Abstract:
The elongated report is a proposal to invest either in 401k or the Indexed Universal Life (IUL). Important to note that it was very important to discuss the issue as many Americans are just investing their annual contributions to the traditional 401k, juts because others are doing it. But is this the best option to consider always?
The report begins with statistical evidence comparing the performance of 401k and the IUL which gives a clear interpretation that the structure of IUL is itself investor-friendly and is association with features as S&P 500 Index, caps, floors and many others, make it a lucrative option for the investors. However, in order to have an in-depth understanding of both of the investment products we discussed the advantages and disadvantages of each of them and it was very easy for us to conclude that 401k is no match for IUL and suffers from a number of drawbacks related to after payout tax burden, costly and difficult access to funds invested, zero flexibility and lot more. Thus, in the recommendation we provided few options that a 401k account holder can consider to roll over into an IUL policy.
Illustration:
Introduction:
i)Background:
In this section, we will look over some statistical evidence to compare the performance of the 401k plan and the Indexed Universal Life (IUL).
ii)Problem:
The above statistical evidence provides a pre-discussion proof that IUL returns are much more consistent and higher the 401k plan. However, there are publications that raise their concern over the minimum guaranteed returns with IUL policy. For Instance, Important to note that most of the IUL policies have a guaranteed minimum return on the annual basis for the cash value in the account and even if the value of the cash account falls below this rate, the company is obligated to credit the account for the policyholder with the differential amount. However, what is left unnoticed is that many IUL policies do not offer the guaranteed rates on the annual basis but instead over an “indexing period” which could be 5-10 years. For example, if during the 5 year index period, the IUL earned, -10%, 13%, 10%, -8%, 9%, this will average well above the minimum guaranteed rate of 2% annually. However, the example shown below proves that if the rates are not calculated annually, the IUL can also have negative returns:
iii) Purpose:
The sole purpose of this report is to compare the investment performance of the traditional 401k plan and the Indexed Universal Life Plan. By the end of all the discussions both theoretical and statistical, we will come to a conclusion as which investment product is best for the US citizens.
iv) Scope:
As discussed in the problem sections, there are some IUL policies that do not calculate minimum guaranteed return on annual basis and this might affect our conclusion of the report. Hence, we are limiting the discussion on general IUL policies that offer minimum guaranteed returns and calculate them on annual basis. Other than this, we have not placed any limitation on any content of the report.
Discussion:
Many Americans are faced with the dilemma as which investment product is most suitable for them for their after retirement life. We all know about the convectional federal government endorsed product, 401K plan which is a tax qualified, defined pension contribution account where the employer deducts the amount from his employee’s salary and then deposit it to his 401K plan so as to accumulate wealth for the employee’s retirement.
However, many people are now looking forward for another investment product to balance their retirement portfolio well, the Indexed Universal Life Insurance (IUL). The concept of IUL was started in 1980 by the well known insurance firm; E.F Hutton with the sole purpose of creating tax deferred growth. The concept of IUL is much more detailed than the 401K plan. IUL constitutes the benefits of both a life insurance and investment also as it allows the policyholders to tie the accumulation values to the stock market index like S&P 500. In other words, excess of premium payments made by the policyholder above the cost of insurance is credit to the cash value account and the policyholder is given the option to index the cash account with S& P index returns. Furthermore, the IUL policy also provides a minimum guaranteed fixed interest rate component ranging from 2-3%. Thus, the IUL give policyholders the security of fixed universal life insurance with the growth potential of a variable policy linked to indexed returns.
Till now, with the very brief discussion over the IUL and 401K, we can come to a premature conclusion that IUL is a much better investment product than the traditional 401K. However, it is very important for us to weight the advantages and disadvantages of each of them and the following discussion is related to the same:
401K Plan
As already discussed, 401(k) is a traditional retirement saving program endorsed by the federal government itself. Below are some of the benefits of 401K plan:
Advantages of 401k Plan
1. Employers are obliged to deduct the agreed amount from the employee’s salary, thus it is very much convenient for the employee as he knows that till the age of retirement he will face an automatic payroll deduction. Important to note that an employee may agree to contribute 15% of the pay up to a limit of $17,500 unless you’re over 50 years old, in which case you may contribute an extra $5,500 per year.
