Indexed Universal Life (IUL) vs. 401(k)

Indexed Universal Life (IUL) vs. 401(k) – SmartAsset

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When creating your personal retirement plan, there are a variety of tools you can use to fund your long-term savings goals. An employer-sponsored 401(k) is one of them while indexed universal life insurance (IUL) is another. A 401(k) allows you to invest money on a tax-deferred basis while also enjoying a tax deduction for contributions. Indexed universal life insurance allows you to secure a death benefit for your loved ones while accumulating cash value that you can borrow against. Understanding the differences and similarities between IUL vs. 401(k) matters for effective retirement planning. Working with a financial advisor can also make a substantial difference in the amount of money you’ll have when you retire.

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.

IUL is different from fixed universal life insurance or variable universal life insurance. With fixed universal life insurance your rate of return is guaranteed, making it the least risky of the three. With variable universal life insurance, your cash value account is invested in mutual funds and other securities so you’re exposed to more risk. An indexed universal life insurance policy fits in the middle of the risk spectrum.

Cash value that accumulates inside an IUL insurance policy grows tax-deferred. You can borrow against this cash value if necessary, though any loans left unpaid at the time you pass away are deducted from the death benefit.

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-advantaged 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.

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.

IUL vs. 401(k): Which Is Better for Retirement Savings?

Indexed universal life insurance and 401(k) plans can both be used as investment tools for retirement. But there are some important differences to note. With IUL, returns are tied to the performance of an underlying index. If the index performs well, then your policy earns a higher interest rate. If the index underperforms, on the other hand, your returns may shrink. Your insurance company can also cap the rate of return credited to your account each year, regardless of how well the underlying index does. For instance, you may have a cap rate of 3% or 4% annually.

In a 401(k) plan, you have the option to invest in index mutual funds or ETFs but you’re not locked in to just those investments. You can also choose actively managed funds, target-date funds and other securities, based on your time frame for investing, goals and risk tolerance. Your rate of return is still tied to how well those investments perform but there’s no cap. So, if you invest in an index fund that goes up by 20%, you’ll see that reflected in your 401(k) balance.

A 401(k) also affords the advantage of an employer matching contribution. This is essentially free money you can use to grow retirement wealth. With an indexed universal life insurance policy, you’re responsible for paying all of the premium costs.

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 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. Talking with a tax professional or your financial advisor can help you come up with a plan for managing tax liability efficiently both prior to retirement and after.

The Bottom Line

Indexed universal life insurance and a 401(k) plan can both help you build wealth for retirement but they aren’t necessarily interchangeable. If you have a 401(k) at work, this may be the first place to start when creating a retirement savings plan. You can then decide if IUL or another type of life insurance is needed to supplement your workplace savings as well as the money you’re investing an IRA or brokerage account.

Tips for Investing

  • When using a 401(k) to invest for retirement, pay close attention to fees. This includes the fees charged by the plan itself as well as the fees associated with individual investments. If a mutual fund has a higher expense ratio, for instance, consider whether that cost is justified by a consistently higher rate of return.
  • Consider talking with a financial advisor about how to maximize your 401(k) plan at work and whether indexed universal life insurance is something you need. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to get personalized recommendations for professionals in your local area in just minutes. If you’re ready, get started now.

Photo credit: ©iStock.com/yongyuan, ©iStock.com/kupicoo, ©iStock.com/Piotrekswat

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She’s worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.

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Indexed Universal Life vs. Whole Life Insurance

Indexed Universal Life vs. Whole Life Insurance – SmartAsset

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Life insurance can provide a measure of financial protection against the worst-case scenario. Whole life insurance and indexed universal life insurance (IUL) are two types of permanent policies you might consider if you’re interested in lifetime coverage. While both policies can offer the opportunity to accumulate cash value while leaving behind a death benefit for your loved ones, they aren’t exactly the same. Understanding the differences between IUL vs. whole life insurance can help you decide which one may be right for you.

A financial advisor can help you sort through all the decisions that go into successful financial planning, not just deciding which type of insurance is appropriate.

Whole Life Insurance, Explained

Whole life insurance is a type of permanent life insurance. When you buy a whole life policy, you’re covered for life as long as your premiums are paid. This is different from term life insurance, which only covers you for a set term, say 20 or 30 years.

With a whole life insurance policy, you have a guaranteed death benefit that’s paid out to your beneficiaries when you pass away. Premiums usually remain level even as you age and the policy accumulates cash value over time.

You can borrow against that cash value if needed or use it to cover the premiums for your policy. Any outstanding loans remaining when you pass away are deducted from the death benefit that’s paid to the policy beneficiaries.

