Indexed Universal Life (IUL) vs. 401(k) for Retirement Planning
- Explore the merits of an IUL vs. 401(k) for retirement saving. Learn how each product works and how it affects taxes, access to cash and growth potential.
Indexed universal life insurance (IUL) and 401(k) plans are two common ways to save for retirement — but which is best for you? As you weigh the pros and cons of IUL vs. 401(k) plans, it's helpful to consider your current financial situation and future goals.
What's the Difference Between IUL and 401(k) Plans?
Indexed universal life insurance is a life insurance contract; a 401(k) is a retirement plan. Both options can help you gain access to cash in retirement. Before you take a side in the IUL vs. 401(k) debate, it's important to understand how each product works.
Indexed Universal Life Insurance
Indexed universal life insurance is a type of life insurance that builds cash value. You can access that cash throughout your life by taking loans against your policy or withdrawing funds, depending on the terms of the contract.
As long as you keep up with the premiums on an IUL policy, it stays active for your entire life. Most policies come with a death benefit that goes to your chosen beneficiary after you pass away.
How does indexed universal life insurance build cash value? When you buy a policy, it's tied to a stock market index such as the S&P 500. Every time you pay a premium, a percentage goes toward the cash value. That money earns tax-deferred interest based on the performance of the index. When the index rises, your account builds value quickly; when it drops, your gains slow.
To ensure growth and protect your cash, most insurance providers guarantee a minimum interest rate. That way, you know that the value will increase, even if the market bottoms out.
A 401(k) is an employer-provided retirement account. When you participate, you typically defer a part of your wages into the 401(k); your company may decide to match part or all of your contributions as part of your benefits package. You decide how to invest the money; usually, you can choose from a variety of investment options offered by your employer.
The Internal Revenue Service (IRS) allows several 401(k) plan types:
- Traditional 401(k)
- Safe harbor 401(k)
- SIMPLE 401(k)
Under IRS rules, your 401(k) may allow traditional and/or Roth contributions. Traditional contributions are tax-deferred, which means that you can deduct the amounts from your taxable income. When you withdraw this money, it's subject to income tax. Roth contributions are made with after-tax dollars; you can't take a deduction, but withdrawals are tax-free down the road.
IUL vs. 401(k): What Are the Pros and Cons for Retirement?
Indexed universal life insurance policies and 401(k) plans both let you invest money and earn interest. However, each type of account works differently when it comes to accessing cash and paying taxes.
Access to Funds
In an ideal world, you'd be able to leave your retirement funds untouched until you stop working. In reality, you might need to access the money for emergencies or unexpected expenses.
An IUL policy makes it easy to get cash — as long as your account meets the criteria in the contract, you can take out a loan against the cash value without worrying about approval. Life insurance loans aren't usually taxed as income, unless you give up the policy or stop paying premiums. What's more, there are no penalties for taking loans before you reach retirement age.
With a 401(k), you'll typically pay a 10% penalty if you withdraw money before you reach age 59.5. Withdrawals from traditional 401(k)s are also taxed as income. Some plans let you take loans against the 401(k); if you don't pay it back on time, you may need to pay income tax and penalties on the unpaid balance.
Taxes are an important consideration when you're contemplating IUL vs. 401(k) for retirement. Tax implications are relatively straightforward for an IUL policy — you pay premiums with after-tax dollars, and your account grows tax-free. Loans are typically tax-free as well, but a policy surrender or cash withdrawal will involve taxes on interest and investment gains.
When it comes to 401(k) plans, taxes are more complicated. It's helpful to consider the type of contributions you can make, combined with your current and future tax rate.
If your employer's 401(k) allows Roth contributions, it can offer a significant advantage if you expect your tax bracket to be higher in retirement. You'll pay taxes now, but you'll save money by paying the lower tax rate. This type of 401(k) strategy is often an attractive option when you're in the early stages of your career.
Do you think your tax bracket will be lower when you retire? Traditional 401(k) contributions may be the better option — this strategy also frees up money for other investments or daily expenses in the present. Plus, you'll pay less in taxes when you withdraw money in retirement.
Both IUL policies and 401(k) plans allow for tax-free growth. However, 401(k)s have some big advantages in terms of potential gains. To start, you typically have more flexibility in choosing investments, which can increase the potential for gains. If your employer matches your contributions, you can increase your savings — and your returns — without contributing more money.
Because there's no limit on growth in a 410(k), you have plenty of opportunity to earn interest. On the flip side, you may lose money if your investments perform poorly.
In contrast, IUL policies typically come with a cap on interest rates, limiting the growth potential of your account. However, policies with a minimum guaranteed interest rate also protect you from loss. If you have a low risk tolerance, this may be the more attractive option.
If one of your primary goals is to leave an inheritance, an IUL policy might be a good choice. The death benefit typically passes to your beneficiary tax-free. Keep in mind that if you die with an active loan, the remaining balance will likely be subtracted from the death benefit. Some policies let you withdraw from the cash value instead of borrowing from it; this option can also reduce your death benefit.
It's important to designate your beneficiary in the life insurance contract. Otherwise, the death benefit will go to your estate, where it can be subject to taxes.
You can pass a 401(k) to a beneficiary, but they'll usually need to pay taxes. To avoid this, you might choose to make Roth contributions or roll your 401(k) into a Roth IRA.
Should You Use an IUL Policy or 401(k) to Save for Retirement?
Indexed universal life insurance and 401(k) plans both have benefits and drawbacks when it comes to saving for retirement. By considering your age, financial situation and future plans, it's easier to compare IUL vs. 401(k) plans and make the right selection for you.