Life Insurance vs 401K Account for Retirement

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The 401k plan has become synonymous with saving for retirement. There are, however, other options that you can consider, either instead of or in addition to contributing to a 401k. One of these options is to purchase a whole life insurance policy.

Whole life insurance provides life insurance protection, but it also provides an investment. Here are some of the differences between a 401k and a whole life insurance policy.

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Contribution Limits

There is a limit to the amount of money the IRS will let you sock away for retirement without paying taxes on it first. The limit for 401k contributions in 2015 is $18,000.

If you are over 50, you can contribute an additional $6,000. Once you reach this threshold, you lose the tax deductible advantage of 401k contributions.

There is no limit to the amount of money you can pay into a whole life insurance policy. Some financial advisors will recommend ‘over-funding’ an insurance policy so as to increase the amount of money that earns dividends and investment returns.

Tax Treatment

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A 401k or other qualified retirement plan is both tax deductible and tax deferred.

This means that you invest pre-tax money, and you do not pay taxes on the principle or the earnings until you withdraw the money.

This means that you can put more money to work, but it also means that you will be taxed on the full amount of every withdrawal when you start taking money out of the account.

The money you invest in a life insurance policy is tax deferred, but not tax deductible. You invest after-tax money, so you have already paid the tax on the principle amount.

The earnings are tax deferred, so you don’t pay any taxes on that money until you withdraw it.

This makes for a much smaller tax bill once you begin to withdraw the money.

There are other tax advantages to a whole life insurance policy. The dividends you receive from a whole life insurance policy are not taxed as long as they don’t exceed the amount you have paid in premiums. And the benefit that is paid to your beneficiaries when you die is typically free of federal income tax.

Taxation to Heirs

When you pass on your 401k account to your heirs, they will be taxed in one of two ways, depending on how they take the money. If they take a lump sum, they will be taxed on the entire sum, since the contributions were made by you pre-tax.

If they choose to ‘stretch’ the account, turning it into a retirement account for themselves, they will be subject to taxation the same way that you would have had you withdrawn the money during your lifetime, meaning they will be taxed as they withdraw it.

The proceeds from a life insurance policy typically pass on to heirs without incurring federal income tax.

Depending upon the size of your estate and the ownership of the policy, estate taxes may be levied upon the policy’s proceeds, but proper estate planning can provide further protection from taxes.

Ability to Withdraw Funds

A 401k account has fairly strict limits on withdrawing funds. If you withdraw funds prior to age 59½, you will pay a 10% penalty in addition to paying the taxes on the withdrawal.

And you cannot withdraw funds, except for certain reasons related to the purchase of a home or a college education, if you are still employed by the company administering your 401k. In addition, you must begin making withdrawals in the year in which you turn 70½ years old.

If you want to withdraw money from your whole life insurance policy, you can do so, up to the amount of your available cash balance. There are no limits or penalties to the amount that you can withdraw.

Ability to Borrow Money

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You can borrow money from your 401k plan, within limitations.

You can borrow up to half of your balance, but no more than $50,000. If you leave your employer, you have to pay the entire loan back.

If you do not pay back the loan, you will be taxed on the amount outstanding.

If you have a cash balance in your whole life insurance policy, you can take a loan against any or all of the amount.

You can choose to repay the loan according to your own schedule, or you can choose not to repay it.

If there is an outstanding loan on your policy when you die, the death benefit will be reduced by the amount of the loan.

Investment Risk

A 401k plan includes investment options which can usually be selected by the employee. These options can range from a fixed income account to mutual funds to age-based investment portfolios.

Once the investment options are selected, they do not change unless you change them, except in the case of the age-based portfolios, which are automatically adjusted as the employee ages, reducing the volatility as you near retirement.

If you have a 401k account, you should pay attention to where your money is invested, since your portfolio will not be adjusted according to the condition of the market.

Many people lost large sums of money in their 401k accounts during the Great Recession of 2009.

The investments in a whole life insurance policy are fairly conservative. The investment portfolio is managed by the insurance company, and a certain rate of return is guaranteed by the company.

The guaranteed return provided by a whole life insurance policy is often considerably better than a fixed-interest investment, particularly in the current low interest rate environment. The return is backed by the issuing insurance company. Insurance companies are not immune from failure, but have historically been more reliable than the general market.

Other Benefits

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A 401k plan is a good way to save for retirement. Once you retire, however, you must take the money you have saved and roll it into an IRA or another qualified account.

At this point, you are on your own.

You will manage your own investments, and you will determine how best to withdraw the money so that you don’t outlive it.

This can be a challenge for many retirees, particularly as they age.

A life insurance policy can provide a stream of income in retirement, and provide an inheritance as well.

Many policies can be set up to ‘pay’ you a monthly amount to supplement your other income in retirement.

In addition, some policies include a disability benefit, a long-term care benefit, or a benefit for a chronic or terminal illness.

There are other kinds of permanent life insurance that may also have a place in your financial plan. Universal life insurance and variable life insurance can also provide coverage for your entire life, as well as an investment component.

Comparing your options will help you make the right choice for you and your family.

The 401k plan has helped many Americans save money for retirement, and is often considered to be the ‘best’ retirement savings vehicle.

It is not, however, the only way to save for retirement, and in some cases, may not be the preferred way.

Understanding the advantages of other options, especially whole life insurance, will help to ensure a comfortable retirement for you and an inheritance for your heirs.

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