Which is better for retirement: Index Universal Life vs 401K
Retirement planning can be overwhelming to most people. All of the different options for plans and investments can lead to what I call paralysis by analysis. Which essentially means you get paralyzed by all of the options and end up doing nothing because you are so overwhelmed.
Please tell me I’m not the only one who falls into this trap.
This post is designed to break down the difference between using a 401k plan and an indexed universal life policy for your retirement planning.
Before we can get into the difference between 401K plans and index universal life (IUL) let’s dig into the basics of what an IUL plan is.
Related Post on Retirement Planning: The First Step You Must Take When You Begin Planning For Your Retirement
What Is Indexed Universal Life Insurance?
There are three main components to IUL Life insurance policies:
- Indexed universal life insurance policies are a hybrid between whole life and term insurance, but with an investment component.
- They have a typical death benefit which means that upon your death a lump sum will be paid to your beneficiaries.
- They also have a cash benefit that accumulates based on a stock market index.
Your funds are never invested in the stock market but are tied to a stock index like the S&P 500. Each year your interest is credited to your account based on the performance of the stock index.
However, there is a caveat to indexed funds. You have an index cap and an index minimum. Each universal life policy has its own restrictions, but most funds typically range from 0 to 11-13%.
This means that if the S&P performs at 20% for the year, the max you can receive is an interest rate of 12% which kind of bites. However, on the other end, you are protected from significant losses since the minimum cap is at zero.
If the market ever drops below zero you investment’s won’t lose money. Think about that for a second – that means your starting asset is protected – Win, Win, Win!!!
In the investing world, this is called the rule of zero.
I personally believe this rule is very underemphasized in financial planning.
I’m going to be super blunt right here. Very few people have the knowledge or skills to beat the market.
Most of us just don’t have the time, inclination or desire to spend hours pouring over company reports to find just the right stocks to invest in. Even mutual funds and index funds take a decent amount of time and research to generate significant returns.
The average investor just isn’t going to be making huge gains unless they are lucky and investing during an up market.
Most of us just don’t have that type of luck – I know I don’t!
The rule of zero creates a form of asset security that isn’t found in any other investment vehicle. Yes, you won’t see the crazy highs of the market, but you also won’t deal with the crazy lows either.
I wrote a detailed post that explains the rule of zero in more detail and has a couple of illustrated charts that show how amazing this rule can. You’ve got to see these numbers to truly get the value of the 0% floor. Check out Why Do You Need IUL Insurance?
How can you use indexed universal life insurance for retirement?
Most people view life insurance as a way to protect their family in case of early death. Newer life insurance products have some amazing benefits that have made them an excellent tool for retirement planning.
In the past, most people purchased a basic whole or term policy to cover their death and were done.
An IUL policy is funded with after-tax dollars (often called non-qualified money). This means you have already paid taxes on what you pay into your IUL which means distributions are tax-free.
More importantly IUL’s offer tax efficient benefits for your beneficiaries. Death benefits from life insurance policies are not taxed. This means that life insurance is a great way to pass on money to your kids without killing them in taxes.
There are multiple ways to structure index universal life policies, if your policy isn’t structured correctly then you quickly lose many of the positive benefits of an IUL. I believe in max funding IUL policies, this means that as much of your monthly payment as possible goes to the cash value and you purchase as little life insurance as possible.
By max funding your IUL as soon as possible, you give the cash value of the account more time to grow. Your death benefit won’t be as high to start, but by year 10 or so will quickly begin to increase. If you are using an IUL for retirement planning you need to make sure that you are prioritizing your cash value from the beginning to get the maximum value from compounding interest.
Your cash value is what you will be using to fund your retirement, not the death benefit.
401K vs. IUL
I’ve always been a huge proponent of investing in 401K plans as soon as possible. I opened my first plan at 24 when I had my first real job and never looked back.
Gradually as I became more financially savvy I began to realize that although 401K plan were great, they weren’t necessarily the ideal retirement vehicle. 401K plans are full of hidden fees and can very quickly lose value as the market fluctuates.
IUL’s also have built-in fees, but since they aren’t percentage based, don’t take a larger portion of your income over time.
If you choose a max funded IUL nearly all of your fees are front-loaded in the first ten years. You will definitely pay more in fees in your first 5 years than a traditional 401k plan, but by year 10 you will have minimal costs. Most importantly, none of the costs are tied to your account value.
This means that by year ten while you are still paying 1.25%-2.25% of the overall value of your account to fees in a 401k, within the Index Universal Life plan your fees are purely tied to set amounts based on administrative overhead, not percentages.
In my mind, I’d always rather pay front-loaded fees, then fees that are tied to a percentage. Think about your Costco membership. You pay an annual fee to visit the store and subsequently save money. You aren’t charged a percentage of your purchases to get the benefits of Costco membership.
One of the additional benefits of a Max Funded Indexed Universal Life policy is the fact that you can take distributions without worrying about age penalties. I had to pull money out of my Roth IRA and was charged a 10% penalty to use my own money. It was so frustrating.
However, even though there aren’t penalties, I don’t recommend going that route because IUL insurance policies have an amazing loan provision feature.
When taking a loan out on your indexed universal life policy you are in super simple terms loaning yourself your own money. Typical IUL loan rates are 4%-6% and since it is a loan you can’t be taxed on the money pulled from the account.
You can take a loan from your 401K plan but are limited to 50,000 or ½ the value of the policy (whatever is lowest). You are loaning yourself the money as well, which is nice, but if you ever leave your current employer and are unable to pay back the loan in 90 days the remaining balance is treated as a withdrawal and you are hit with a 10% tax penalty and charged any regular taxes you would typically be liable for.
IUL Insurance Pros and Cons
Advantages of a Max Funded Index Universal Life Policy:
- Asset protection – 0% floor protects your money from losses when the stock market crashes periodically
- Death benefit and cash component built into the policy
- Tax advantages
- The death benefit is not taxed to your heirs
- Loans/disbursements are not taxed
- Tied to an indexed fund, but your money is not actually invested in the stock market
- No broker management fees – Administration fees that gradually decrease and are not charged as a percentage.
Disadvantages of a Max Funded Index Universal Life Policy:
- Money tied to a cap which means that you won’t have a gain of larger than 11-13%.
- Cost of the death benefit is higher than a standard term life insurance policy since you are also getting the cash component of the policy.
- Once your policy is in place you can’t increase the amount without going through additional underwriting, unless you make changes within the first six months.
- This also means you can’t over contribute or you kill your MEC limit which means you lose the tax advantages of an IUL policy.
Is an IUL policy right for you?
Honestly, I can’t answer that questions without running illustrations and getting a snapshot of your financial situation. However, I can say that in virtually every scenario I’ve run into, a properly structured IUL policy can be amazing.
Here is the deal, you have to make sure it is structured correctly. One of the dirty little secrets of the insurance world is that term policies and max funded IUL policies earn the lowest commission.
A properly structured IUL policy doesn’t make an agent anywhere near as much money as a whole life policies or even a level premium IUL policy.
If your policy isn’t structured correctly then you lose out on the real benefits of using an IUL policy.
If you have questions about an existing policy or want me to run some number for you give me a call at 475-619-2740 or drop me a quick email and I’ll see what I can do to help.