Indexed Universal Life Insurance vs. 401(k)

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When you open up a toolbox, you’ll find an assortment of tools: hammers, pliers, screwdrivers, etc. Similarly, when you open up a book on financial planning, you’ll see chapters on 401(k) retirement plans and indexed universal life insurance. Like the tools in the toolbox, these financial products might be in the same container, but they’re very different in design and purpose.

Jump ahead to these sections:

Some life insurance agents will advise you that indexed universal life insurance is as good, if not better than, having a 401(k) plan as a retirement funding vehicle. On the other hand, financial planners will tell you that they serve two completely different purposes.

This article will look at both products and see how they stand alone, if they have any commonality, and when you should select one, the other, both, or neither.

Overview: Indexed Universal Life Insurance vs. 401(k)

Let’s start our comparison by looking at each product individually.

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Indexed universal life insurance (IUL) 

Indexed universal life insurance (IUL) is a life insurance product sold by many life insurance companies and their agents. It’s permanent life insurance, meaning that as long as you pay the required premiums, the IUL policy will stay in force for as long as you live. This is unlike term life insurance, where the policy terminates after a set number of years.

These are the four major components of an IUL policy:

  • Face amount: This is the amount of money listed on the first page of the policy that specifies the amount of money the insurer will pay out when the insured person dies.
  • Death benefit: This is the actual payout and is determined by subtracting any outstanding policy loan value from the face amount.
  • Beneficiary: This is the person/persons/institution who is named in the policy and receives the death benefit paid by the life insurance company.
  • Cash value: This is the amount of money accumulated in a policy’s savings component. A portion of every premium dollar paid on the policy accumulates in that portion of the life insurance policy, and an annual rate of return is applied to the cash value by the life insurance company.

The policy owner can borrow the cash value. If it’s not repaid when that person dies, the outstanding loan amount will be deducted from the policy’s face amount. 

401(k) plans

401(k) plans are named after the section of the United States Tax Code that designates them as a “qualified retirement plan,” meaning that the 401(k) receives tax advantages approved by the IRS.

401(k) plans are not life insurance plans and have no death benefit. A beneficiary is named, however, and they receive the account balance when the plan owner dies. A 401(k) is strictly a retirement planning vehicle.

An employee funds their 401(k) plan with “pre-tax” dollars, meaning the amount they contribute each pay period is subtracted from their gross pay before taxes are calculated and deducted.

Traditional 401(k) plans allow the contributor to select from various mutual funds (similar to variable universal life insurance), including exchange-traded funds and target-date funds.

Costs: Indexed Universal Life Insurance vs. 401(k)

The costs of an IUL policy and a 401(k) use different terms and are calculated differently.

The cost of IUL is called a premium. Premiums can be paid monthly (most common), quarterly, semi-annually, or annually. 

The monthly premium of an IUL policy is primarily dependent upon four factors:

  1. Age of the applicant: Premiums increase each year you get older.
  2. Health history: You can be declined or charged more based on your health history.
  3. Gender: Females have lower premiums than males because they have longer life expectancies.
  4. Smoker or non-smoker: Rates are higher for smokers because of the health risks involved.

The cost of a 401(k) plan is called a contribution. With a 401(k), the employee (if the plan is employer-sponsored) selects an amount of money they would like to contribute to the plan each pay period. The maximum amount an employee can contribute in 2021 is $19,500.

Contributions are added to the current account balance, and investment rates of return will determine its future value.

Payouts and Taxes: Indexed Universal Life Insurance vs. 401(k)

IUL policies pay a one-time lump sum death benefit to the beneficiary named in the life insurance policy. The death benefit of a life insurance policy is received tax-free by the beneficiary. When the policy is in force, the growth of the cash value is tax-deferred.

A significant tax benefit of IUL is tax-free policy loans. A policyholder can withdraw a percentage of the cash value without paying any taxes on the amount borrowed. The loan does not need to be paid back; an outstanding loan balance is deducted from the death benefit.

401(k) payouts work differently. With a 401(k), the employee determines, upon retirement, how they would like the account balance distributed. It can be paid out in a lump sum or in installments called required minimum distributions. These distributions must begin on or before you reach age 72.

Upon withdrawal of money from a 401(k), the funds are taxed at ordinary income tax rates. Since the money in the 401(k) account was contributed pre-tax, and the account grew tax-deferred, there isn’t any tax break when the money is withdrawn. Each year, a minimum amount, called a required minimum distribution, must be withdrawn.

Any 401(k) payouts to a beneficiary are taxable.

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Should You Get Indexed Universal Life Insurance, a 401(k), Both, or Neither?

Opinions vary widely on this question. Life insurance agents love IUL, and retirement planning specialists love the 401(k) plan. They each have their niche; sometimes both are needed, and sometimes neither.

Indexed universal life insurance, being first and foremost an insurance product, is recommended for someone who wants permanent life insurance and the opportunity to accumulate tax-deferred cash value within the policy alongside the death benefit. Someone would be comfortable with IUL if they can tolerate moderate stock market risk because the cash value is tied to a market index.

A 401(k) plan is ideal for an employee of a company that offers the 401(k) as an employee benefit. Financial planners advise just about everyone to contribute the maximum amount allowable to their 401(k) plan since it lowers their taxable income and the investments grow tax-deferred. 

An employer match of an employee’s contribution is also attractive to many employees. The employer typically declares a percent match each year, usually 3% to 6%. 

Someone who might benefit from having both IUL and a 401(k) would be an individual who had contributed the maximum amount allowable to their 401(k) and wanted more life insurance coverage than they already had, perhaps to pay for a funeral with life insurance.

Someone who wouldn’t benefit from either would be difficult to find. They would no longer need to put money away for retirement and would have no need for additional life insurance. High net worth individuals and retirees are two groups that might decline both.

Common Alternatives to Indexed Universal Life Insurance or the 401(k)

A common alternative to IUL is term life insurance. Many financial advisors believe in the theory that everyone should “buy term and invest the difference.”

For example, instead of spending $400 per month for an IUL policy, they would advise that you buy the same face amount of term life insurance for $100 per month and invest the $300 difference into mutual funds or other types of investments.

An alternative to the 401(k) is the Roth IRA. With a Roth, contributions aren’t tax-deductible, the money grows tax-deferred, and the payout is tax-free since income tax was already paid on the money that funded it. 

Traditional IRAs are also an alternative or supplement to the 401(k). They’re tax-deductible, grow tax-deferred, and like the 401(k), they’re taxed at regular personal income tax rates when money is taken from the account.

Ask an Expert 

The best way to determine if an indexed universal life insurance policy is the best type of life insurance policy for you is to consult with a professional life insurance agent. 

If you’re interested in enrolling in your company’s 401(k) plan, speak with your human resources department or benefits manager. They can help you enroll in the plan, and the investment company can give you recommendations on how to allocate your contributions.

To see if you need both or neither, consult with a fee-only financial planner. They should give you objective advice on your best strategy since they aren’t going to receive a commission on any insurance you buy or investments you make.

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