Consumers are asking what is better. How do you compare an IUL vs 401k? Do you ever wonder if your 401k is the best choice for retirement savings? Will there be enough to retire? Are your savings safe from another market downturn like the one in 2022?
Are there options other than a 401k? What is better, an Indexed universal life or a 401k? Maybe you should consider a mix of the two options. We will review the IUL vs 401k debate in this article.
We don’t think that anyone should focus on only one option when planning for retirement. You should have at least 3 legs to your financial stool.
Growth, Risk, and Tax Benefits of IUL vs 401k
Millions of Americans contribute some of their earnings to employer-sponsored retirement plans because it is offered to them.
From the day you started your first job, all you heard was to start saving for retirement in your 401k. But as we’ve learned, it is always best to explore all available options so you can make the most informed decision. One of those options we should explore is indexed universal life insurance, commonly referred to as IUL. You may or may not have heard of IUL, but I can assure you that you will be hearing more in the future.
Understanding Indexed Universal Life Insurance (IUL)
Indexed universal life has been around since 1997 and is currently growing in popularity because of its ability to produce tax-free retirement income that is safe from market risk. Here, we’ll discuss IUL vs 401k.
You may be asking, life insurance? I thought this was about saving for retirement. Don’t worry, it is. I want to talk about the two main benefits that an IUL can provide. The obvious first part is that it provides a life insurance payout when you die. In addition to that, an IUL builds cash value throughout the years as you pay your premium. This cash value can then be used to supplement your retirement. The distributions from your IUL are tax-free.
So what is an IUL, you ask, and how does it compare to a 401k? As mentioned above, it is an indexed universal life insurance policy. Yes, you pay premiums for the policy, just like other types of life insurance. The goal of an IUL policy is to earn interest at a higher rate than your traditional universal life insurance policy. When you pay your premium, a portion goes towards the cost of the life insurance and fees, and the remainder is added to the cash value of the policy. You allocate your premium to one or more index options that you expect to earn higher than normal interest. Your cash value then grows at the rate at which your selected index options grow. The idea here is to pay as much money as you can into the policy while keeping the amount of life insurance to a minimum.
Remember that your money is not directly invested in the stock market with an IUL policy, which keeps it safe from stock market losses.
Most IUL policies have a guaranteed minimum interest rate of around 2%-3%, ensuring you will never have a negative return. You will be able to earn a bigger return while ensuring that your money is not at risk of being lost. You get part of the stock market growth while protecting yourself from losses.
Market Risks and the Safety of IUL vs 401k
As mentioned earlier, many people invest for retirement in a 401k. While this does offer initial tax benefits, consider what a crash in the market could do to your hard-earned money. In 2008, people who lost 50 percent of their funds took about six years to get their 401k back to where it was before the crash. Again, in 2022, we had another market correction, the largest since 2008. The S&P 500 lost around 20% of its value in 2022. If you had money in the market, you lost.
How to Balance IUL vs 401k for Retirement Security
Impact of Market Losses on Retirement Savings
What would happen if you were nearing retirement when a 20% loss happens? Many in this predicament don’t stay in the market, so they never recover their losses. Imagine if you saved your entire working life for retirement, and a year before you retired, half of your savings were gone in the flash of an eye. Not so with an IUL vs 401k.
Advantages of Diversified Strategies
Doesn’t it make sense to put some of your retirement savings in a strategy that protects against market losses and guarantees you a minimum rate of return?
Cost and Fees Comparison
There are fees associated with both a 401k and an IUL. You can count on around 2% fees on your 401k plan. It doesn’t sound like a lot, but an average worker will pay around $150,000 in 401k fees over their lifetime, and a high-income earner will pay closer to $400,000 in 401k fees. So the question then becomes, what are you getting in return for your 2 percent?
An IUL vs 401k comparison is best explained using our 401k vs IUL Calculator.
Guaranteed Returns with IUL
Remember that with the IUL, you are guaranteed a return, and with a 401k, you are not. Over the last 25 years since IULs have existed, returns have been consistently around 6% to 7%. The main reason for this is the floor guarantee. The 401k can’t provide this same level of safety.
Early Withdrawal Penalties
We all know that taking early withdrawals from a 401k is not a great idea. Sometimes, however, we go through tough times where it is necessary to access those funds.
When you withdraw from your 401k before age 59 ½, you get a 10% penalty and pay federal and state taxes on the amount withdrawn. This will usually propel you to a higher tax bracket than you are currently in. You could lose over half of the withdrawal to income taxes. Imagine if you made a $50,000 withdrawal. You can count on $5,000 just in penalties, and you still have to pay taxes on the $50,000.
With an IUL, you pay no such penalty, regardless of age. You can withdraw your funds or borrow against your life insurance. You don’t even have to pay the loans back.
