401(k) or IUL - Which is Better?

 

Since indexed universal life insurance (IUL) is often mentioned as an alternative to a 401K, IRA, or other qualified plan, let's look into the basics of IUL vs. 401K.

Feedback from clients show that the biggest advantage IUL has over 401Ks and IRAs is that you can have reason to hope for double digit gains, but still sleep at night, knowing that the investment component of IUL will never incur a loss! The prospects for higher returns are enhanced by the use of leverage - not available with a 401(k), IRA, or other types of qualified plans. Also, even if you put some or all of the money into the policy's Fixed Account, many of these policies currently pay interest at above 4% - much higher than the banks. Using the Early Cash Value Rider, available with some carriers, the client may also be able to have access to 90% or even 100% of his cash the first year. No more waiting around for years the achieve a high level of liquidity, thus lessening the need to keep his liquid assets in banks. This effect is also highly useful with alternative and supplemental plans called 409A or SERPs.

IUL is a bit like a Roth IRA, but with important differences. First, IUL provides a life insurance benefit, which can be substantial depending on how it is structured. Some carriers offer a Waiver of Specified Premium Rider that can make your retirement plan self-completing in the event you cannot work due to disability. Imagine asking your 401K provider to make your contributions for you if you can't work!

Have you ever reached the end of the year, only to find that you haven't been able to fund your 401K to the maximum allowable? Even worse, have you been in a position to put in extra the following year? Any qualified plan, including a 401K, do not allow catch-up contributions for past years. IUL, on the other hand, is only limited as to cumulative contributions. If you under-fund in one year, in most cases you can play catch-up anytime in the future. In the real world, this feature may turn out to be one of the most critical advantages IUL has over a 401K, an IRA, a Simple IRA, or a SEP.

IUL has virtually no restrictions on the amount one may contribute or when one can distribute funds. A person usually accesses funds from IUL through policy loans. While many people are apprehensive about adopting a pattern of borrowing, the leverage made possible via IUL is generally considered an acceptable risk once understood.

But what about the "bottom line"? Which approach can result in more retirement income for an individual after income taxes are taken into consideration? The surprising answer may be "IUL". The newest uncapped index strategies sometime back-test at returns approaching 10% - pretty impressive when you also know you will never get an index return of less than zero thanks to hedging.

With 401Ks, the higher yields are only achieved by investing in stocks, ETFs, or mutual funds. All of these are unprotected against investment loss. Remember 2008? There was no place to hide! If you owned the S&P in your 401K, you lost over 30% in one year.

The biggest contributing factor to the potentially stronger performance of IUL has to do with  leverage.

Also, the government only lets you get two out of three potential income tax breaks:

1 ) Tax-deductible contributions;

2 ) Tax-deferred accumulation of earnings;

3 ) Tax-free distributions.

IRA's, 401K's,  Roth IRA's, and IUL all get 2 out of 3. See CPA Ed Slott's video>

While contributions to IUL and Roths are not deductible, the investment buildup has the same tax deferral as for a qualified plan. And unlike a non-Roth qualified plan, IUL retirement distributions (via loans) are not not taxable. Roth distributions are only tax-free if taken after age 59 1/2 with certain exceptions, and participation in a Roth has significant contribution limits and other restrictions.

However, the 401(k) or traditional IRA get a deduction now, while some of the Roth or IUL tax advantages come later. Therefore, it is important to run the numbers for given contributions, durations, changes in tax rates now vs. during retirement, and of course, investment return assumptions.

Another way of looking at this is to consider a farmer in one state being told there was to be a 10% tax on the value of seed. Another farmer in a neighboring state is taxed 10% on the value of all harvested grain. If you were a farmer, which state would you rather live in? The "seed" money for IUL is taxed now, but the harvest at retirement may be able to be taken tax-free. On the other hand, the 401K, IRA, or other qualified plan may not be taxed now before assets grow, but the "harvest" at retirement is taxed at ordinary income rates. Of course, it's not that simple. Having more seed to plant can result in a larger harvest. It also depends upon the elapsed time before the harvest. And what if the tax on the harvest were at a different rate than the tax on seed? (See historical tax rates) (Back to IUL Table of Contents)