401(k) vs. Indexed Universal Life Insurance - Which Is Better?

Millions of Americans put their money into their company sponsored 401(k) retirement plan every single pay period. It's mainly fo r the purpose of making sure that we are not financially broken during our retirement years. The question that remains to be answered is, Is the 401(k) retirement plan the best option for achieving your goals?

As we’ve been told countless times, it is always best to explore the options that are available so you can make the most informed decision.

What Is A 401(K)?

A 401(k) is a type of qualified retirement plan that allows you to set money aside for retirement on a tax-deferred basis. Contributions are deducted from your paychecks via a salary deferral. Your employer can also offer a matching contribution. The IRS limits the amount you can and your employer can contribute each year. For 2024, the contribution is limited to $23,000. Workers over the age of 50 can contribute an additional $7,500 per year.

With a traditional 401(k), contributions are made using pre-tax dollars. Any money you contribute is automatically deducted from your taxable income from the year. When you begin taking money out of your 401(k) in retirement, you’ll pay ordinary income tax on withdrawals. Any withdrawals made before age 59.5 may be subject to a 10% early withdrawal penalty as well as income tax.

Traditional 401(k) plans allow you to invest in a variety of securities, including mutual funds and exchange-traded funds. Target-date funds are also a popular option. These funds automatically adjust your asset allocation based on your target retirement date.

There’s no death benefit component with a 401(k). This is money you save during your working years that you can tap into in retirement. Unless you’re still working with the same employer, you’re required to begin taking minimum distributions from a 401(k) beginning at age 72. Failing to do so can trigger a tax penalty equivalent to 50% of the amount you were required to withdraw.

What Is Indexed Universal Life Insurance?

Indexed universal life insurance is a type of permanent life insurance coverage. When you buy a policy, you’re covered for the rest of your natural life as long as your premiums are paid. When you pass away, the policy pays out a death benefit to your beneficiaries.

During your lifetime, an IUL insurance policy can accumulate cash value. Part of the premiums you pay are allocated to a cash-value account. That account tracks the performance of an underlying stock index, such as the Nasdaq or S&P 500 Composite Price Index. As the index moves up or down, the insurance company credits the cash value portion of your policy each year with interest.

At this point you may be asking, why are we discussing life insurance? I thought this was about saving for retirement?

Well, you can use this policy for retirement planning similar to a 401(k) plan due to the fact that the intent of both is to grow your money for the purpose of using it during your retirement years.

What's The Difference Between The Two?

One of the biggest differences and the one that will probably have the most impact on your retirement quality of life is how your money will be treated in regard to taxation.

If you're investing in a 401(k), the gains in your account will grow tax-free, which is great, BUT are fully taxable at the highest tax rate possible when taking distribution in retirement. The bigger the gains, the bigger the share the government can take! 

The question to ponder is, do you think taxes will be lower in the future when you are of retirement age?

With a 401(k), you generally can’t tap into this money penalty-free before the age of 59.5, even in the case of a hardship withdrawal. You may be able to avoid a tax penalty if you’re withdrawing money for qualified medical expenses but you’d still owe income tax on the distribution. You could take out a 401(k) loan instead but that also has tax implications. If you separate from your employer with an outstanding loan balance and fail to repay the loan in full, the entire amount can be treated as a taxable distribution.

Qualified distributions in retirement are taxable at your regular income tax rate. And if you pass away with a balance in your 401(k), the beneficiary who inherits the money will have to pay taxes on it.

If you place your money in an Indexed Universal Life (IUL) Policy, the growth is also tax free like with a 401(k) but when you go to utilize your money for retirement, you can get your money tax free. You can also utilize money within your policy prior to 59.5 without there being any type of penalty, unlike with a 401(k) plan.

Another big difference between the two centers on tax treatment and withdrawals. With an indexed universal life insurance policy, you can borrow against the cash value at any time. You’ll pay no capital gains tax on loans and no penalties unless you surrender the policy completely or fail to repay what you borrow. Death benefits pass to your beneficiaries tax-free.

With a Indexed Universal Life Policy you are also not confined by the IRS to a low contribution limit per year. You may have the desire and the funds to want to put aside a substantial amount of money for your retirement future. You can do that with an IUL.

Related: IRS Tax Code 7702 Explained: How It Affects Your Life Insurance

A 3rd significant difference between the two is that a 401(k) plan places your money into the stock market and mutual funds while an IUL does not. 

Having your money placed in the market gives you unlimited upside potential for the growth of your money which I'm sure everyone would agree is a beautiful thing for your retirement but what is equally unlimited is the downside potential. If the stock or fund plummets, so will the money in your 401(k) account. The year 2020 was a eye opener for those with a 401(K) account. Many people saw significant amounts of their hard earned retirement money disappear due to the downturn of the market.

Indexed Universal Life Insurance operates differently than a 401(K). 

• An IUL links to an index, like the S&P500 but doesn't actually place your money into the index. 
• An IUL also has what is called a "floor", which is the minimum rate that will be credited to your cash value. The typical "floor" is 0%. 

Those two points mean that your cash value increases with the upside of the linked index and because there is a 0% "floor" you will never lose any money no matter how far the market crashes. You are protected from losing your hard earned retirement funds.

Which Is Best For You?

That is a question you truly have to answer for yourself. 

Indexed universal life insurance and a 401(k) plan can both help you build wealth for retirement but they aren’t necessarily interchangeable. IULs offer a death benefit, while 401(k)s do not.  IUL policies come with an additional cash value that can be borrowed against if you need the money for other expenses. 401(k)s offer more investment options than IULs, and employers often match a portion of employee contributions. It’s important to consider your needs and goals when deciding which is better for you. Start saving for retirement as soon as possible – the earlier you save, the more time your money has to grow.

If you would like to learn what an Indexed Universal Life Insurance policy can do specifically for you, click HERE to book your free consultation today.