401(k) vs. IUL
In the last decade, we had two major market crashes. Understandably, many working professionals worry about the long-term safety of their money. They may have retirement saving plans such as 401(k) plans at their disposal. But with its contribution limits, costly tax implications, and investment options’ exposure to market risk, the 401(k) can be unseemly for conservative-minded savers.
One trend we have seen is presentation of “IUL,” or indexed universal life insurance, as an alternative to the 401(k). To be clear, IUL isn’t an investment strategy, it is a type of permanent life insurance. So be wary of discussions in which IUL is treated as an investment vehicle, especially relative to a 401(k) plan. With that said, IUL may be attractive to retirement savers, including younger professionals, on account of its more tax-efficient advantages over the 401(k), among other benefits. Some advantages include protection against market downfalls, more flexibility with contributions and money access, and better tax treatment for future income. Keep in mind, though – just like with any financial product, suitability will always depend on individual client needs, circumstances, and objectives. Here’s a quick overview of indexed universal life insurance, and how it can differ from a 401(k) as a wealth-accumulating option. IUL Basics Just like with other permanent life insurance products, indexed universal life insurance comes with a savings component (also called an investment component). It also has a cash benefit that can be tapped should any needs come up.
Where it differs from other permanent life insurance options is its interest-earning potential. It offers some potential for savings growth while keeping your money intact when the market falls:
A policyholder’s account isn’t linked to bond funds, but rather to stock indices such as the S&P 500.
Interest is credited to the account based on how this index performs. If the index goes up, your cash balance increases by a proportion of that gain.
Why a proportion, you may ask? Insurers rely on a formula to determine how much interest your cash balance earns.
If the index gained 12%, your cash balance may increase just 6-9%. That’s because this formula is used to calculate a percentage of index gains.
There also tends to be a cap on interest crediting. In the past, an average upper-range cap would be around 12% or so. So if the S&P 500 had a stellar year and gained, say, 15%, your cash balance would get a percentage of that increase.
However, this trade-off for limited growth comes with reliable market protection. If the index takes a nosedive, or records any negative change, your cash balance is credited 0% -- so there are no losses from negative index changes.
Some IUL policies offer a “protection floor” of higher minimum interest crediting in down-market periods, such as 1%.
You can see how this growth potential with market protection is one of the primary differences between IUL and the 401(k). Contrastingly, 401(k) savings are completely at the mercy of the market when it tumbles.
401(k) vs. IUL Differences With that overview, what distinguishes IUL from the 401(k)? Of course, it depends on the type of 401(k) plan you have. But let’s lay out some of the differences between IUL and the ubiquitous, traditional 401(k) plan. One of the chief differences is how IUL and 401(k) plans are classified within the tax code. Life insurance is covered under Section 7702 of the IRS tax code, whereas 401(k) plans are treated under – surprise! – Section 401(k). Check them out for context.
Unlike with traditional 401(k)s, IUL is funded with non-qualified money, or after-tax dollars. So what you pay into IUL has been taxed already. That’s good news for future income – potentially tax-free retirement income! IUL also offers the advantage of a tax-efficient death benefit for loved ones. And what are some other differences?
401(k)s may come with an employer match, while IUL policies do not have this incentive
Money within a 401(k) plan is exposed to losses from market downfalls
401(k) plans don’t let you borrow against them with the same flexibility as you might with IUL, generally speaking
401(k) withdrawals before age 59.5 are subject to a 10% penalty and income taxation
Unlike with the 401(k), distributions from an IUL policy, when taken as loans, are non-taxable
Withdrawals from a 401(k) are subject to more substantial tax liability
There are less restrictions on contributions to an IUL policy than they are to a 401(k) plan (these do come with some requirements)
In the 2018 tax year, the contribution limit for a 401(k) is set at $18,500
With its contractual guarantees, IUL offers the benefit of preserving your earning power in your professional working years
Indexed universal life insurance can also be customized for different situations: there are riders for chronic illness, work disability, and other specialized circumstances
Of course, IUL comes with its own downsides. Benefits from indexed universal life insurance may be realized after a period of 20-25 years. For this reason, this may not be an appropriate option for mature professionals or Americans getting close to retirement age.
IUL can also come with different fee and cost structures. Some policy options are better than others. It’s important to work with a knowledgeable, impartial, independent advisor when discussing suitability and looking for possible insurance solutions.
Need Help with Your Planning? If you need help finding the right IUL policy or another guaranteed insurance strategy for your financial needs, JenniferLangFinancialServices.com can assist you. You can connect directly with a financial professional who understands these vehicles and how they can fit into an overall retirement planning strategy.