How Is an Indexed Universal Life Insurance (IUL) Different from a 401(k) Retirement Plan?

Recently, within financial social media circles, there has been a lot of hype around Indexed Universal Life Insurance (IUL) being a more viable option for retirement saving vs a 401(k). Proponents (typically insurance sales associates who earn commissions for selling the product) have touted IUL’s policies as the panacea of retirement planning with the ability to be “your own bank.”

You may be asking yourself: Are these claims true? Can this product really help me save for retirement more efficiently than other savings vehicles such as 401(k)s and IRAs? What are the tax implications? What is the best product for me? In this blog, we will address these questions and many others so you can make an informed decision about the differences and help you determine if and when each product is or is not appropriate for you.

What is an Indexed Universal Life Insurance Policy? What is a 401(k)?

Indexed Universal Life (IUL) is a type of permanent life insurance policy that also offers a cash value component. The cash value can be used for multiple purposes including retirement savings, supplemental income, and other financial needs.

On the other hand, a 401(k) is an employer-sponsored plan that helps employees and business owners alike contribute for retirement. It offers tax advantages and often employer matching contributions. As you will learn here, these are not substitute products and are suited for unique needs and objectives. Most everyone needs to build savings for retirement, and the need for life insurance will depend on your goals and financial situation.

What are the primary objectives of an Indexed Universal Life Insurance Policy? Of a 401(k)?

An IUL policy’s primary objective is to provide a death benefit to beneficiaries upon the death of the insured. Secondarily, the policy contains a cash value account that can be accessed during the insured’s lifetime.

A 401(k) plan’s primary objective is to help employees, including business owners, save for retirement. Contributions to a 401(k) can be made with either pre or post tax dollars (via Roth if your plan allows). Monies then can grow tax–deferred until withdrawal during retirement, or in the case of Roth contributions, tax–free, earnings and all. Further, most employers provide a matching contribution that the employee would not otherwise receive unless they participate in their 401(k) plan.

How do the fees compare/differ between IULs and 401(k) plans?

IUL fees are extensive and can be broken down into the following categories:

• Insurance Cost – Cost of providing death benefit

• Admin Fees – Fees covering processing paperwork, maintaining records and customer service

• Surrender Charges – If you cancel or surrender the policy within a certain time (typically after the first several years after issuance)

• Rider Fees – Optional riders such as accelerated death benefit rider or long-term care incur additional fees

• Indexing Fees – May be fees associated with tracking the performance of the chosen index or indexes

• Loan Interest – If you take a loan against the cash value of your IUL policy, you may be charged interest on the loan amount

• Mortality and Expense Risk Charge – This fee covers the insurance company’s expenses risk of providing death benefit to the policyholder

401(k) fees include the following:

• Setup or Conversion Cost – One time charge to either set up your first plan or convert from another provider

• Administration/Record Keeping Charges – Ongoing expense to service your employees, plan sponsors, and help ensure your plan is run in a compliant manner

• Investment Expenses – These include fund expense ratios, revenue sharing (12b-1s), custodial, and/or investment management services

• 401(k) Loan Charge – if you take a 401(k) loan, there is typically a one-time charge to initiate it. From there, as you pay back the loan, the money goes directly back to you (this includes any interest). The interest is designed to help you catch back up on your retirement savings and is not going to a provider.

What are the tax differences between IULs and 401(k) plans?

IUL contributions are made via premium payments with after-tax dollars, meaning they are not tax-deductible. Any cash value growth within an IUL grows tax-deferred, meaning you do not pay taxes on the growth if it remains in the policy. Withdrawals from the cash value of an IUL are typically tax-free up to the amount of premiums paid. Any withdrawals above this amount may be subject to taxes depending on policy structure.

Traditional 401(k) contributions are made with pre-tax dollars, reducing taxable income in the year of the contribution. Roth 401(k) contributions (a plan feature available in most 401(k) plans) are made with after-tax contributions and then can be accessed (earnings and all) tax-free in retirement. Withdrawals from a traditional 401(k) are taxed as ordinary income in retirement; however, there are no dividend or capital gains tax as you accumulate wealth. Withdrawals from a Roth 401(k) are tax-free if the account has been open for at least 5 years and the individual is over 59½. Assets withdrawn from a traditional or Roth 401(k) before age 59½ may incur a 10% penalty.