Indexed Universal Life Insurance, Explained

Indexed universal life insurance is also permanent life insurance coverage. Similar to whole life insurance, IUL insurance policies can accumulate cash value over time. You can take out loans against the cash value or leave it in the policy to grow.

The biggest difference between whole life and IUL is how cash value accumulates. With a whole life insurance policy, the cash value is guaranteed by the insurance company. If you’re using life insurance as an investment, that means the rate of return on your policy is fairly predictable.

Indexed universal life, on the other hand, works differently. The rate of return and the rate at which cash value accumulates in the policy is based on the performance of an underlying stock market index. Stock market indexes track a particular sector or segment of the market. So, for example, your IUL policy may track the movements of the S&P 500 Composite Price Index or the Nasdaq.

While the return potential for an indexed universal life policy can be higher than whole life insurance, returns aren’t unlimited. Insurance companies can impose a cap rate or ceiling on your returns each year. For instance, your policy might have a cap rate of 3% or 4% annually. The insurance company may also offer a minimum guaranteed rate of return.

IUL vs. Whole Life: Which One Is Better?

Indexed universal life insurance and whole life insurance can both help you accumulate cash value while retaining a death benefit. But one may suit you better than another, depending on your financial needs and goals. This is where it helps to understand what each one is designed to do. For instance, you might choose a whole life insurance policy if:

  • You’re interested in guaranteed, stable returns year over year
  • You want reassurance that premium costs won’t increase over time
  • You want a guaranteed death benefit with the option to borrow cash from the policy if needed

Whole life insurance is more expensive than term life insurance, but it can be less expensive than indexed universal life insurance. Guaranteed returns also make it the less risky option of the two, which may appeal to you if you’re looking for a more conservative addition to your financial plan.

On the other hand, there are some benefits to choosing an IUL policy over whole life. For example, you may consider an indexed universal life policy if:

  • You’re interested in earning higher returns
  • You need or want flexible premiums
  • You’re looking for a way to supplement retirement income

Indexed universal life insurance carries more risk since your returns hinge on how well the policy’s underlying index performs. It’s possible that you could even lose money but those losses may be limited if your insurance company offers a guaranteed minimum rate of return.

You also have more leeway with IUL insurance premiums compared to whole life insurance premiums. For example, you may be able to adjust your premium amount or temporarily suspend making premium payments and allow them to be covered by the policy’s cash value.

With both types of policies, the cash value can grow on a tax-deferred basis. You wouldn’t owe capital gains tax on earnings unless you were to surrender the policy. And any death benefits passed on to your policy beneficiaries would be tax-free.

How to Choose a Life Insurance Policy

Life insurance is something most people need to have and there are several questions to consider when choosing a policy. Specifically, ask yourself:

  • How long you need coverage to remain in place
  • What amount of coverage is appropriate for your financial situation
  • How much you’re comfortable paying toward premium costs
  • Whether you’re interested in accruing cash value
  • What degree of risk you’re comfortable taking

These questions can help you determine whether term life or a permanent life insurance policy is the better fit. And if you opt for permanent life insurance, they can also help you decide between IUL vs. whole life insurance.

Don’t forget that there’s also a third permanent life insurance option available: variable universal life insurance. With variable universal life insurance, you’re investing the cash value portion of the policy directly into mutual funds or other securities, rather than tracking a stock market index. This type of policy can offer the highest return potential but it can also carry the most risk.

Talking to an insurance agent or broker can help you decide whether IUL vs. whole life insurance or another type of life insurance, makes the most sense. You may also want to talk to your financial advisor about how to use life insurance effectively when crafting your estate plan.

The Bottom Line

Indexed universal life insurance essentially combines an investment tool with a life insurance policy. You might find that attractive if you’ve exhausted your 401(k) contributions or IRA contributions for the year but still have money to invest. On the other hand, you might lean toward whole life insurance if you want a guaranteed death benefit with lifetime coverage.

Tips for Estate Planning

  • Using an online life insurance calculator can help you determine how much life insurance you need. Generally, financial experts often recommend having anywhere from 10 to 15 times your annual income in coverage but the specifics of your situation may dictate having a larger or smaller death benefit.
  • Talk with your financial advisor about the best type of life insurance for your needs and how much coverage to get. If you don’t have a financial advisor yet, finding doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can help you connect with professional advisors in your local area in minutes. If you’re ready, get started now.

Photo credit: ©iStock.com/AleksandarGeorgiev, ©iStock.com/PeopleImages, ©iStock.com/designer491

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She’s worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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