Life Insurance vs. 401(k): A Comparison of Savings Options

Although a life insurance policy can be used to save for retirement, 401(k) plans often yield higher returns. They also cost less, making the 401(k) a better investment vehicle for many older adults who are nearing retirement age. This guide compares life insurance vs. 401(k) investments to help you make sense of your options.

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Life Insurance vs. 401(k): The Basics

Life Insurance

Life insurance is a type of insurance that pays a fixed amount of money upon the insured person's death. The payment is made to the person designated as the beneficiary on the account, such as a spouse or a child. Proceeds from a life insurance policy are typically used to replace the income of the deceased person. For example, if one of the spouses in a dual-income household passes away, the surviving spouse may use the life insurance payout to make mortgage payments, pay utility bills or cover medical expenses.

401(k) Plans

A 401(k) plan is an account that allows employees to put aside part of their wages for retirement. Each participant decides how much they want to contribute, and that amount is deducted from their gross wages each pay period. For example, an employee may decide to contribute $100 per paycheck. Because the contribution is deducted from the employee's gross pay, no tax is due until the account owner takes a distribution. Employers can also contribute to 401(k) plans, helping employees increase their retirement savings without increasing their personal contribution amounts.

Term vs. Whole Life Insurance

When older adults compare life insurance vs. 401(k) plans, they're typically looking at whole life policies rather than term life policies. While whole life policies offer lifetime protection, term policies only cover the insured individual for a set period of time, usually 10 to 20 years. A whole life policy also builds cash value, which is why whole life insurance is sometimes used as an investment to help older adults save for retirement.

Pros and Cons of Life Insurance

Advantages

Life insurance with built-in cash value has several advantages. One of the key advantages is a guaranteed interest rate on some policies. With a 401(k), account returns are based on market performance. From 2010 through 2016, the average 401(k) account increased at a compound average growth rate of 14.2%. That sounds great, but remember that account values can decline significantly during an economic downturn. During the 2008 financial crisis, 401(k) participants with more than $200,000 in their accounts posted average losses exceeding 25%.

Funds held in a life insurance policy are also more accessible than funds in a 401(k). With few exceptions, early 401(k) withdrawals are subject to a 10% penalty, reducing the net amount of each withdrawal. There's no such penalty for accessing the cash value of a life insurance policy, regardless of the policy owner's age or financial circumstances.

Disadvantages

One of the major drawbacks of cash-value life insurance is the high fees and premiums. When Forbes contributors Ryan Frailich and Jason Metz compared cash-value policies, they found that a $500,000 policy from one national insurer would cost more than $4,000 per year. The management fees for this type of insurance may also be higher than the fees charged for the management of a 401(k) account. 

Although cash-value insurance comes with a guaranteed rate of return, that rate is often lower than what an investor could earn by contributing to a 401(k). Some policies have rates of return that are as low as 1% to 2%. In contrast, the average rate of return for a 401(k) composed of 40% bonds and 60% stocks ranges from 5% to 8%.

Can Life Insurance Be Held in an IRA?

Many investors wonder if they can hold their life insurance policies in an individual retirement arrangement. An IRA is similar to a 401(k) because it allows an investor to save for retirement. Unfortunately, there's no way to purchase life insurance within an IRA or roll an existing insurance policy into an IRA.

Can a 401(k) Be Used as Life Insurance?

Some employers permit their employees to use 401(k) funds to purchase life insurance. At first, you can only use 25% of your contributions to pay for variable universal life insurance or term life insurance; you can use 50% of your contributions to pay for whole life insurance. This limitation goes away after you've had your account for five years. Using 401(k) funds to buy life insurance can change your tax situation, so you may want to consult a certified public accountant or enrolled agent before making a purchase.

Using Life Insurance for Retirement

If you decide to buy life insurance as part of your retirement plan, there are a few ways to use the funds to cover your financial needs. The first is a withdrawal on the cash value of the policy. If you only withdraw up to the total amount of premiums you've paid, you may not have to pay any tax on these withdrawals. Another option is to take out a loan on the life insurance policy. When you borrow against your life insurance, the policy serves as collateral for the loan.

Depending on the terms of your policy, you may also be able to use the cash value of your policy to pay your premiums. If you don't have to include the premium in your monthly budget, you'll have more money available for housing, food and other living expenses. Finally, if you no longer need your cash-value life insurance policy, you can surrender it and receive a lump sum payment.

Planning for Retirement

When comparing life insurance vs. 401(k) plans, a 401(k) plan may be the best way to save for retirement. You get to decide how much to contribute, the rate of return is typically higher than the guaranteed rate on a life insurance policy and it usually costs less to have someone manage the plan. Before making an investment, you may want to discuss your options with a financial planner to ensure you make the right decision for your family.