2. All the deductions made in respect of 401K are tax deductible and hence, the individual will be ending up with lower taxable income and federal income taxes
3. 401K plan also allows the individual to borrow the sum required from his account for reasons as purchase of home, paying for education or medical expenses, etc. However, the loan is required to be paid back within the period of 5 years along with the interests and the interest paid is directly credited to the account.
4. 401K plans also allows the individual to choose from a variety of investment vehicles which includes:
- Money market funds
- Stable value accounts or bank deposit accounts
- Bond Mutual Funds
- Stock mutual funds
- Stocks(both of the company as well as outside)
Important to note that the each accountholder is provided with the option as which investment vehicle he wants his 401k contribution to be invested. For Instance, if the account holder is ready to take risk, he might prefer investment in stocks or bonds as they have high risk which is compensated with the higher earning potential. On the other hand, if he prefers low risk horizon, he will prefer to invest in stable accounts. This feature of 401k offers flexibility to the account holders.
Disadvantages associated with 401K plan
1. Borrowing from own saving’s in 401k is a costly affair and involves a lot of rules and regulations. For Instance, if any of the account holder requests for early withdrawal before the age of 59.5 years, he will be subjected to a 10% penalty and the borrowed income will also be treated as a regular income. Furthermore, the borrower is required to repay the amount borrowed along with 5% interest rate and if in case he is fired from the job before all the payments are made by him, then the outstanding amount will be treated as an early withdrawal. In addition, any money borrowed stops earning interest that would have contributed to the growth of the account.
2. Although the 401k contribution offers tax deduction and all the tax saved grows tax deferred. However, at the time of withdrawals, all the money is treated as regular income and is again taxed at federal taxation rates. So, what the accountholder saved at the time of building their account will be paid back at the time of withdrawals.
Indexed Universal Life Plan(IUL)
Advantages of Indexed Universal Life Plan:
1. The structure of the IUL is convenient and user friendly as the premium paid by the policyholders is bifurcated as premium to compensate for cost of insurance and the other part for cash value account. Unlike 401k, if the policyholder dies, regardless of age, his/her family will be entitled to claim the death benefit which will be free of income taxes. The amount of death benefit will depend upon the structure as how the policyholder has set up his IUL plan.
2. Another important feature of IUL is the indexation option. The policyholder is provided an option to index the growth in his cash value account to the S&500 index. Thus, during bullish times, when the S&P goes up, so does the value of cash account, but when the S& P goes down during bearish periods, the IUL is not affected. This is because only the growth in cash account is indexed to S&P index and the cash value continues to grow at the minimum rate of return of 2-3%, depending upon the company and the product. This floor feature that protects the cash value from loss is one of the most important aspects of IUL
3. IUL also offers premium flexibility to the policyholder. For Instance, if any year, the policyholder is facing financial hardship, IUL allows him/her to pay only the minimum premium amount required to keep the policy in force. On the other hand, the policyholder can also increase the premium to amount to overfund his cash value account within the limit allowed.
Thus, either the policyholder is under financial distress or is enjoying the financial freedom; the IUL structure offers him sufficient flexibility to adjust his premium payment. Furthermore, at the annual review of his account, if the policyholder is not satisfied with the index tied to the growth amount of cash value, he also have the option to change it and also the crediting method (fixed, annual point-to-point, monthly average, etc).
4. Unlike 401k, the premium amount paid for IUL is not tax deductible, however, the growth amount in the cash value is tax deferred just as under 401k.
Disadvantages of Indexed Universal Life Plan:
1. The premium paid into IUL are not tax deductible, hence the policyholder will be ending up with higher taxable income for the assessment year. Furthermore, not all the money paid in excess of paying premium amount is credit to the cash account since part of the money must be used to pay the cost of insurance and other fees.
2. Just as the floor feature protects the decline in the cash value account, the IUL is also having cap feature, which limits the growth of cash value during bullish time periods.