Can an Indexed Universal Life Insurance Policy really serve as my own bank?

Not exactly – The claims that IULs can be your own bank are an oversimplification and can be misleading for many reasons.

Here are a few key points that differentiate IUL policies and your traditional bank:

• Liquidity and access to funds: Money within a bank can in most cases be accessed quickly and easily, while accessing the cash value in an IUL can take much longer depending on policy restrictions and waiting periods.

• Fees and charges: IUL policies often come with high fees and charges, including premium loads, cost of insurance, admin fees and surrender charges if you terminate/cancel the policy.

• Loss of Coverage with Default on Payments: If you default on payments past the grace period, you can lose coverage, and your beneficiaries cannot claim benefits upon your death. In some instances, the insurance provider may let you reinstate it by catching up on payments and paying interest charges. However, you may be subject to updating associated health questions that can impact your ongoing costs. With a 401(k), the money is always yours, including vested employer matching regardless of whether you quit contributing.

• Risk and Guarantees: First and foremost, IUL policies, and the cash value, are not FDIC insured like standard bank accounts. IUL cash value performance is tied to the performance of the stock market. While there is typically a floor to prevent losses, the growth potential is capped (meaning you may not fully benefit from market upswings).

Which product is best for me?

Most experts will agree that these are not comparable products. If you want death benefits for your survivor and are concerned your retirement savings will not be enough, then you may want to consider an IUL or other life insurance product. However, contributing to your 401(k) (and receiving a company match) is a benefit that helps you build for yourself and your family in retirement, which is a different objective altogether. Sure, the IUL can provide access to a cash account, but again this is not the primary purpose of the product.

Whether you want or need an IUL is a highly individual question and depends on your primary financial objective and goals. However, below we will attempt to cover advantages and limitations for an IUL and a 401(k), so you can further delineate these products and make a more informed decision regarding the best way to manage retirement and taking care of your loved ones after death.

Indexed Universal Life (IUL) Policies

Advantages:

1. Tax-Advantaged Growth:

   • Cash value grows tax-deferred, and loans against the policy can be tax-free if structured properly.

2. No Contribution Limits:

   • No government-imposed contribution limits, you contribute as much as you want per year.

3. Death Benefit:

   • Provides a death benefit to beneficiaries, which can be a valuable estate planning tool.

4. Market Downside Protection:

   • Some policies have built-in floors that can protect against market losses.

5. No RMDs:

   • There are no required minimum distributions, allowing you to control withdrawals according to your needs if you choose to use for this purpose

Limitations:

1. Complexity and Fees:

   • IUL policies can be complex and come with high fees and charges, including cost of insurance, administrative fees, and surrender charges if you no longer want the policy.

2. Loss of Coverage if You Fail to Pay Premiums:

   • There is generally a grace period, but if for whatever reason you do not pay premiums you can lose coverage, and your beneficiaries cannot claim benefits.

3. Loan Costs:

   • Loans against the policy accrue interest and, if not repaid, reduce the death benefit that is paid to the beneficiary.

4. Market Participation Limits:

   • For most policies, investment growth is tied to a stock market index, but gains are typically capped, limiting upside potential.

5. Sales Practices:

   • These policies are often sold by insurance agents who may emphasize benefits without fully explaining costs and risks.

401(k) Plans

Advantages:

1. Tax Advantages:

   • Pre-Tax Contributions: Contributions are made with pre-tax dollars, reducing your taxable income for the year.

   • Tax-Deferred Growth: Investments grow tax-deferred until withdrawn.

   • Tax-Free Growth via Roth Contributions: After-tax contributions can be accessed (earnings and all) tax-free in retirement.

2. High Contribution Limits:

   • For 2024, the contribution limit for a 401(k) is $23,000 for individuals under 50, and an additional $7,500 catch-up contribution for those 50 and older.

   • Plus, any employer matching or 401(k) profit share goes beyond these individual contribution limits up to $69,000 total.

3. Variety of Investment Options:

   • You typically have a range of investment options, including mutual funds, ETFs, stocks, and bonds, allowing for diversified growth potential. You can also customize your investment portfolio to support evolving retirement goals.

4. Loans and Hardship Withdrawals:

   • Some plans allow you to take loans or hardship withdrawals under specific conditions. You pay the money back to your own account, any interest and all, not to a provider.