Additional benefits of an IUL vs 401k
Most IUL policies include accelerated benefits, but 401ks do not.
What this essentially means is that if you suffer from a critical illness such as a heart attack, cancer, or stroke, funds can be paid to you now. This is an acceleration of the death benefit. Now consider long-term care. If you cannot perform 2 of 6 activities of daily living, most of your death benefit can be accelerated to help cover the cost. Mobility, bathing, eating, dressing, personal hygiene, and using the restroom are the six basic activities of daily living. This money can then be used to cover the cost of long-term care. This benefit is considered by many for covering the cost of long-term care due to the higher cost of individual long-term care insurance.
IUL vs 401k: Tax Deferred or Tax-Free?
The 401k is fully taxable since these funds have never been taxed. Income from your indexed universal life insurance policy, however, will be paid to you tax-free.
Would you rather pay taxes on the seed or the harvest?
If you are in a 25% income bracket at retirement, you must withdraw $134,000 from your 401k to net $100,000. And, the income from your indexed universal life policy is not taxable as income.
Using IUL as a retirement supplement offers multiple benefits you can not get from your 401k.
- You are providing an income tax-free death benefit for your family.
- You are creating a retirement income stream that is tax-free.
- You are protecting yourself from critical, chronic, and terminal illnesses.
- You are protecting your retirement savings from market risk.
And unlike other forms of insurance (car, home, long-term care, etc.) that you pay for and may never need, an IUL insurance policy is guaranteed to be used. This gives you guaranteed value for the money you put into your policy.
Pros and Cons: IUL vs 401k
Pros of IUL
- Tax-Free Income: Income from an IUL is tax-free if the policy is structured correctly.
- Life Insurance Benefit: Provides a tax-free death benefit to beneficiaries.
- Protection from Market Crashes: Cash value growth is not directly tied to the stock market.
- Guaranteed Minimum Interest: Most IUL policies offer a guaranteed minimum interest rate.
Cons of IUL
- Fees: IUL policies have fees because it is a life insurance policy.
- Complexity: The policies can be complex and difficult to understand.
- Lower Returns: Potentially lower returns compared to high-performing investments in 401k.
- Medical Underwriting: Requires medical underwriting, which can be a barrier for some individuals.
Pros of 401k
- Employer Matching: Many employers offer matching contributions.
- Tax-Deferred Growth: Contributions and earnings grow tax-deferred until withdrawal.
- Automatic Contributions: Easy to contribute directly from payroll.
- Higher Contribution Limits: Higher annual contribution limits compared to IRAs.
Cons of 401k
- Required Minimum Distributions (RMDs): Mandatory withdrawals starting at age 72.
- Early Withdrawal Penalties: 10% penalty for withdrawals before age 59½, plus taxes.
- Market Risk: Investments are subject to market risk and fluctuations.
- Limited Access: Access to funds is limited until retirement age.
IUL vs 401k: Maximizing Retirement Income and Security
Using an IUL as a supplement to your 401k offers optional benefits. You are guaranteed a minimum return while protecting yourself from things like the market crashes of 2000, 2008, and 2022.
It may be a good idea to have options. When you put all of your retirement savings only in traditional plans, you are subject to history repeating itself. We have been able to help thousands of people like you improve their financial position by introducing them to indexed universal life.
IUL may or may not be right for you. If it isn’t, we will tell you. If it is a possibility, we can show you the options.
We can quickly run a model of an IUL to see if it will work for you; call us at 1-800-712-8519 or use the IUL calculator on this page.
FAQs: Common Questions About IUL vs 401k
What Are the Key Differences Between a 401k and an Indexed Universal Life (IUL) Policy?
A 401k is a retirement savings plan sponsored by employers, offering tax-deferred growth and typically including investment options like stocks and bonds. An IUL, on the other hand, is a type of life insurance that provides both a death benefit and a cash value component, with returns linked to a market index but with certain protections against market downturns.
How Does the Tax Treatment of a 401k Compare to That of an IUL?
401k plans offer tax-deferred growth, meaning you pay taxes on withdrawals in retirement. Contributions are tax deductible. IULs offer tax-deferred growth on cash values and tax-free distributions in retirement. IUL premiums are not tax deductible.
Can I Access My Funds in a 401k and IUL Before Retirement?
With a 401k, early withdrawals before age 59½ typically incur penalties and taxes. Some plans allow loans. In contrast, IUL policies provide more flexible access to cash values through loans or withdrawals at any age.
Which is Better for Long-Term Retirement Savings: IUL vs 401k?
The answer depends on individual financial situations, goals, and risk tolerance. A 401k might be more suitable for those who prioritize high growth potential and are comfortable with market risks. An IUL could be better for those seeking a combination of life insurance protection and tax advantages, with more stable, albeit potentially lower, investment returns. A combination of the 2 should be considered.
