IUL vs 401k: The Key Differences Explained
Asking whether you should put money in an IUL vs. 401(k) is such a complex question dependent on the individual situation. Quite frankly, with some people’s fact patterns, I would say “do neither” an IUL or 401(k) whereas with others I would say “do both!”
Also, comparing IUL to a 401(k) plan is really comparing apples-to-oranges in terms of:
- their risk profiles
- how they’re each taxed
- the amount of liquidity available before age 59.5.
This article will dig into the advantages and drawbacks of both IUL and a 401(k) as well as discuss why it may be optimal to have some of both, as well as the optimal order to start an IUL vs. 401(k).
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Table of Contents
What is an IUL and a 401(k)?
IUL is a permanent life insurance policy with a complex savings component offering limited stock market exposure, whereas a 401(k) is a pre-tax retirement account invested in actual mutual funds.
This table shows a summary of IUL’s pros and cons from our detailed article on Indexed Universal Life insurance.
Conversely, here is a breakdown of the pros and cons of a 401(k) plan:
In looking at these IUL vs. 401(k) charts you likely noticed that IUL’s pros were often 401(k)’s cons and vice-versa.
So, is it possible that you should perhaps have some of each if resources allow?
How a 401(k) and IUL Can Complement Each Other
Since the comparative tables above reveal that many of IUL’s pros happen to complement the cons of a 401(k) and vice versa, let’s discuss how having money diversified between both may be better than being fully allocated to an IUL vs. 401(k).
Unlimited 401k Upside Coupled With IUL’s 0% Floor
The fact that a 401(k) has unlimited upside potential with full stock market participation sounds great until you fully participate in a multi-year downturn like 2000-2002 or even a single-year plunge like 2008. Both of these negative runs resulted in peak-to-trough portfolio drawdowns over 50%.
Being fully invested in mutual funds without any buffer assets can put a lot of pressure on a portfolio since losses of any magnitude require even more gains to recover. Although you may have time to reinvest and recover while still working, any income taken during the down years compounds the losses since it requires cashing out more shares that have no chance of recovering.
Imagine if you had a few years’ worth of retirement income to draw from inside an IUL. If so, you could’ve let your 401(k) fully heal during the negative years rather than cash out more shares of mutual funds while they’re down to create the same amount of retirement income you took the year before.
By the way, certain IUL policies have uncapped S&P 500 index crediting strategies. Set up a time with one of our independent agents to understand your options here.
Taxable 401(k) Withdrawals vs. Tax-Exempt IUL Income
Less of a distribution from an IUL policy is needed to equal the same 401(k) withdrawal since distributions from an IUL are tax-exempt vs. fully taxable from a 401(k). The tax treatment of Indexed Universal Life can be especially useful as certain political regimes will likely have Congressional control for possibly 4-8-12 years at a time.
Having tax-diversified dollars to draw from will be paramount as tax policy ebbs and flows throughout your retirement years. We have what’s known as a progressive tax in the US, where higher levels of income pay a proportionately higher rate.
Can you think of a reason or two or 33 Trillion why tax rates must get higher in the future?
Being able to supplement that final month or two of income each year from an IUL can keep you from bumping into whatever your next higher tax bracket is. Otherwise, you’ll have to cash out proportionally more shares from your 401(k) to satisfy the same amount of income in those final months which caused you to hit those higher tax brackets.
Limited Liquidity Available with a 401(k) vs. IUL
Any withdrawals to your 401(k) prior to age 59.5 will be subject to not only tax at whatever your highest bracket is but also an additional 10% tax penalty. Some 401(k) plans offer a penalty-free loan for 50% of your account balance up to $50,000 (assuming you have $100k in your account). You must cash out investments to create liquidity for the loan, but you do pay yourself back 100% of the principal interest. The interest rate is generally around the WSJ-Prime rate (8.5% as of December 2023).
The term of a 401(k) loan is generally 5-years and principal plus interest should be paid monthly or quarterly. Failure to pay back the loan on time will result in the unpaid balance becoming a taxable distribution resulting in that 10% tax penalty. If you quit your job, the 401(k) loan generally becomes due within 60 days. If you get fired, you may have until the next tax filing deadline (including extensions) to pay the outstanding loan into another 401(k) or IRA.
Withdrawals from an IUL are completely tax-free up to the amount you’ve paid in premium at any age, while your earnings can continue to grow tax-deferred in the policy. Tax-exempt policy loans are available at any age up to around 95% of your account value with no dollar limit. Your cash value continues compounding in the IUL investments, while the insurance company gives you a loan from their general account.
Technically no principal or interest payments are due since the loan is against the death benefit, which automatically pays off any loans upon your passing. Interest will accrue against your cash which has the opportunity to grow by more than the loan interest depending on your IUL investment strategies. It’s recommended to schedule at least interest-only payments with the insurance company so you can potentially earn compound growth on an increasing balance while paying simple interest on a flat balance. Some IUL policies currently have locked loans in the 5%-6% range.
Learn more about how life insurance loans work in this content roundup we have on borrowing.