5. Posthumously, Your Beneficiaries Receive Remaining 401(k) Savings:

   • When you start your 401(k) account, you are asked to name beneficiaries and contingent beneficiaries. If you fill this out and have 401(k) savings, your money will pass to your beneficiaries. If you rolled your 401(k) into an IRA and assigned beneficiaries, the same will occur and no need to worry about probate. It is always good to ensure you have beneficiaries assigned and update as needed.

Limitations:

1. Required Minimum Distributions (RMDs):

   • If you leave your money in your 401(k) and retire, you must start taking RMDs at age 73 (as of 2023), which can affect tax planning and your overall retirement strategy. If you remain employed at the company past 73, you need not take RMDs from your associated 401(k) plan until you retire.

2. Market Risk:

   • Investments are subject to market fluctuations, which can impact the value of your retirement savings. There is no floor available for market losses. However, there are typically stable offerings be it a stable value portfolio or a money market if you want to limit risk to the markets in retirement.

3. Limited Access:

   • You cannot access your funds without penalties before age 59½, except under specific circumstances like hardship withdrawals or loans. Your plan may even restrict it further than 59½. Regardless, when you retire past the age of 59½ you have full access to your money.

How do you make sense of it all?

401(k) Plans will generally be best for business owners or individuals looking for a tax-efficient means to build retirement savings. 401(k)s tend to be a straightforward, low-cost retirement savings vehicle with tax advantages and potential employer matching contributions for all participants. If you are a business owner, consider a 401(k) if you want to offer a retirement vehicle to you and your employees with high contribution limits, both pre- and post-tax (Roth) contributions, a variety of investment options, and the ability to take a loan/hardship withdrawal under specific conditions. Also, it is worth noting that the 401(k) vested money is always the employee’s, there is no issue or consequence if you quit contributing (other than potentially having less saved for retirement) and beneficiaries will receive any remaining funds posthumously.

IUL Policies will be best suited for individuals seeking a life insurance policy that pays a death benefit to the beneficiary of the policy, with the added potential of growth and flexible access to cash value. Before purchasing an IUL, be certain you understand all the complexities and costs involved so there are no hidden surprises that catch you off guard and that premiums are affordable for you.

Key Takeaways:

• While some social media pundits suggest an IUL is a substitute product for a 401(k), it is not. These are different products with different objectives, features, and costs.

• Indexed Universal Life (IUL) is a type of permanent life insurance policy that also offers a cash value component. The cash value can be used for multiple purposes including retirement savings, supplemental income, and other financial needs.

• A 401(k) is an employer-sponsored plan that helps employees and business owners alike contribute for retirement. It offers tax advantages and typically employer matching contributions

• The primary purpose of an IUL policy is to provide a death benefit to beneficiaries upon the death of the insured. Secondarily, the policy contains a cash value account that can be accessed during the insured’s lifetime.

• 401(k)s primarily help employers and employees save for retirement. Contributions to a 401(k) can be made with either pre- or post-tax dollars (via Roth if your plan allows). Monies then can grow tax–deferred until withdrawal during retirement, or in the case of Roth contributions, tax–free, earnings and all. Any remaining money post death goes to beneficiaries.

• Premium payments for an IUL policy are made with after tax dollars, meaning they are not tax-deductible. If you default on premium payments past the grace period, you can lose coverage and your beneficiaries would receive no benefits. Traditional 401(k) contributions are made with pre-tax dollars, reducing taxable income in the year of the contribution. Roth 401(k) contributions are made with after-tax contributions and then can be accessed (earnings and all) tax-free in retirement. Dividends and capital gains are not taxed in a 401(k) plan.

• Which product is best? This is not an either-or decision as the products are not substitutes. 401(k) plans are designed to help employees and business owners build retirement savings with tax advantages plus receive potential employer matching contributions (free added money). IUL policies may be a consideration for individuals seeking a life insurance policy that pays a death benefit to the beneficiary of the policy, with the added potential of growth and flexible access to cash value. IUL or term life insurance may be a need if you want to pass money to heirs and do not believe your retirement savings will meet the goals you have defined.

• This material is intended only as general information for your convenience and should not in any way be construed as investment or tax advice by ShareBuilder 401k. The owner/participant should consult with their tax advisor regarding any specific tax strategies. *