The best time to start preparing for your long-term financial future is now. Two of the best ways you can do that is by investing in a retirement plan, like 401(k), and an Index Universal Life Insurance (IUL) policy.
Understanding the difference between IUL vs. 401(k) will help you plan efficiently for retirement and your family’s economic well-being.
Read on to find out more about IUL vs. 401(k): how they compare and which is better for your unique financial needs. We also highlight the differences between IUL vs. Roth IRA to give you more insight into how to use all your options to build your wealth successfully.
What Is Index Universal Life Insurance (IUL)?
Index Universal Life Insurance is a permanent life insurance policy that enables you to grow a separate cash account while securing death benefits for your heirs. IUL policies use a portion of your premiums to cover life insurance expenses, then pay you interest or dividends based on the performance of a stock market index like the S&P 500. Some insurance companies give you the option to choose which indices you’d like to follow.
When the stock market rises, your insurance provider will deposit a percentage of their investment profits into your cash value account. What’s great about having an IUL insurance policy is that you won’t lose any money if the stock market plummets. Most Index Universal Life Insurance policies have a 0% floor which protects your cash value from losing money.
As the policyholder, you’re free to withdraw funds from your cash value account or use them as loan collateral while you’re still alive. However, your beneficiaries won’t inherit any remaining cash value from your Index Universal Life Insurance account.
What is 401(k)?
You might have heard about 401(k) plans from your employer, but you might not fully understand what the term means. A 401(k) is a retirement savings plan that companies offer as a workplace benefit.
A traditional 401(k) allows you to allocate pre-tax dollars from your salary to different investment markets. If your annual income is $60,000 and you invest $4,000 pre-tax in your retirement plan, you’d pay taxes on only $56,000. Your investments are also tax-deferred. Funds from the plan are only taxable when you’re ready to withdraw them.
On the other hand, a Roth IRA 401(k) plan contributes money from your paycheck after the IRS deducts taxes. In this case, all withdrawals are tax-free since you’ve already paid taxes on that income.
When you die, the funds in your 401(k) account will be transferred to your beneficiary. If you don’t designate a beneficiary, the money in your account will become part of your estate to pay off any outstanding debt.
Roth IRA vs. Roth 401(k)
Roth IRA and Roth 401(k) plans are not the same. The Roth 401(k) is newer to the financial industry and was designed as a hybrid of the Roth IRA and 401(k) plans.
So, how exactly do the two retirement plans differ?
In a Roth IRA, you can contribute after-tax dollars for retirement. The benefit of this plan is that you can grow your account tax-free and withdraw funds without paying additional taxes (this typically applies to accounts that are open for longer than five years by the time you start withdrawals at age 59 ½).
This is similar to a Roth 401(k) plan, except you aren’t obligated to start making withdrawals when you turn 72. You could grow your Roth IRA account and leave all the money to your beneficiaries.
In addition, Roth IRAs offer more investment options than Roth 401(k) plans. Unfortunately, your only options on a Roth 401(k) plan are those offered by your plan provider with commission fees.
The disadvantage of a Roth IRA is that there’s an income limit on who can contribute to an account. As of 2023 (per IRS rules), workers who earn $153,000 annual income (or $228,000 combined with their spouse’s salary) aren’t eligible to open a Roth IRA account.
Even if you have a Roth IRA plan, you can’t contribute more than $6,500 per year (or $7,500 if you’re over 50). The contribution limit is relatively low, making it more challenging to accumulate substantial retirement savings.
However, there aren’t any income restrictions with a Roth 401(k) plan, and you can contribute up to $22,500—allowing you to save much more in the long run if you max out on your contributions regularly.
The greatest advantage of having a Roth 401(k) plan is your ability to borrow up to $50,000 from your balance for a loan. This isn’t a feature of a Roth IRA.
How Long Will My Money Last: IUL vs. 401(k) Calculator
Since 401(k) plans and Index Universal Life Insurance function differently, your savings for each depend on unique factors.
When comparing IUL vs. 401(k), the first step is to understand the overall purpose of retirement funds compared to insurance benefits. Your retirement funds should be able to sustain you (and your spouse or family) for a few years after you stop working. Most permanent life insurance policies cover short-term expenses for your beneficiaries.
You should estimate your retirement needs based on your current income and the standard of living you want to keep during your retirement. Typically, the cost of living doubles every 20 years.
You can use this inflation calculator for more accurate results. If you find 80% of your current annual income and multiply that by 2, you’ll get an estimate of the amount you’ll need to survive if you retire within the next two decades.
How long will the money from your 401(k) last? That depends on:
- How long you live;
- Your basic needs and medical expenses; and
- The effect of inflation on market prices when you retire.
We want to introduce William Bengen’s 4% rule here to make the calculation easier. If you withdraw roughly 4% of your retirement income annually (considering inflation), the funds should last about 30 years.
On the contrary, when comparing IUL vs. 401(k), the value of your Index Universal Life Insurance policy depends on factors such as;
- Your current income;
- The estimated cost of your funeral expenses;
- The size of your family; and
- The income streams in your household (whether someone else is employed or not).
The more beneficiaries you hope to support, the more money should go toward your death benefits. The amount of time your insurance benefits last will depend on how your beneficiaries choose to spend the funds. In reality, you don’t have much control over their allocation.
IUL vs. 401(k): Which Is Better for Retirement Savings?
The primary purpose of permanent life insurance is to provide additional financial support for your family after you die. Although you can withdraw money from your cash value account for personal needs, your insurance provider will deduct that amount from your death benefits.
By using the accumulated cash, you decrease the amount your beneficiaries receive to cover expenses when you pass away. Ergo, Index Universal Life Insurance isn’t designed for retirement savings.
A 401(k) account is more suitable for growing a retirement account. Moreover, if you apply for a Roth 401(k) plan, then the money you withdraw from your account when you retire will be tax-free!
IUL vs. 401(k): Which Is Better for Investing?
Index Universal Life Insurance offers an excellent opportunity to reap the benefits of the stock market without being invested in the stock market. You also get to avoid losing money during market downturns. When you use profits from your cash value account, it will reduce the amount of money that your family receives. Upon death, the profits from your investment won’t be released to your beneficiaries. Instead, your life insurance provider will absorb the money.
While a 401(k) won’t include death benefits (since it’s not an insurance policy), it’s still a more lucrative investment option because your beneficiaries can inherit your accumulated savings. It’s also easier to grow a 401(k) account, especially if your employer offers 401(k) matching.
It’s important to note that inherited 401(k) proceeds are taxable. However, life insurance is inherited completely tax-free.
401(k) matching is a workplace benefit in which your employer agrees to match your yearly contributions to your retirement account. It allows you to make double the investment every year potentially. If your employer offers matching contributions, ask about their vesting policy. Sometimes, you can only claim matching contributions after their designated vesting period.
Is an IUL Better Than a 401(k)?
An IUL Insurance policy is ideal for someone who wants to earn profits while reserving financial provisions for their heirs. A 401(k) provides income protection after retirement. Each serves a different purpose.
That’s not to say you need to choose between IUL vs. 401(k). You can have both an Index Universal Life Insurance policy and a 401(k) retirement account.
Nevertheless, you should know that the terms of these policies change every year. The sooner you plan for your financial future and your family’s security, the less costly it will be.
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