For many, the 401(k) plan is the default standard for retirement planning. But on social media, some creators seem to be pushing a different rumor: that it’s better to invest in life insurance – namely, indexed universal life, or IUL – for retirement over a 401(k).
What makes the IUL key, some say, is that it offers both a death benefit and a cash value component that mirrors a market index. Unlike a 401(k) plan, account owners can also access this cash value during their lifetime.
But before cashing out your 401(k) for a life insurance policy, here’s what else you need to know.
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ADAdvertisementA refresher on 401(k)s and indexed universal life
401(k)s and IULs might be mentioned in the same conversation, but they’re meant for different purposes.
- A 401(k) plan is a retirement account that lets you invest in the market, typically through mutual funds or ETFs, and often with the added benefit of an employer match. Contributions can be made as pre-tax or after-tax (if you have access to a Roth 401(k) plan), and investments grow tax-deferred. Fees are generally transparent and relatively low compared with insurance products.
- An indexed universal life policy, by contrast, is a permanent life insurance policy with a cash value component that is tied to a market index. While it typically offers a death benefit and potential tax advantages, compared to a 401(k) it also comes with relatively higher costs, more complex rules, and capped returns that can limit growth.
» A deep dive into indexed universal life insurance
401(k)s vs IULs: at a glance
401(k) plan | Index universal life insurance | |
|---|---|---|
Purpose | Provide a tax-advantaged way to save and invest for retirement. | Life insurance that offers a death benefit and a cash-value component. |
Tax treatment | Contributions can be pre-tax or Roth, depending on the account, and grow tax-free. Withdrawals are taxed as ordinary income (Roth withdrawals are tax-free). | Premiums are paid with after-tax dollars and cash value grows tax-deferred. Contributions may be withdrawn tax-free, but not earnings. |
Contribution rules and limits | Annual IRS limits apply, though employees can add after-tax dollars up to the IRS limit. Employers may also match a portion of employee contributions. | Premiums may be limited by policy rules and tax. guidelines. No additional match for policy premiums. |
Withdrawal rules | 10% penalty on early withdrawals before 59½, except in some circumstances. Minimum distributions required starting age 73. | Cash value can be accessed through withdrawals and policy loans, which may reduce the death benefit and trigger taxes or surrender charges. |
Risk exposure | No caps on market gains or losses based on chosen investments. | Returns may be capped, and insurance costs can reduce or offset gains. |
Fees and complexity | Generally lower cost and more transparent about fees and investments, though plan fees may vary by provider. | Higher fees, commissions, and complexity compared to retirement accounts. |
Best use case | W-2 employees saving for retirement, especially those with an employer match. Also offered to self-employed individuals through a solo 401(k). | Select high earners with permanent life insurance needs. |
Should an IUL replace your 401(k) for retirement?
Two aspects of IULs have made it attractive to some as potential replacements for 401(k)s: its cash value component and the flexibility of withdrawals.
Cash value component
The investment aspect of an IUL’s cash value is why some consider it a replacement for 401(k)s, but it doesn't work like a true stock market investment. Instead, policyowners pick which stock and bond indexes they want it to mirror, such as the S&P 500. Their insurance company then pays interest on a portion of the premiums based on that index’s performance. With average stock market returns at 10% annually, some say the cash value’s growth over time could generate enough money for retirement.
Realistically, however, market volatility means the returns won’t always be 10%. And IUL returns are affected by policy rules on caps participation rates, which could eat into investment gains (but also protect from full losses). Policyholders should also monitor both their policy and the stock market closely, as well as pay premiums to keep the policy from lapsing.
In comparison, a person can invest all of their 401(k) contributions in the market, with no caps on gains or losses. Employee contributions are vested immediately, though some companies may have other rules around employer contributions.
Withdrawal flexibility
Because 401(k)s are meant to be invested long-term, taking money out isn’t easy. Early 401(k) withdrawals before age 59½ for nonqualified reasons may trigger penalties and taxes, though some hardship withdrawals may be permitted. It is also possible to take out a 401(k) loan, depending on plan rules.
The appeal of an IUL is that withdrawals can happen when the cash value has accumulated enough, and aren't restricted by age. Withdrawing contributions (though not earnings) could also be tax-free.
In practice, it could be many years of monthly premium payments before the policy accrues enough cash value to withdraw from. That's because premiums typically first go towards insurance costs, administrative fees, and agent commissions first. The interest percentage may be less than what could be earned in a high-yield sayings account or in the stock market.
Additionally, if you’re withdrawing from your cash value and the market has declined, it could potentially reduce your death benefit, says Mindy Yu, a certified investment management analyst and director of investing at Betterment, based in New York. You might also be required to pay more into your policy to cover any market losses and keep it active.
How life insurance could work in your financial portfolio
When it comes to retirement, Nadia Fernandez, a certified financial planner at Financial Finesse in Los Angeles still recommends considering a Roth IRA before an IUL Since Roth IRAs are funded with after-tax dollars, there’s more flexibility on withdrawals. If you have money left over after maxing out your retirement accounts and any health savings accounts, she says, an IUL could be a possibility.
William Toczylowski, a certified financial planner with NerdWallet Wealth Partners based in New York, explains further. “There’s a lot of different things you could do as an alternative to owning life insurance,” he says. For high earners who want to continue maxing out retirement savings, he suggests contributing after-tax dollars into a 401(k) up to the annual limit, as well as doing both backdoor Roths and mega backdoor Roths.
» Learn more: backdoor Roth and mega backdoor Roth
Still, there may be some scenarios where life insurance could make sense. “The first question to ask yourself is what is the need for the death benefit for the insurance policy,” Toczylowski says. Perhaps one spouse earns significantly more than the other, or if there are children or a mortgage involved.
Once a purpose for life insurance is established, it’s easier to explore which options, such as a term or whole life, might work better to avoid overpaying for life insurance.
Toczylowski says he doesn’t view IULs as an asset class. “Just because there’s a short-term tax benefit doesn’t mean it’s the best investment as well,” he says, mentioning that brokerage accounts offer tax loss harvesting while still being liquid.
At the end of the day, when it comes to retirement savings advice, particularly on social media, Fernandez says to consider the source.
“You want to make sure as much as possible you’re getting guidance and information from someone that doesn’t stand to profit from the choice you make.”
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