Conclusion:
On comparing the advantages and disadvantages of both 401k and IUL, a careful reader can easily interpret that 401k is no match for IUL. Structural flaws, difficult access and many other disadvantages of 401k make it a inferior investment product as compared to IUL. Below are few arguments in favor of IUL:
1. Unlike 401k, the policyholder of an IUL is provided with a benefit that regardless of his age of his death, his/her beneficiary will be provided with tax-free payment. On the other hand, under 401k, if the account holder is unmarried, all the payments to the beneficiary will be taxed as regular income, a huge burden.
3. As already discussed extensively regarding 401k borrowings, the accountholder has to face number of restrictions relating to age, reason and cost of borrowings. For Instance, any withdrawal from the 401k account before the age of 59.5 years will attract 10% penalty and taxation liability on the sum received. On the other hand, the cash value that builds in IUL can be assessed by the policyholder without any penalties and the sum borrowed are not also taxed and these borrowings can be used for any purpose as education expenses, repairs, vacations etc. The ‘Zero-Cost Policy Loans’ makes IUL much attractive option than 401k.
4. In comparison to the 401k plan, an IUL allows the premium to be paid modified as per the needs and financial circumstances of the policyholder and there are very few limitations on the amount to be modified. On the other hand, 401k plan has a ceiling of $17500 per annum and even if the accountholder is facing financial distress, he cannot reduce the contribution to 401k plan.
5. Although the premium paid under 401k plan is tax deductible and premium paid under IUL is not, but important to note that at the same time, income from 401k is fully taxable and that under is IUL is not. Hence, even if an accountholder of 401k would have saved thousands of dollars for the premium paid, at the time when he will receive the sum, he will end up paying much more than what he saved during his working life.
6. The cash value in IUL can grow without any requirement to take money out and this provides an option to build the funds further. On the other hand, under 401K, the accountholder is obligated to take a minimum amount beginning at the age of 69.5 years and this limits the growth of funds. Overall, this advantage is for people falling under high income group.
7. The growth amount of cash value which is indexed to S&P 500 grows with little risk, this is because, when the market is in bullish periods, the account goes up till the cap amount and when it goes down, and the account stays the same as it has a ‘floor’ provision. Thus, the policyholder under IUL is not worried about his cash value account performance courtesy ‘cap and floor ‘provisions. For Instance, during the time period of 2000 to 2010 when S&P 500 faced multiple ups and downs, indexed life accounts earned 9% per year of average return as they only participated when the market went up, not when it went down. On the other hand, under 401k plan, the accountholder is given an option to choose the investment class in which he wants his contributions to be invested. However, there is no such provision of caps and floors and the accountholder is completely dependent on the performance of the market. However, since recently market saw bearish trend for a long period of time, may retirees were shocked to see that their retirement account has gone down by large amount. This force the retirees to continue working in Wal-Mart stores, warehouses etc to earn a decent living which their retirement account was unable to do so.
7. The cash value of IUL is associated with a minimum rate of return ranging from 2-3% depending upon the insurance company and its policy. However, contributions made to 401k are not having any guaranteed return associated with them.
The above discussed 7 points gives us a clear and concise conclusion that Indexed Universe Life plans are much more attractive investment products than the convectional 401k.
Recommendation:
Works Cited
Bell and Associates. (2013). 401(k) Retirement Accounts Or Indexed Universal Life Insurance?
Equity Indexed Universal Life Insurance. (n.d.). Retrieved July 6, 2014, from http://www.investopedia.com/terms/e/equity-indexed-universal-life-insurance.asp
Galant, P. (2013). Indexed Universal Life Insurance. Optimus Group Plc.
Goodman, M. (2013, May 11'). Advantages of an IUL. Retrieved July 6, 2014, from http://indexuniversallife.net/241/the-401k-versus-the-iul-part-two/
Goodman, M. (2013, May 11). The 401(k) Versus the IUL (Part Two). Retrieved July 6, 2014, from http://indexuniversallife.net/241/the-401k-versus-the-iul-part-two/
Langford, T. (2012). The Top 10 Reasons not to buy Equity Indexed Universal. Alabama.
What Are the Advantages of a 401(k)? (n.d.). Retrieved July 6, 2014, from http://www.practicalmoneyskills.com/personalfinance/lifeevents/benefits/401kadvantages.php