Which Should I Start First IUL or 401(k)?
What if you can only currently afford to fund either your 401(k) or IUL right now? If so, you may want to ask yourself questions like these to decide which to contribute to first:
- Will I likely need some or all of this liquidity before age 59.5?
- Will it rattle me if this particular contribution experiences short-term losses?
- Will my income likely be higher in the future pushing me into a higher tax bracket?
If you answered yes to any of the above questions, then perhaps you may consider delaying contributions to your company 401k until you develop enough accessible powder in the short term.
Remember too that Indexed Universal Life is a life insurance product that is both age and health-sensitive. If you see the value of incorporating life insurance as both a risk and tax mitigation tool, then you may consider locking in the insurance sooner rather than later since there is no age or health cap on a 401(k).
That said, if your 401(k) offers a company matching program you probably want to contribute the minimum necessary to qualify for the maximum match (often around 4%-6% of your salary).
IUL vs. 401(k) With & Without a Company Match
There is one huge redeeming quality about a company 401(k), and that would be your free company match. As much as I don’t like the uncertainty and lack of control with a 401(k) plan, if your employer is willing to give you fully vested free money simply for contributing to your retirement, then I suggest you take it.
However, you may want to figure out what your minimum contribution would be to get the maximum company match. If you’re not getting any company match whatsoever, I would strongly consider the potential future implications of putting money into such a plan.
Problems with Maxing 401(k)
Look at it this way, a 401(k) without any matching is like an investment partnership between you and the governmental taxing authority:
You contribute your own money to this partnership.
They contribute the tax dollars you’d otherwise owe if you pay into the 401(k).
You decide on the investment vehicles.
They decide on the partnership’s distribution parameters and timeframes.
You dictate exactly when to take these distributions and at what amounts.
They dictate exactly what their share will be depending on how much you take.
If anyone else invited you into this kind of partnership, would you accept?
Why send your money to federal prison with so many rules and restrictions, especially when the warden can change the terms of your sentence with a stroke of a pen?
Think of how many times both tax rates and distribution rules have changed over the years. You’ll almost certainly put your money in a 401(k) with one set of assumptions, and take it out later with a completely different set of variables you have absolutely no control over.
Did you even realize that everybody’s tax rates are set to revert to the 2017 brackets at the end of 2025?
Looking at this graphic we can see that even the lowest tax brackets were raised when the US was in dire need of tax revenue after World Wars. This time we just have a massive national debt issue. As we discussed before, tax rates are set to rise for almost everybody at the end of 2025.
If you’re in one of the higher tax brackets I can understand maxing your 401(k), especially if you plan to move to a state with lower state tax in retirement (like I plan to do). Otherwise, it’s quite possible you won’t be able to retire in a lower bracket since many folks will lose things like tax credits and deductions for children, mortgage interest, business expenses, etc.
What’s the Catch With IUL?
The catch with IUL is that it is primarily an insurance product with a certain premium obligation. To have it excel for cash value growth and income, the IUL policy must be designed, funded, and monitored properly. Clients should treat Indexed Universal Life as a lifelong commitment to make the most of what it offers.
I highly recommend that any potential buyer of IUL should thoroughly educate themselves about product selection and what-if scenarios before buying IUL.
Also, it’s worth noting that I don’t believe IUL is the end-all-be-all of financial products in general…or even compared to other life insurance products.
It reminds me of the joke asking if Ringo Starr is the best drummer in the world, and comedian Jasper Carrott responding that Ringo wasn’t even the best drummer in the Beatles. 😁😂🤣
I feel the same way about Indexed Universal Life being a tweener product of sorts between its permanent life insurance product peers Whole Life and VUL.
Final Word on IUL vs. a 401(k)
Unfortunately, most financial reps and influencers are attached to either pure investments or pure insurance and their clients suffer as a result. Ironically, these same financial pundits may also be telling you out of the other side of their mouth to diversify.
Complementing a 401(k) plan with IUL may help you be more nimble in managing both asset volatility and adverse tax regimes in retirement. The existence of a non-correlated and tax-exempt asset class like fixed life insurance products can keep you from redeeming more shares in your 401(k) when markets are down and/or taxes are high.
Perhaps more importantly, having a cache of liquidity using fixed life insurance as your own private bank before retirement can create timely investment opportunities or keep you from cashing out a 401(k) for emergencies.
None of this means you shouldn’t do your 401(k), but the question becomes more of when and how much, given its unfavorable rules that can be changed without your control.
Regardless, you should do thorough research and stress-testing of any type of insurance policy before entering into what should be a life-long financial commitment.
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John “Hutch” Hutchinson is the founder of BankingTruths.com, an educational site discussing how to maximize the lifetime benefits of both Whole Life Insurance and Indexed Universal Life Insurance by creating your own private family banking mechanism.
Information presented in this article by John “Hutch” Hutchinson is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities product, insurance products, financial services, or investment strategies. Be sure to first consult with a knowledgeable, ethical, and licensed insurance professional before implementing any strategy or product discussed herein.
