Indexed universal life (IUL) insurance policies, like other permanent life insurance products, feature an insurance component as well as a cash benefit that holders can tap when they want. However, instead of crediting a policyholder’s account based on conservative bond funds, insurers tie it to a stock index like the S&P 500.
Indexed universal life insurance can offer an option for tax-free income during retirement, but there are some downsides to consider when comparing them against tax-advantaged IRA and 401(k) retirement plans.
- IUL contracts protect against losses while offering some equity risk premium.
- IRAs and 401(k)s do not offer the same downside protection, though there is no cap on returns.
- IULs tend to have have complicated terms and higher fees.
- High-net-worth individuals looking to reduce their tax burden for retirement may benefit from investing in an IUL.
- Some investors are better off buying term insurance while maximizing their retirement plan contributions, rather than buying IULs.
How IUL Policies, IRAs and 401(k)s Work
Indexed universal life policies give the policyholder exposure to the stock market while protecting against losses. If the underlying stock market index goes up in a given year, owners will see their account increase by a proportional amount.
Life insurance companies use a formula for determining how much to credit your cash balance. While that formula is tied to the performance of an index, the amount of the credit is almost always going to be less. For example, if the market increases 10% over a year, your cash amount may only go up by, say, 7% or 8%.
Click Play to Better Compare Indexed Universal Life vs IRA and 401(k)
IRAs and 401(k)s are tax-advantaged retirement savings accounts in which you can invest in assets like stocks. Money deposited into the accounts can either be deducted from your taxable income for that year as with traditional accounts, or your deposits can be withdrawn tax-free in retirement a with Roth accounts.
IRAs are set up by individuals while 401(k)s are employer-sponsored. Employers often provide matching contributions to 401(k)s as a benefit.
Costs of IUL Policies, IRAs and 401(k)s
With an indexed universal life policy, there is a cap on the amount of gains, which can limit your account’s growth. These caps have annual upper limits on account credits. So if an index like the S&P 500 increases 12%, your gain could be a fraction of that amount.
Some investors may be willing to accept the potential for lower returns to mitigate their downside risk. Many IUL policies have a 0% guaranteed minimum credit rate, which means that your account would not lose value if stocks declined.
IUL policies also tend to have high expenses, including administrative fees and surrender charges, associated with permanent life insurance. The commission paid to sales reps is particularly steep, possibly amounting to the entire first year of premiums. From there, sales fees frequently continue at around 5% annually before tapering off. As a result, the cash balance of your account may not show any substantial growth for years.
There are no fees to open an IRA or 401(k), however you can face fees and taxation if you withdraw your funds early. With 401(k) plans, investments are typically mutual funds, which may charge fees of about 1% to 2%.
Is IUL Worth It?
IULs may benefit some investors, such as high-net-worth individuals who want a death benefit and who do not want their family to face a tax bill after their death.
Irrevocable life insurance trusts have long been a popular tax shelter for such individuals. If you fall into this category, consider talking to a fee-only financial advisor to discuss whether buying permanent insurance fits your overall strategy.
For many investors, though, it may be better to max out on contributions to tax-advantaged retirement accounts, especially if there are contribution matches from an employer.
Can You Lose Money in a IUL?
With an indexed universal life (IUL) policy, you are usually protected from losing money, depending on the terms of the policy. Some policies have a guaranteed rate of return.
Do You Pay Taxes on IUL?
One of the key features of indexed universal life (IUL) is that it provides a tax-free distributions. So it can be a useful tool for investors who want options for a tax-free retirement.
Is it Better to Have 401(k) or IRA?
Generally, financial advisors would recommend contribu6ting to a 401(k) before an IRA especially if your employer is providing matching contributions. A 401(k) also has higher contribution limits and a higher catch-up contribution for people over age 50.
The Bottom Line
Indexed universal life insurance has some significant differences compared to IRAs and 401(k)s. Mainly it offers a death benefit and an option for tax-free withdrawals during retirement, but investors may potentially earn more through other assets invested through retirement accounts.
Which type of product is right for you will depend on your particular financial situation. Consult a financial advisor to review how each product would work in your overall financial plan.