For most people, just thinking about retirement planning can bring on a headache. When you begin to consider all the options out there, what they can do and what they can’t do, it can be a little (or maybe a lot) mind-numbing.
When they’re working at mid to large size companies, most people just place their trust in the company’s retirement plans and then typically never give it a second thought. Are you the type of person that wants to be thrown in with the masses and then pray you’ll have the money to enjoy a retirement lifestyle that you’ve dreamed about?
Or are you the type of person who wants to check on things to make sure your retirement accounts are always increasing and not being eaten up by market losses and fees? Don’t you want to know what you don’t know?
In this article, we’re going to look at Indexed Universal Life insurance (IUL) versus the 401(k) and discuss which one will deliver best for you and your family.
What is a 401(k)?
In case you’ve never really looked into a 401(k) and want to know what it can actually do for you, we’re going to fill you in and then discuss the pros and cons.
A 401(k) is an employer-sponsored retirement plan that allows you to defer a portion of your income into an investment account where you can earn interest based on the performance of the market. The money you invest in your 401(k) plan is not taxed until you begin withdrawing from your plan. When you begin withdrawing money from your IRA, those funds will be taxed at a rate you would normally pay at the time of the withdrawal.
Many employers who offer a 401(k) will match a portion of your investment up to a limit they select. In most cases, your employer’s match is made with company shares and not cash. This means, if the value of the company shares goes down, your 401(k) will be impacted as well.
How Does a 401(k) Work?
Let’s use a simple example to walk you through the process.
John Smith makes $500 per week and wants to set aside 5% of his weekly pay for the company’s 401(k). This means that John will be investing $25 (pre-tax money) each week into his account. John’s paycheck will then show $475 in gross pay for his federal tax liability but his payroll taxes will be based on the full $500. John’s state taxes will depend on the state he works in so the $25 deferral may or may not be subject to state income taxes.
The company’s 401(k) administrator then places John’s $25 investment into an investment portfolio. The investment portfolios selected are typically based on what John’s appetite for risk is. The fund manager will then invest the money into funds that line up with the risk John is willing to take.
Employees should think of their 401(k) as a long-term commitment but they can make changes to their portfolio if they are not happy with the returns or their appetite for risk has increased or diminished. Over time, the 401(k) will build an asset that John can use as an income stream at retirement.
What are the Pros and Cons of a 401(k)?
Every investment product has pros and cons and it’s important to know about them in advance so you can choose the product that will work best for meeting your retirement goals.
Here’s a shortlist of the good stuff about a 401(k) retirement plan:
- High Contribution Limits – The 2019 limits on 401(k) contributions is $19,000 but increases to $25,000 when you are 50 or older.
- Contributions are tax-deductible for each year you make them.
- Tax-Deferred Earnings – The 401(k) account holder has no tax liability on the interest or capital gains until the time of distribution.
- Employer Matching – Your employer can match your 401(k) contributions up to $56,000, or $100% of your annual compensation, whichever is lower. If you are 50 or older, the match limit is increased to $62,000.
- Emergency Funds – Employees can borrow money from their 401(k) for emergencies or financial crisis.
Here’s a shortlist of the not-good stuff about a 401(k) retirement plan:
- Few Options – Most employers offer 401(k) plans that are considered to be short on options. Make sure you understand where your money is being invested and the returns you should expect.
- Withdrawals are Taxable – When you begin withdrawing money from your 401(k) all of each withdrawal is considered income and will be taxed based on all of your income.
- Early Withdrawal Penalty – If you take a withdrawal from your account before age 59 ½, that withdrawal is taxable and you’ll be charged a 10% penalty for early withdrawal.
- RMDs – Required minimum distributions must begin the year you turn 70 1/2. If you continue to work, your tax rate could increase as a result of the additional income.
What is an IUL?
IUL stands for Indexed Universal Life insurance. This is life insurance that is purchased with a focus on wealth accumulation rather than the death benefit. The IUL is basically a cross between whole life insurance and term insurance but has an investment component that can be used for retirement planning.
The IUL must always have a death benefit since it is life insurance, but most policyholders choose a low death benefit so more of their premium can be invested in the various indices to earn interest. The funds in your account are never actually invested in the market; rather they are linked to the stock index or indices that you select.
Each year interest is credited to your account which is based on the performance of each index you have selected. The IUL lets you take advantage of the market without actually being in the market.Two controlling factors will affect how much you can earn and how much you can lose.
- The Cap – The cap represents the maximum amount of interest the insurer is willing to credit your account at the end of a crediting period. This means if your policy has a Cap of 12% and your index earned 18%, your account would be credited the Cap rate of 12%. Each company designates its own cap rates so you will need to shop around to determine who is offering the highest Cap.
- The Floor – The floor in your IUL represents the minimum amount of interest the insurer can credit your account at the end of a crediting period. Most companies have a floor rate of zero which means if your index loses money and posts -6%, your account would be credited 0%. In other words, you would not lose any money in your investment account.
Since insurance companies set their Floor and Cap rates and many of them are different, it’s important that you shop with a broker who represents the top IUL insurance companies so you can find the highest Cap and the lowest Floor being offered.
Let’s talk Pros and Cons of the IUL
Pros of the IUL
Here is what makes an IUL a great investment alternative:
- Earn interest based on the market without investing in the market. The gains in your IUL will typically be higher than other traditional retirement products.
- Your account earnings grow on a tax-deferred basis and the death benefit is paid tax-free to your beneficiary.
- There are no annual contribution limits (premium payments) so you can invest more than the minimum premium to jump-start your earnings.
- Your account is immune from losing money due to market volatility.
- Withdrawals can be made at any time and can be done tax-free because they are taken as low-interest loans that do not have to be repaid.
- There are no required minimum distribution rules that could result in IRS penalties.
Cons of the IUL
Like with any investment product there are some downsides to consider:
- Underwriting – Since the IUL is an insurance policy, you will have to medically qualify for your policy.
- It’s Complicated – IUL insurance is a complicated product and most policyholders will have to rely on an insurance professional to help them understand the inner workings of the product.
- Fees – All investment products and insurance products have fees that can impact your actual earnings over time.
The Bottom Line
As I mentioned earlier in this article, retirement planning can be pretty confusing for most folks who are looking to save for retirement. There are many products to choose from and there are many companies that offer the products. What you select should be up to you and based on your current circumstances and your goals for the future.
There is a lot of information out there comparing Indexed Universal Life with a traditional 401(k). Find out which one will work better for you by discussing your retirement goals with a financial professional who will listen, understand, and give the best advice.