, and if it lapses with a loan outstanding you owe income tax on the gain even though you receive nothing. The phrase 'you can never lose money' is describing one component of the crediting formula, not the contract.

Do policy loans reduce the death benefit?

Yes, and this is the part most often left out of a retirement income pitch. An outstanding loan balance plus accrued interest is subtracted from the death benefit before anything is paid to your beneficiary. If you draw income for twenty-five years and the loan compounds at the policy loan rate the whole time, the balance can consume most of the death benefit by the end. Withdrawals reduce it too, dollar for dollar. So retirement income out of a life insurance policy is not free money — it is death benefit your family does not receive, and the arithmetic of that trade is shown year by year in the calculator above.

Assumptions, limitations and disclosures

Everything this planner produces comes from the assumptions you enter. No carrier data, no product, no cost-of-insurance table and no historical index return is used anywhere in it. The default values are round placeholder numbers chosen so the page renders something on first load — they are not industry averages and not rates anyone has offered you.

What the model does

• Deducts your premium load from every premium, then deducts an annual policy fee and a cost of insurance charged on the net amount at risk at a rate that compounds upward with your age.
• Applies the cash value corridor of IRC §7702(d)(2) so the death benefit — and therefore the cost of insurance — cannot fall to zero as the account value grows.
• Credits the index at min(cap, max(floor, index return × participation)), applied after charges, once a year.
• Runs a conservative and an optimistic scenario side by side and headlines the conservative one.
• Takes retirement income as withdrawals to cost basis first and policy loans after, compounds unpaid loan interest, reduces the death benefit by withdrawals and by the loan balance, and stops the projection at the year the policy would lapse.
• Solves for the largest level annual income the policy survives to your chosen age, rather than assuming one.
• Compares the result against a Roth IRA funded with the same after-tax dollars and a traditional 401(k) grossed up for the deduction and taxed on the way out.

What the model does not do

• It does not use any carrier’s expense, mortality or crediting tables, and it is not an illustration under Model #582 or AG 49-A.
• It does not simulate market volatility or sequence-of-returns risk. Real index returns are not a constant, and a smooth assumed rate flatters both the policy and the 401(k)/Roth comparison.
• It does not compute your 7-pay limit, test whether a design would be a MEC, or check whether the premium satisfies the §7702 definitional limits.
• It does not model surrender charges, no-lapse guarantees, multipliers, bonuses, riders, index account switching, or monthly (as opposed to annual) charge deduction.
• It does not adjust for inflation, model state taxes, Social Security, pensions, or the taxation of any specific transaction — and it does not know whether you are insurable.

Sources

• 26 U.S.C. §7702 — Life insurance contract defined, including the §7702(d) cash value corridor
• 26 U.S.C. §7702A — Modified endowment contract defined (the 7-pay test)
• 26 U.S.C. §72(e) and §72(v) — distributions, loans, and the 10% additional tax on MECs
• 26 U.S.C. §101 — Certain death benefits
• IRS — Life insurance & disability insurance proceeds
• IRS Publication 525 — Taxable and Nontaxable Income
• IRS — COLA increases for dollar limitations on benefits and contributions
• IRS — Retirement plan and IRA required minimum distributions FAQs
• NAIC — Life insurance illustrations (AG 49 / AG 49-A history and effective dates)
• NAIC — Actuarial Guideline XLIX-A as revised, adopted 12/11/2025 (PDF)
• NAIC — Life Insurance Illustrations Model Regulation #582 (PDF)
• NAIC — Life insurance consumer information

Educational projection only — not a policy illustration, not a quote, not an offer of insurance, and not tax or legal advice. Actual policy values depend on the carrier, the product, your underwriting class, and the caps, crediting rates and charges the insurer declares — none of which is guaranteed. “Tax-free income” on this page means withdrawals to cost basis and policy loans from a contract that is not a modified endowment contract and is kept in force until death, under federal tax law as it currently stands; change any of those conditions and the tax treatment changes. Loans and withdrawals reduce the death benefit, and a lapse or surrender with a loan outstanding is a taxable event. Verify every figure against a carrier illustration and confirm your tax position with a qualified tax professional before acting.